Netflix: Reed and Ted's Excellent Adventure
Board: Value Hounds
Netflix third quarter revenue was a record-breaking $1.1 billion for a 22% gain year-over-year. More importantly, operating income is beginning to recover after bottoming in 2012 and increased an astounding 254% as operating margins went from 1.8% one year ago to 5.2% for a 340 basis point improvement.
Hastings reported the service had slightly over 40 million members in Q3 -— up from 30 million Q3 2012. Around 5 million subscribers have a dual (DVD/streaming) membership. The company added a total of 9.39 million paid, unique subscribers.
Combined results show Netflix is adding subscribers growing revenue at double-digits, and more importantly, leveraging those additions against costs and improving margins. The leveraging of content costs has been a question mark. Leveraging is just analyst-speak for fixed costs successfully offset by revenue gains allowing those costs to be spread across more subscribers rather than increasing in tandem. In other words, margins improve.
Netflix is two businesses and by looking at their relative contributions, it becomes clearer where the improvements are coming from. The two businesses are consolidated streaming (international and domestic) and DVD rentals. Streaming is growing fast and consuming most of the cash while DVD rentals are slowly disappearing and paying most of the freight.
Streaming is adding subscribers rapidly with DVD continuing to lose members. In the past year, streaming added 10.9 million and DVD lost 1.5 million. On a quarterly basis, domestic streaming growth is far slower than international as the domestic base is large and maturing. Each of the last four quarters shows domestic adding at a slightly lower percentage to the base. International is still adding in the high teens, but is also down year-over-over year. As the consumer base grows it’s more difficult to keep adding at higher and higher percentages. The $64 billion question is how fast will adds decline and how many members are ultimately achievable. Comparing domestic member increases to the growth period in DVDs (pre-2010) it’s obvious that it’s slowing noticeably as the membership exceeds 30 million.
[See Post for Tables]
Financial results Netflix style
Revenue and operating income reported by Netflix are a combination of GAAP and non-GAAP in an attempt to help the investor see how each streaming business is doing. By the reported numbers, the domestic streaming service appears to be a profitable contributing to profits. Netflix calls this contribution to profits.
By the third quarter, domestic streaming was reported as contributing $166 million to profit at 24% margins. International continued to run in the red with a ($74) million operating shortfall and a (40)% margin. Contribution to profits has a uniquely Netflixian definition. It starts with the revenue generated by each segment and subtracts the cost of sales and marketing costs only. No other operating expenses are recognized.
Cash based financial results
Netflix changed its reporting recently and is making the cost of sales available by segment. In the past, DVD costs were combined with streaming making it hard to know just how each segment was doing. It’s now possible to compare the actual contribution to profits of streaming and DVDs. Netflix is still running on DVD earnings and without them, would be in the red.
GAAP costs of sales are not the same as cash cost of revenue. GAAP costs are based on amortization and that isn’t what the company spends in a given quarter. In the third quarter, cash costs of streaming outstripped GAAP by $20 million because amortization does not accurately reflect the cash cost. Amortization spreads costs over discrete periods disregarding when the cash was spent. Amortization is a close approximation but slightly understates what Netflix is spending on content. While this is absolutely compliant reporting, it’s helpful to look at costs a different way.
Cash cost of content, profits, no profits and margins
Since Netflix‘s future is streaming and the past is DVDs, it makes sense to look at them as two separate businesses and to combine the streaming businesses. International expansion is the growth vehicle and it doesn’t make sense to uncouple it from domestic and regard them as separate.
The following table is how Netflix reported contribution to profits and it’s a mash-up of GAAP revenue/costs but operating profit margin is redefined (contribution to profits) and does not include administrative and tech. It tends to overestimate the profitability of domestic streaming and makes it difficult to evaluate how combined streaming is doing.
Domestic streaming has seen huge improvements in both gross and profit margins supporting the arguments that content and marketing costs can be successfully leveraged across a bigger subscriber base.
International streaming has gained some ground but is still a drag on overall streaming profitability.
Without combining streaming into the one business, it’s not possible to know if streaming is making Netflix money. The combined business is doing better by the Netflix definition of profitability and is a far better business than it was a year ago.
Using Netflix definitions of profit, the streaming business is making strides towards viability as a standalone business, but the model ignores some important costs including tech and administrative and per the last conference call, those are set to increase in 2014. If tech and administrative expenses are added to marketing costs, streaming operating losses are around ($40) million and it that affects the bottom line lowering earnings. Now that the company is reporting GAAP cost of sales separately for each segment, it’s finally possible to calculate gross margins, estimate the percentage of operating expenses that accrue to streaming and DVD and know which business is making positive contributions to earnings on a GAAP basis.
Non-GAAP X-ray of Netflix profits
Using the newly reported cost of sales separately for each segment, it’s finally possible to go beyond GAAP and estimate the cash cost of content. Since the Netflix business model makes it necessary to use amortization for cost of sales, being able to calculate the actual cash cost improves visibility into bottom line profitability. It’s not GAAP and doesn’t replace GAAP—it’s just another way to understand the business.
Cash costs start with the cash flow statement and go on to blend in a portion of the costs of sales from the income statement. To estimate operating income, administrative and tech expenses are added to marketing and apportioned based on revenue percentages for DVD and combined streaming. Interest expense is not included.
Streaming costs and margins
Netflix’s combined streaming business is close to making a profit and has improved since Q3 2012. DVDs continue to pay the costs and make the profits. The Q3 EPS of 52¢ was quadruple the Q3 2012 13¢ but the increase was due to smaller losses in streaming and continuing profits in DVD rentals. The DVD business lost 1.5 million members in the last 12 months and revenue declined 18.2% or around $50 million, but it still managed to offset streaming losses. Absolute subscriber defections are slowing and there will be a core group that always wants DVDs and DVD+streaming and numbers will stabilize -- around 5 million is my guess. DVD profits won’t be able to offset streaming losses much longer, but streaming appears to be on track to hit profitability in the next few quarters. An indication that streaming is much improves are the expanding margins as revenue growth outpaces costs.
DVDs have been good to Netflix
In the excitement of Netflix’s switch to streaming and the seemingly boundless video on demand market, DVDs have become an after thought and it’s easy to forget how good the business was when DVDs ruled. Growth was off the charts; earnings reached all time highs and margins expanded to record levels.
In 2008, streaming was in its infancy—there were 12000 titles compared to 100,000 individual DVD titles. The tables through 2009 are largely DVD results and streaming was a small part of business and thrown in for nothing with a DVD membership. All margins were better than streaming margins and subscriber growth pre-2008 was far more rapid than current rates for domestic streaming. DVDs were a great business and investors loved the company.
In spite of the continuing slide in the DVD business it maintains high margins and pays for the costs of the streaming business allowing Netflix to return to positive earnings as losses in streaming moderated. In the recent quarter, DVD gross margins were 49% and the contribution to profit margin was 48%. It’s an efficient moneymaker.
DVDs are unfortunately a dinosaur and Netflix has prudently hitched its wagon to the VOD star becoming a force in streaming, shaping the future of VOD and pushing the boundaries. Unquestionably they positioned the business to dominate VOD but whether they can recreate the high growth, high margin business DVDs made possible is an unanswered question. Successful return to the glory years means Netflix will have to transcend what is currently regarded as the upper limits of an attainable market—30 million domestic subscribers and 114 million international subscribers. The 30 million seems to be where traditional cable tops out domestically and 114 million is the number of HBO global subscribers. Nobody really knows how high that number can go—no VOD service has been there before to blaze the trail creating a quantifiable market.Whither thou goest Netflix?
Who knows is the obvious answer. The sky-high valuations in excess of the most optimistic DVD years would suggest the market suspects Netflix will blow through the 30 million/114 million numbers. Even though VOD is a few years old, the limits of the VOD market are an undiscovered country and open to brand new numbers never reached by cable. Netflix has obscured even the obscure with its decision to become a producer of content making it a hybrid between premium cable channels and HuluPlus. It’s difficult to know where subscriber numbers, revenue growth, content costs and competition are going to take Netflix’s profits, but we have the tools to track them and it’s never a dull company.New Developments in MediavilleSo you want to be in movies?
Ted Sarandos is predicting the death of movies, killed by greedy theater owners who won’t allow Netflix to stream new releases. Since the major studios stubbornly cling to wanting exclusivity for months after release, Sarandos has threatened to enter the movie business. He will need a lot more money. Netflix now has $1.6 billion in balance sheet content liabilities due within one year and $2.3 billion off balance sheet liabilities coming due within 12 months—nearly $4 billion. There will be additional costs added on during the year-there always are. TTM revenue is $4.1 billion.
Netflix’s streaming selection of movies is not great. Can they afford to pay for same day release blockbusters and make movies? Get out the checkbook.
Netflix chief content officer Ted Sarandos launched a blistering attack on theater owners for stifling innovation, warning in a speech Saturday that they “might kill movies.”
“Theater owners stifle this kind of innovation at every turn,” he said. “The reason why we may enter this space and try to release some big movies ourselves this way, is because I’m concerned that as theater owners try to strangle innovation and distribution, not only are they going to kill theaters–they might kill movies.”
Just days after indicating on Netflix’s third-quarter earnings calls his interest in getting into the movie Sarandos went a step further today when he suggested releasing “big movies” on Netflix the same day they appear in theaters.
“Why not premiere movies on Netflix the same day they’re opening in theaters? And not little movies. House of Cards Season 2 in the can almost
Sarandos also hinted plans at a third season of “House of Cards,” which is currently in its last week of shooting season two. FX and Turner Hate Netflix
Interesting article on how content providers and distributors work together. Video on demand has altered the relationship and the industry is in flux. Unbelievably, networks that do VOD can’t stream entire current seasons of their shows and are limited to five. Netflix doesn’t get streaming rights usually until the new season has started, then they can show the previous year. So current complete seasons are not easily viewable except by paying iTunes or Amazon for episodes.
Netflix says it will not pay the standard high prices for programming if it ends up being available on other networks prior to Netflix getting it a year or so later. http://www.vulture.com/2013/10/fx-turner-netflix-battle-for-...
Let’s say that your friends have become increasingly obsessed with a new TV show that’s already on episode eleven of a thirteen-episode season. You finally realize that you are missing out on something great and want to quickly catch up in time for the finale … but you’re out of luck. Most networks only have rights to stream the last five episodes of their series on their websites and VOD.
Netflix usually doesn’t post the whole season until a few weeks before the next season begins. But Vulture has learned that a couple of cable’s biggest programming powerhouses, FX and Turner, are fighting back on this industry standard, telling TV studios that they will not buy any new show unless it comes with the right to keep streaming every episode in a current season until it ends.
Netflix has made its position on the issue clear: If studios give into these demands, the service could dramatically cut the price it pays for streaming rights, potentially denying producers millions of dollars in revenue. A battle of the binge is brewing
But FX and Turner don't believe it's win-win-win, which is why they want streaming and VOD rights to the entire current seasons of their series, not just the last five episodes. The main argument: that the incomplete set hampers a network’s chances of turning latecomers into regular viewers in a first season. "Unless you have the whole season up, you're not really letting viewers come into a series," our veteran industry insider says.
Comcast is pitching a new low-cost, broadband-plus-TV bundle designed for consumers who have shunned or canceled traditional cable TV, using HBO as a key enticement for those who don’t want to pay for a full package with other cable channels like ESPN, Fox News or TNT.
The nation’s No. 1 cable operator confirmed that it has launched a trial offer of “Internet Plus,” which includes broadcast TV, video-on-demand, HBO (and HBO Go) and 20- or 25-Mbps broadband. Subscribers also get access to Xfinity Streampix, Comcast’s Netflix-style multiscreen VOD service with several thousand TV shows and movies.
The bundle is priced at $39.99 or $49.99 per month for 12 months (depending on market), which is $15 less than the starting price for bundles with Comcast’s expanded basic cable lineups. The price goes up to $69.95 monthly after the first year. The limited-time offer is being promoted across Comcast’s footprint to new residential customers, but may not be available in certain areas.
Media always provides excellent dish. Stay tuned.