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Netflix’s House of Cards

24 Jul, 2013 By: Thomas K. Arnold

I found it quite interesting that Netflix’s stock price plunged — by as much as much as 11% in after-hours trading July 22, even though the company appears healthier than ever.

Its subscriber count was up from last quarter, revenue continues to trend upward, and a week earlier Netflix snagged more than a dozen Emmy nominations for original series such as "Arrested Development" and "House of Cards," the first Internet series to be nominated in major categories.

Attribute this apparent dichotomy to the fact that Wall Street is a demanding beast, with high expectations. Netflix reported it added 630,000 streaming customers in the United States in the second quarter, a healthy number, by any measure — except, of course, to analysts, who had expected an average of 700,000.

And yet analysts aren’t exactly being “tiger parents” with unrealistic (and, perhaps, unattainable) expectations. Netflix’s own high-end forecast was 880,000.

While the Street and analysts fret about subscriber growth rates, they ignored the 800-pound gorilla buried in the financials: Netflix lost nearly 500,000 disc subscribers in the quarter. It was the first uptick in packaged-media attrition since Netflix began separating disc and streaming results in 2011.

So what, right? Wall Street, analysts, media, pundits and Netflix management have been preparing packaged media’s obituary for years. The only problem with their “perfect” streaming world is that packaged media is what keeps Netflix’s bottom line from turning the same color as its red logo.

Indeed, Netflix generated a $109 million contribution profit on $232 million in revenue from DVD, Blu-ray Disc and hybrid streamers in the quarter. That’s nearly a 47% contribution margin, and more than twice the 22.5% contribution margin heralded by Netflix on its domestic streaming business.

In fact, packaged media represented the bulk of Netflix’s overall operating profit when factoring in technology, marketing and rising content costs associated with streaming. And don’t forget, Netflix’s ambitious international expansion, which it claims is being supported by domestic operations, lost $66 million in the quarter.

Michael Pachter, research director with Wedbush Securities in Los Angeles, contends Netflix neglected to attribute $137 million in G&A and technology spending toward streaming expansion both domestic and abroad. If this spending would be properly allocated, Pachter writes, domestic streaming would generate an operating profit of only $65 million for the second quarter, while domestic DVD would generate an operating profit of $79 million.

And Netflix plans to bow service in Holland by the end of the year, furthering expansion costs that must be minimized elsewhere in the business such as packaged media.

Yet, when asked during Netflix’s inaugural live video webcast July 22 about management’s apparent indifference toward disc rentals, CEO Reed Hastings — as usual — shrugged off concern. He reiterated that 7.5 million subscribers opt for packaged media from Netflix, which he said carries any conceivable title worth renting — more so than SVOD.

In their letter to shareholders, Hastings and CFO David Wells wrote, “The world is moving from linear TV to Internet TV, and Netflix is leading that evolution.”

And that may be true. But until it gets there, Netflix would be wise not to ignore its by-mail disc roots.

“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 a July 23 note.

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