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CFO McCarthy: Netflix Streaming ‘Not Good’ Yet

16 Jun, 2010 By: Erik Gruenwedel

Netflix CFO Barry McCarthy June 16 said the online DVD rental pioneer’s limited content selection for its vaunted streaming service devalues Netflix streaming as a standalone property.

Speaking at an investor event in Chicago, McCarthy described a “virtuous cycle” in home entertainment that relegates major studio releases to preferred distribution channels such as transactional video-on-demand (VOD) and DVD/Blu-ray Disc sellthrough, and places the subscription-based business model, including streaming, at the end of the chain.

As a result, much of Netflix's streaming content revolves around catalog TV programming and dated movies. Indeed, McCarthy said a common theme among some (short-selling) investors is that Netflix is unable to afford new release streaming content — a reality he said the service is attempting to overcome.

“Is the [current] streaming service all by itself great? No, it’s really not that good,” McCarthy admitted. “If that virtuous cycle ever breaks [however], it will be a dynamically different model. We’ll only know over time whether or not we have completely disproved it.”

Netflix has seen its subscriber base nearly double since 2008 due in large to subscribers having value-added (free) access to movie and episodic television streaming into the home via myriad channels, including Internet-connected Blu-ray players.

McCarthy said there are fundamental cost differences between delivery of subscription streaming and the DVD rental business. They include moving from a variable cost business model (disc postage, handling and packaging costs) to a largely fixed lower cost model delivering of content electronically.

With the future migration to streaming effectively rendering Netflix operating a broadcast business model, the CFO said costs associated with serving the incremental subscriber would be low compared with packaged media.

“The implications for pricing and the opportunities to capitalize on price-elasticity [the change in quantity demanded caused by a change in price] are substantially different and could provide enormous leverage if you have a good [streaming] service,” McCarthy said.

But he said the opposite is also true should Netflix be unable to successfully convince the majority of its subscribers to continue paying for packaged media rentals. Without maintaining high levels of customers predisposed to physical rentals, there is the risk to gross margins and overall profitability, McCarthy said.

He said the average revenue per subscriber has fallen over the past 10 years from $20 per month to $12, while the profit margin per sub has increased.

“There is much greater demand for the service at $9 per month than at $20,” McCarthy said. “By default, the $8.99 plan for one DVD rental out at a time has becomes the price point for streaming. It’s been great for the business, increased demand and profitability.

The executive said rental preferences among subscribers have little changed over years from a predominantly (70%) catalog-driven user. Indeed, shipments of rental discs continue to grow on a year-over-year basis at about 18% to 20% a year.

McCarthy said the DVD-by-mail business drives Netflix’s competitive advantage over other services, adding that if investors didn’t care about earnings and free cash flow, the service would spend more to license content.

He said Netflix’s year-over-year spending on streaming content has grown “dramatically” compared with the growth rate in overall revenue and profit. The executive also said that many new releases are contractually obligated toward cable channels such as HBO (Warner) and Starz (Sony).

“[Studios] need to have a healthy business so we can have a healthy business,” McCarthy said. “And our objective is to grow their revenue stream as well as our own.”

He said the launch of the Apple iPad tablet computer has been a public relations win for Netflix, despite the fact the proportion of streaming to the device is “inconsequentially” small compared with video game platforms such as Xbox 360, PlayStation 3 and Nintendo Wii.

McCarthy said the barriers from walled operating systems are coming down so that in the future Internet TVs with built-in browsers will allow users to rent movies anywhere on the Web.

“In that world, I think brand will matter,” he said.

Separately, Netflix named Ann Mather, an entertainment industry veteran who has served senior finance roles at Pixar Animation Studios, The Walt Disney Company and Paramount Pictures, to its board of directors. 

Mather’s appointment, effective July 1, maintains a seven-member board with the previously announced departure of Greg Stanger.  She will chair the board’s audit committee.

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