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Netflix Adds Subs, But Q4 Profit Drops 13%

25 Jan, 2012 By: Erik Gruenwedel

Maligned disc rental business contributes operating income of $194 million on revenue of $370 million

Netflix Jan. 25 said it added 610,000 domestic subscribers in the fourth quarter (ended Dec. 31). Of that number, 220,000 were streaming-only subs. It added 380,000 streaming subscribers internationally.

Netflix ended the quarter with 24.4 million domestic subscribers, compared with 19.5 million domestic subscribers at the end of the same quarter the previous year. At the end of the third quarter, Netflix had 23.8 million domestic subscribers. The company ended the period with 21.67 million domestic streaming subscribers, which included 8.4 million hybrid streaming/disc subs.

"We exceeded our domestic streaming contribution margin target of around 8%, due to higher than expected streaming members and revenue, as well as some under-spending in both content and marketing," CEO Reed Hastings and CFO David Wells wrote in a shareholder letter.

Total international subs reached 1.86 million compared to 510,000 a year ago. The international properties, which include Canada, Latin America, Mexico and the Caribbean, generated an operating loss of $60 million.

The streaming service recorded total net income of $41 million, down nearly 13% from net income of $47 million during the previous-year period. Domestic revenue topped $847 million ($876 million globally), compared with revenue of $592 million ($596 million) last year.

Overall domestic profit totaled $246 million, up 62% from operating income of $152 million last year.

Los Gatos Calif.-based Netflix said it lost 2.76 million disc subscribers during the period, underscoring further fallout from last fall's price hike to it popular hybrid disc/streaming rental plan. It ended the quarter with 11.2 million disc subscribers — which includes hybrid subs — compared to 13.9 million disc subs in the third quarter.

Notably, the domestic disc rental business, which includes DVD and Blu-ray Disc titles, generated operating income of $194 million, with a contribution margin exceeding 52%. Disc revenue topped $370 million.

The strong incremental revenue/margins supplied by disc rentals underscore a dilemma to Netflix’s mantra that the future is paved in streaming-only gold. In reality, the foundation for ubiquitous streaming is being paid for by old-school packaged media, according to Michael Pachter, analyst with Wedbush Securities in Los Angeles.

“Each DVD customer generates $5/month in operating profit, while each streaming customer generates less than $1/month in operating profit,” Pachter said. “That means they need 5 new streaming subs for each 1 DVD customer they lose.”

Eric Wold, analyst with B. Riley & Co. in Los Angeles, said the loss of disc subs was on the low end of company projections. Wold said Netflix is hedging its bets that declining disc subs ultimately will save the company higher operating costs compared to streaming.

"I’m not sure if they necessarily want to immediately stop the DVD subscriber losses," Wold said. "If a subscriber chose to cancel that is probably better for the company in the long run. Over [time] the profit contribution from a streaming subscriber has much more leverage than a DVD subscriber and requires much less working capital investment and variable cost control…so the mix shift will be beneficial."

Hastings and Wells, in the letter, said that as a result of termination of the content license agreement with Starz Entertainment at the end of February, Netflix will lose 15 major Disney titles, including Toy Story 3 and Tangled, among others. The Disney titles represent 2% of Netflix's domestic viewing, according to the executives.

About the Author: Erik Gruenwedel

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