Netflix: Subscriber Growth Leading To Margin Expansion

| About: Netflix, Inc. (NFLX)
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Readers of my previous columns will note that I have been skeptical of the Netflix (NASDAQ:NFLX) operating model as a content aggregation and distribution middle man. That skepticism abated with the announcement that Netflix stated its goal was to become HBO before HBO could become Netflix, and unveiled a host of exclusive content offerings, including House of Cards.

The distribution versus content owner battle hinges on two things: content exclusivity and direct access to the consumer via multiple screens. Netflix undoubtedly is the leader in distribution, as can be seen by its subscriber growth rates in its Q1 numbers:

  • Added 3 million new subscribers in the quarter (2.03 million domestically), to 36 million paid subscribers in total.

In terms of content exclusivity, one sentence stood out to me in the investor letter:

As we continue to focus on exclusive and curated content, our willingness to pay for non-exclusive, bulk content deals declines.

Management clearly understands that exclusive content is the moat that will differentiate the Netflix platform with respect to other content distribution services. If users can access content in one place, from Netflix only, then Netflix will contend with less price competition because the content won't be commoditized through non-exclusive license deals on other platforms. Of the top 200 most watched Netflix programs, 74 were available on Amazon (NASDAQ:AMZN) Prime, up from 73 last quarter. Netflix clearly needs exclusive content to differentiate from the Amazon Prime threat. Amazon, too, understands the digital subscriber land grab, as it released 14 pilots of exclusive content to its Prime subscribers to vote on which gets turned into an original series.

While Netflix may have to pay more for exclusive license deals from content owners, its content distribution platform is clearly set up for significant margin expansion as more subscribers sign up for the service.

Since Q1 2012, contribution margin (i.e., profit left over to cover fixed expenses after all variable expenses have been deducted) in its domestic streaming business has expanded in concert with subscriber growth, from 14.3% in Q1 2012 to 20.6% in Q1 2013. Contribution margin is negative, but improving, in the international streaming business as it scales up its subscriber base.

In afterhours trading (at 4:45 pm ET), Netflix shares exchanged at $210, up 27% from the opening of the day's session, representing an $11.8 billion valuation. I'm not buying shares here, but I am continuing to monitor the disruption going on in the digital media and content distribution business.

Clearly, though, content exclusivity and digital distribution is a valuable platform-based operating model.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.