Digging Into Netflix's Cost Of Subscription, Part 2

May.22.11 | About: Netflix, Inc. (NFLX)

This article is part of a series. Click to view Part 1.

Netflix, Inc. (NASDAQ:NFLX) has been on a tremendous run lately, posting a 52 week return of over 130%. Furthermore, its recent earnings exceeded expectations but cautioned about slower growth in the upcoming quarter. This article will focus on costs per paying subscriber, and also try to quantify the reduction in DVD viewing by subscribers since the introduction of content streaming. However, the first step is to pull the paying subscriber figures for each of the preceding 10 years:

Paying Subscribers (Thousands)

Year Average Paying Subscribers Year End Paying Subscribers YE Paying % of Total YE
2010 14,786 18,268 91.3%
2009 10,464 11,892 96.9%
2008 8,268 9,164 97.6%
2007 6,718 7,326 98.0%
2006 5,083 6,154 97.4%
2005 3,169 4,026 96.3%
2004 1,988 2,486 95.2%
2003 1,115 1,416 95.2%
2002 626 796 92.9%
2001 307 400 87.7%
Click to enlarge

Source: NFLX 10-K Filings

Streaming Content Costs on the Rise

Once again, NFLX's incredible growth is on display. The following table (repeated from Part 1) shows that the overall growth is matched by substantial growth in the various components that make up the cost of subscription.

Cost of Subscription Detail ($ millions)

Year

DVD Amor-

tization

Stream-

ing Content Costs

Total Content Postage & Packing

Stream-

ing Delivery

Total Content Delivery Other
2010 160 252 412 542 55 598 144
2009 175 72 246 494 25 519 144
2008 168 32 200 407 10 417 144
2007 167 20 187 327 5 332 146
2006 134 0 134 257 0 257 141
2005 91 0 91 174 0 174 129
2004 74 0 74 114 0 114 85
2003 40 0 40 59 0 59 49
2002 15 0 15 29 0 29 33
2001 20 0 20 15 0 15 15
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Source: Digging into Netflix's Cost of Subscription Part 1

However, the historical growth of total expenses does not really provide much insight, beyond perhaps the surprise that the company's largest cost item is postage and packaging. This is probably a key driver of the desire to shift to streaming content, which should be substantially more scalable from a delivery perspective. The following table will focus on the content components, and the postage and packaging component on a per paying subscriber basis. Note that content and content delivery costs for nonpaying subscribers are included in marketing expense.

Cost Detail per Paying Subscriber ($)

Year DVD Amortization Streaming Content Total Content Postage & Packaging
2010 10.82 17.05 27.87 36.66
2009 16.68 6.85 23.53 47.23
2008 20.32 3.83 24.15 49.24
2007 24.80 2.98 27.77 48.70
2006 26.41 - 26.41 50.65
2005 28.81 - 28.81 54.90
2004 37.34 - 37.34 57.57
2003 35.61 - 35.61 53.18
2002 24.44 - 24.44 46.65
2001 63.52 - 63.52 47.88
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Source: Derived from NFLX 10-K data

This is where things become interesting, further highlighting the challenges that NFLX may face. Since the introduction of streaming content, content costs per paying subscriber have climbed slightly after an initial dip. This was driven by an enormous increase in streaming content costs for 2010. The salvation was that postage and packaging for DVDs had a significant decrease. However, for the first three years of streaming content, there was little decline in DVD viewing on a per subscriber basis. It is possible that this was the impetus for the stronger push to being a pure streaming company. It appears that users were not migrating away from DVD consumption. It is also interesting to note that from 2001 to 2004, the postage and packaging costs were rapidly increasing on a per paying subscriber basis.

Netflix has Surpassed 3 Billion DVD Shipments

The same methods used to determine the cost of subscription detail can be applied to the shipment of DVDs to paying subscribers, when combined with a few key announcements by Netflix. Netflix shipped its 1 billionth DVD, the movie "Babel," around February 25, 2007. Netflix also shipped its 2 billionth DVD, "Nick and Norah's Infinite Playlist," around April 2, 2009, just over 2 years after the 1 billionth DVD was shipped. This information is sufficient to apply some mathematics, since NFLX also gives the percentage increase in DVDs shipped over each previous year. The other adjustment is to account for paying subscribers against free subscribers. I'll assume that free subscribers and paying subscribers order the same number of DVDs on average.

NFLX DVD Shipments by Year

Year Growth From Previous Year Estimated DVD Shipments (millions) Estimated % to Paying Subscribers Estimated DVDs Shipped to Paying Subscribers (millions)
2010 10% 675 93.3% 630
2009 19% 616 97.2% 598
2008 19% 519 97.8% 507
2007 20% 436 97.7% 426
2006 42% 363 97.0% 352
2005 53% 256 95.8% 245
2004 102% 167 95.3% 159
2003 111% 83 94.4% 78
2002 117% 39 91.5% 36
2001 82% 18 84.5% 15
2000 375% 10 NA NA
1999 688% 2 NA NA
1998 NA 0.3 NA NA
Click to enlarge

Source: Derived from NFLX SEC Filings, NFLX articles, and author estimates. Growth for 1999 and 2000 are estimated from financial figures. Assumes that growth in DVDs shipped to paying subscribers is the same as overall growth in DVDs shipped. In years where there is a substantial change in the percentage of free subscribers, this assumption will not work.

One other interesting note in this analysis is that Netflix probably hit the 3 billionth DVD shipment some time around August or September of 2010. I'm guessing it was "The Hangover," but I could be wrong on that.

Decline in DVD Shipments began long before Streaming Content

The final step is to take the number of DVDs shipped to paying subscribers and divide by the average number of paying subscribers. One key note here is that some plans are streaming only. There is no adjustment for that since NFLX does not provide sufficient detail on subscribers per plan.

DVDs Shipped per Paying Subscriber

Year Estimated DVDs Shipped to Paying Subscribers (millions) Average Paying Subscribers (000) DVDs per Paying Subscriber per Year DVDs per Paying Subscriber per Month
2010 630 14,786 43 3.6
2009 598 10,464 57 4.8
2008 507 8,268 61 5.1
2007 426 6,718 63 5.3
2006 352 5,083 69 5.8
2005 245 3,169 77 6.4
2004 159 1,988 80 6.7
2003 78 1,115 70 5.8
2002 36 626 57 4.8
2001 15 307 50 4.2
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Source: Based on Author Calculations. Average Paying Subscribers from NFLX SEC Filings

Were there Cracks in the Netflix Business Model Earlier?

The most interesting take away is that the decline in DVD shipments per paying subscriber began long before the introduction of streaming. My estimate is that it was between 2004 and 2005. This was potentially an indication of new paying subscribers choosing plans that allowed fewer DVDs at a single time. It could also indicate increased competition for subscribers' recreational time, resulting in subscribers spending less time watching Netflix DVDs.

Consumer Cost per DVD Ordered Through NFLX

Year Revenue ($ millions) Average Paying Subscribers (millions) Average Revenue per month ($) Average DVDs Shipped Average Cost for Consumer per DVD ($)
2010 2,163 14.8 12.19 3.6 3.43
2009 1,670 10.5 13.30 4.8 2.79
2008 1,365 8.3 13.75 5.1 2.69
2007 1,205 6.7 14.95 5.3 2.83
2006 997 5.1 16.34 5.8 2.83
2005 682 3.2 17.94 6.4 2.78
2004 501 2.0 20.98 6.7 3.14
2003 270 1.1 20.21 5.8 3.46
2002 153 0.6 20.34 4.8 4.26
2001 76 0.3 20.60 4.2 4.96
Click to enlarge

Source: NFLX SEC filings and Author Calculations

The above analysis shows that consumers spent more per DVD ordered in 2006 than in 2005, ending a substantial decline in cost per DVD. This is also representative of a substantial erosion in the NFLX value proposition to subscribers, when considering the increasing availability of even cheaper entertainment options ranging from Facebook to YouTube. While it might seem trivial, perhaps the effort of getting DVDs from the mailbox, then packing and mailing them back, was beginning to wear on consumers? Was the introduction of streaming content not just an effort to reduce costs, but also a necessity to shore up the Netflix value proposition to consumers? Do these numbers highlight the threat of Redbox, which charges consumers a little over $1.00 per DVD?

It should be noted that the recent increase in unit DVD cost for subscribers is not necessarily representative of a declining value proposition, since subscribers can also view streaming content.

As noted in the 10-Ks, NFLX is incurring substantial commitments for streaming content. These costs will be distributed over a growing subscriber base; however, the key question is whether that subscriber base will be growing quickly enough to sustain margins.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.