Our current price estimate of $126 for Netflix implies a premium of about 75% to the market price and is hinged on our expectation that Netflix will recover from this temporary slump. However, 2011 showcased the company's delicate relationship with its customers, which will need to be nurtured even more now.

Netflix's expensive arrogance

Beginning 2011, Netflix seemed unstoppable and the accelerating subscriber additions demonstrated high customer demand for its services. The company misunderstood the reason behind its success and daftly hit customers with a sudden 60% price increase for dual-service subscribers (DVD+streaming) without explaining the rationale behind this decision. Netflix did not have content that would make it indispensable, and instead, customers were partly sticking around due to its low subscription price.

The decision not only put the brakes on expansion but led to subscriber losses for the first time in many years. The situation was exacerbated after Netflix's announced rebranding of its DVD business to Qwikster. Netflix later reversed this decision. The subscriber backlash and resulting smaller customer base sent the stock price plummeting. We note that the subscriber losses were primarily concentrated among DVD customers.

Transformation

From being a collator of older content, Netflix began its transformation in 2011 as one of the service providers for first-run TV content. The company acquired series such as "House of Cards" and "Lilyhammer," and is now working with a director on the production of 13 episodes of a horror series, "Hemlock Grove." While this is just the beginning of a transformation, Netflix will face severe competition from traditional pay-TV service providers. This will lead to higher content costs as we have already forecast.

International expansion

Netflix began its international expansion in 2010 by entering Canada, and the pace accelerated in 2011 with a foray into Latin American markets. The company also announced  the U.K. and Ireland as its next destinations.

Nevertheless, doubts surround the prospects for success in Latin America and the U.K. The former has obstacles in the form of low per-capita income, lack of credit card usage and low broadband penetration. While the latter has strong local competition from broadcasters and Amazon's Lovefilm. However, over a period of seven to eight years, we expect Netflix to gain a significant subscriber base in international markets.