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Analyst: Netflix Overstates Domestic Streaming Profitability

24 Oct, 2012 By: Erik Gruenwedel

When Netflix reported a $91 million contribution profit from its domestic streaming business — which represented 16.4% of its total third-quarter (ended Sept. 30) margin — it would appear the company’s focus on subscription video-on-demand was beginning to bear fruit.

Contribution profit is determined by revenue minus the cost of that revenue and related marketing expenses.

Upon closer scrutiny, however, it appears the Los Gatos, Calif.-based rental service overstated streaming’s positive impact on the bottom line by not fully allocating related technology and development (T&D) and general and administrative (G&A) costs, according to Michael Pachter, analyst with Wedbush Securities in Los Angeles.

Netflix has long put most of its eggs in the SVOD basket — a market it essentially created in 2007 while at the same time giving its pioneering by-mail disc rental business the cold shoulder.

While few dispute digital distribution is the future of home entertainment, Netflix is betting its future on it — so much so, it is aggressively launching service internationally, largely on the back of anticipated domestic subscriber growth and disc rentals.

Indeed, disc rentals, which include hybrid disc-streaming subscribers, generated $131 million in contribution profit and more than 48% margin.

Pachter said the international streaming segment (which generated a $92 million contribution loss in Q3) accounted for 9%, 7% and 5% of total revenues in the last three quarters, respectively, yet was allocated 22%, 20% and 19%, respectively, of cost of revenues and marketing expense in those time periods.

Meanwhile, when factoring in T&D spending and G&A to the three business units, the domestic streaming segment is far less profitable than its contribution profit would suggest. Pachter said T&D and G&A — both are excluded from the contribution profit calculation — disproportionately impact domestic streaming as the bulk of T&D expenditures are incurred to support streaming, and G&A should be allocated based upon revenue.

“When combined, these two line items offset over 90% of Netflix’s domestic streaming consolidated contribution profit through the first three quarters of the year,” Pachter wrote in an Oct. 24 note. “We think that this is a gross [understatement], and one that has led many investors to conclude that the domestic streaming business is highly profitable.”

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