Netflix (NFLX) investors clearly believe that the company's marginal profitability is a blip on the radar screen. Pretax margins, which had been as high as 14% in early 2011, have dropped to only 1% in recent quarters. This sudden drop in profitability is generally attributed to two factors: 1) high start-up costs associated with international expansion, and 2) the lingering effects of Netflix's ill-advised (and subsequently abandoned) plan to spin off its DVD-by-mail business. As the international business matures and customers forgive Netflix for the Qwikster debacle, the company's profits will bounce back, along with the share price. So the story goes.
However, Netflix's margins are doomed. While the company's streaming business is profitable in the U.S. and Canada, it will never achieve the level of profitability of the DVD-by-mail business. The international segment may eventually become profitable, but will have to survive on even thinner margins than the domestic streaming business. Netflix has a permanent problem: when it attempted to spin off the DVD business, it killed off the truly profitable part of the enterprise. Streaming margins are peaking well below 10%, and revenue growth is too slow to justify the company's current enterprise value of $4.7 billion, or approximately 2X streaming revenue. The stock is therefore significantly overvalued at its current price above $90.
The Death of the DVD
Netflix's pricing changes and associated DVD spinoff plan last year effectively torpedoed the DVD business, which was providing a contribution profit of $194 million as late as Q4FY11 (the first time that domestic streaming and DVD results were broken out). The number of paid DVD subscriptions has rapidly dropped from 13.8 million in last year's Q3 to less than 8.5 million in this year's Q3. Meanwhile, the contribution profit had dropped to $131 million as of last quarter, and is expected to decline again next year. The pace of subscriber loss has slowed, but is still fairly rapid at nearly 700,000 lost DVD subscribers per quarter. Unless Netflix manages to halt the subscriber loss very soon, the DVD business is likely to lose critical mass by the end of 2014.
Netflix's management team has taken a strangely stoic view of this deterioration, arguing that it was bound to happen because of a general shift to online media consumption. However, the DVD business is the profit center for Netflix, with a roughly 50% contribution margin. Management ought to be making strenuous efforts to stem the decline of the DVD business. Instead, CEO Reed Hastings seems to be content to encourage the migration of DVD subscribers to the streaming-only subscription service.
Streaming Just Isn't That Profitable
There's just one problem; the streaming business is not very profitable, and margins in that business are peaking. In the most recent shareholder letter (link above), Netflix reported a domestic streaming contribution margin of 16.4%, 80 basis points higher than the previous quarter, with Q4's contribution margin projected at 17%. However, this compares with sequential increases of more than 200 basis points in the previous two quarters. The drop off in margin increases suggests that contribution margin will peak just below 20%.
Moreover, in Netflix's accounting scheme, "technology and development" costs are excluded from the contribution cost allocations. However, these expenses are almost exclusively associated with the streaming business. In 2006, before the launch of streaming video (and when the DVD-by-mail business was only 25% smaller than it is today), technology and development costs totaled $48 million for the full year. Today, these costs exceed $80 million per quarter! Nearly all of the additional $70 million in quarterly technology spending can be attributed to the streaming business, and most of that is represented by the domestic business (which still makes up more than 85% of streaming revenue). $40 million is probably a best-case estimate of the technology and development expense associated with the domestic streaming business. Factoring in that amount, the domestic streaming business has a "true" contribution margin of only 9%. To arrive at pretax margins, one must also deduct the streaming business's share of G&A expense and interest expense. (At present, allocating these costs proportionally to revenue would result in pretax margins of 5%-6% for the domestic streaming business).
International margins will almost certainly be lower on a permanent basis due to high competition and Netflix's lower level of brand equity outside the U.S. In the long run, as the DVD business declines and the streaming business reaches maturity, pretax margins are likely to stabilize in the 5%-7% range. Based on the midpoint of this margin profile, Netflix will need to grow quarterly revenues to $1.85 billion (roughly double the current level) just to return to the company's peak pretax quarterly profit of $111 million, achieved in Q2FY11. Yet Netflix's revenue growth has recently hovered between 10% and 15%.
Netflix investors hoping for a return to the company's previous margin profile will be sorely disappointed. Shares are trading at nearly 20X peak-year earnings, yet based on the company's new margin profile, it will take a minimum of five years just to reclaim that level of profit. Shareholders can of course hope, along with Carl Icahn, that a bigger fool such as Amazon.com (AMZN) or Google (GOOG) comes riding to their rescue with a lucrative buyout offer. However, this seems like wishful thinking. Netflix has sent its lucrative DVD business into a tailspin, with profits declining by 30% in just three quarters, and more declines expected next year. With the streaming business being far less profitable, competitors are unlikely to pay a premium to Netflix's current $5 billion market cap when 1) they could probably build a rival business from scratch for less money, and 2) they could wait a few years to snap up Netflix: during which time I expect the fundamental problems discussed above to send Netflix to new lows, reducing the buyout price.
For all these reasons, I think the recent rally in Netflix shares is more akin to a "dead cat bounce" than a sustainable turnaround. As the DVD business continues to decline and streaming margins peak over the next year or so, I expect the market to take a more skeptical view of Netflix's prospects, sending the share price back down towards 2012 lows around $53. I am therefore considering reopening my short position in Netflix at this time.
Additional disclosure: I may initiate a short position in NFLX over the next 72 hours.