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Netflix Eyes Profitable Disc Rental Future

23 Apr, 2013 By: Erik Gruenwedel

Netflix’s pioneering by-mail disc rental business is so-well entrenched, it should remain profitable for years to come, CFO David Wells told analysts.

With Wall Street transfixed on Netflix’s leadership role in the subscription video-on-demand market, and eager to close the book on packaged media, Wells said the service has taken a more pro-active approach toward its 8 million disc subscribers than it did 18 months ago.

Speaking April 22 in the Netflix’s fiscal call, Wells said the service dropped giving guidance on physical rentals, opting instead to focus on profitability.

“That really is the only thing that matters at this point. We’ll continue to report subscribers and revenue, but we’ll only give guidance on the profit,” Wells said.

Netflix reported first-quarter (ended March 31) contribution income from disc rentals of $113 million on revenue of $243 million, compared to contribution income of $146 million on $320 million in revenue during the previous-year period when it had 10 million disc subs.

Indeed, Netflix generated $14.13 of income per disc subscriber compared to $4.50 of income per domestic streaming subscriber — underscoring the reality rentals of DVD and Blu-ray movies is three-times more profitable than streaming. Disc rentals generated 68% of Netflix’s Q1 contribution margin.

In his typical style, CEO Reed Hastings attributed disc rental’s resilience and surprising low subscriber loss with factors such as a “robust holiday DVD release slate and publicity for new movies created by the awards season telecasts” as paramount reasons for boosting Q1 disc results compared to the previous fourth quarter.

Regardless, CFO Wells said it takes a minimum of 1 million subscribers to maintain profitability on disc rentals.

“Given that we’ve got a large investment in equipment that we won’t have to continue to invest in our content library and our DVD content library, we feel pretty good about our ability to maintain those margins going forward,” Wells said.

Eric Wold, analyst with B. Riley & Co. in Los Angeles, contends the recent launch of Redbox Instant by Verison could undermine Netflix’s disc rental ace card going forward.

“Redbox Instant [has] the potential to siphon off some of Netflix’s high-margin DVD subscribers, we continue to believe this could be a drag on [second half 2013] profitability trends,” Wold wrote in an April 23 note.

Meanwhile, Wedbush Securities analyst Michael Pachter — a longtime Netflix bear — believes Netflix underreported $136 million of “other operating expenses” by not applying the general & administrative (G&A) and technology costs proportionally to streaming and disc rental segments.

Pachter said that if Netflix allocated the operating expenses correctly, domestic streaming would generate a contribution profit of only $39 million Q1, while disc rentals generated operating profit of $90 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,” Pachter wrote in an April 23 note.

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