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Analyst: Netflix Masking DVD 'Profit Potential' With Streaming

3 Mar, 2010 By: Erik Gruenwedel

Netflix could unleash even greater profit margins with its by-mail DVD rental business if it cut back on digital streaming expenses, an analyst said.

Eric Wold, with Merriman Curhan Ford in New York, said Netflix could elevate itself as the go-to rental service by non-subscribers (i.e., kiosk, in-store and VOD customers) due to its large catalog (100,000+ titles) of older movies.

Los Gatos, Calif.-based Netflix generates about 70% of revenue from catalog titles, according to company statements. In addition the company said it has reached less than 10.8% household penetration in the United States, which Wold said suggests tremendous opportunity, considering there are 92 million households with a DVD player.

“Not only does Netflix stock a majority of older titles that can easily be searched and accessed (as well as recommended by Netflix’s proprietary algorithms), but it can fulfill consumers’ needs for older movies that do not have to be watched immediately,” Wold wrote in a note.

The analyst said the catalog consumers generate lower churn (less likely to cancel monthly subscriptions) and higher gross margins since older DVD movies have a higher degree of depreciation and are less likely to be part of studio revenue-sharing agreements.

“Even with the advent of additional streaming/VOD services coming into the home, we believe the relatively low price point of DVD rentals will keep the physical DVD segment strong with increasing penetration for at least the next 10 years,” Wold wrote.

Indeed, Netflix increased its projected operating margin to 11% from 10% in 2010, which Wold considers conservative given the service’s 11.5% operating margin in the most recent quarter and the millions it spends affording subscribers with free access to streaming content.

The analyst said efforts by Wal-Mart, Best Buy and TiVo to rollout digital content services, including movie downloads and streaming, revolve around new releases and are complimentary to Netflix’s Watch Instantly service.

“We believe Netflix has the opportunity to throttle back the streaming spend to some degree given the value of the by-mail service, which could unleash tremendous earnings and cash flow power over the coming years (well above current expectations),” Wold wrote.

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