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Analyst Glimpses Beyond Netflix's Pomp and Circumstance

23 Jan, 2014 By: Erik Gruenwedel

Despite launching mailers heralding its disc legacy, Netflix remains obtuse about a shrinking packaged-media subscriber base

Netflix again exceeded Wall Street expectations and thrashed short-sellers’ fantasies in fourth-quarter results, sending shares up nearly 17% to $390.

Yet, Netflix lost about 200,000 disc subscribers during the quarter, ending with 6.93 million subs — down from 8.22 million at the end of Q4 in 2012. While Netflix executives focus primarily on streaming, its domestic by-mail disc rental business continues to be its most profitable segment, with a contribution margin of 52% in Q4, compared with 23% for domestic streaming and a 26% contribution loss for the international business.

Despite accounting for only 18% of consolidated revenue in Q4, packaged media accounted for 49% of total contribution profit. Further distorting the picture, the disc business is burdened by little technology spending, accounting for even higher net profits. Subscriber attrition to Redbox and VOD rental competitors will likely continue to put pressure on Netflix’s margins, according to Wedbush Securities analyst Michael Pachter.

The analyst believes Netflix remains disingenuous in how it allocates expenses within its domestic, international and disc rental businesses.

Specifically, Pachter believes Netflix fails to allocate “other operating expenses,” which totaled $144 million and consisted of general and administrative, and technology spending. The analyst contends that of the $98 million spent on technology, about $18 million was spent on disc rentals, while the $80 million of tech spending attributable to streaming should be allocated based upon use, suggesting that around 23% (around $18 million) should be allocated to international, and the remainder (around $62 million) should be allocated to domestic streaming.

In addition, Pachter believes G&A spending should largely follow revenue, with 63% ($29 million) allocated to domestic streaming, 19% ($9 million) to international streaming, and 18% ($8 million) to disc. He said that if the cost allocations are correctly applied, domestic streaming generated operating profit of $82 million, while disc generated operating profit of $84 million, and international an operating loss of $84 million.

“The company’s lack of concern about declining DVD subscribers is baffling, and management optimism about contribution profit from domestic streaming growth is misguided, in our view,” Pachter wrote.

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