We recently changed the cost structure of our pricing model for Netflix (NFLX) to better align it with the company’s relatively newer reporting structure. Netflix reports contribution margins for its different segments – domestic streaming, international streaming and DVD business. While DVD contribution margins (adjusting for share-based compensation and depreciation & amortization) are currently around 49%, we expect them to decline over time due to the shrinking DVD base. Domestic streaming contribution margins stood at around 19% for 2012, and have been showing consistent improvement due to subscriber growth. The international business is a different story for now. The margins are negative here, and we don’t expect them to swing back to positive for at least a couple of years.
These contribution margins play a significant role in determining the valuation of each of these business segment. As expected, the domestic streaming is the biggest business for Netflix, but interestingly, the declining DVD business is still more valuable than international streaming according to our estimates.
Why Will DVD Margins Shrink?
The contribution margins are profit margins calculated after subtracting cost of revenues and marketing expenses from revenues. For Netflix’s DVD business, the cost of revenues primarily include revenue sharing and content acquisition costs, postage costs and DVD shipment center costs. While revenue sharing costs and postage costs are variable, other costs have large fixed components.
Netflix’s DVD subscriber base is declining. Due to fewer number of DVDs to handle, the company may lose out on the advantage of economies of scale and its distribution centers may not run as efficiently as they used to. In addition to this, the company may not get favorable pricing from studios due to a shrinking base and less negotiating power. The fixed costs of content acquisition will be spread out over a smaller revenue base, implying that Netflix will lose operating leverage. In addition to this, the rising postage costs will also put some pressure on margins. We expect that Netflix’s DVD contribution margins will decline from 49% in 2012 to less than 38% by the end of our forecast period. You can modify the forecast below to see how changes in DVD contribution margins can impact Netflix’s price estimate.
Outlook For Streaming Contribution Margins
The most significant cost component dictating Netflix’s domestic and international streaming contribution margins is content acquisition costs. Netflix negotiates streaming content deals for fixed costs, which it pays over a period of time. As Netflix’s subscriber base grows, these fixed costs will spread over a larger revenue base and margins will increase. The company has been growing these margins every quarter and expects an improvement of 100 basis points per quarter in near future in its domestic streaming contribution margins. As far as its international streaming business is concerned, it is likely to remain unprofitable for the next two years. Although we expect losses to lower each quarter sequentially.
Netflix’s marketing expenses in the U.S. have come down as % of revenues over the past few years. The brand is well known in the region and the company’s marketing needs are lower. Referrals and word-of-mouth modes are doing well. Despite the backlash that Netflix faced in 2011 due to its price increase, subscriber growth has returned and the need for heavy marketing isn’t really there. We expect the same to happen for its international business once the growth stabilizes, and the company builds the needed brand awareness. The expected decline in marketing costs as % of revenues will also aid the margin growth.
On the flip side, even though Netflix is likely to gain operating leverage, getting additional content and re-negotiating older deals is getting more expensive. In addition to this, the company is focusing on bringing original content to its subscribers and the growing competition is bidding up the content prices.
Our price estimate for Netflix stands at $125, implying a discount of about 30% to the market price.
Disclosure: No positions.