Netflix's Horror-Flick Sequel


Following Netflix's blowout quarter, the raft of analyst estimates have come in, and the financial picture seems to look greatly improved. Wall Street bumped its 2013 EPS projection to $1.15 from $0.40, and 2014 looks even rosier. Instead of $1.44, they now believe the streaming champion will bring in $2.74 per share.

There's a problem here, though. At a price around $160 per share, that's a considerable multiple to pay for a stock that already imploded once. This is starting to look like 2010 again for Netflix.

Be kind, please rewind
Let's take a look back and go over what happened last week as shares jumped a whopping 71% for the week. Reporting fourth-quarter earnings, Netflix delivered an EPS profit of $0.13 against expectations of a $0.13 loss. That's enough of a surprise, but the video streamer also made a huge jump in subscribers, adding nearly 4 million subscribers worldwide, bringing its streaming total above 33 million. That's all great news, but some areas were wanting in the report. Revenue grew by just 8% over a year ago as Netflix has chosen to harvest its now 8 million DVD subscribers, but those mail-order holdouts still give the company more contribution profits than its domestic streaming base.

The table below shows the discrepancy among its three segments:


Domestic Streaming

Domestic DVD

International Streaming


$589 million

$254 million

$101 million

Contribution Proift

$109 million

$128 million

($105 million)

Source: Netflix Q4 Letter to Shareholders.

Mail-order DVDs are by far the most profitable segment, but that division has been declining. Without the DVD business, the company would have barely had any gross profit in the quarter.

Additionally, of the 4 million new subscriptions, 1 million of them were not paid.

Deja vu, all over again
The stock situation isn't the only thing giving investors a seen-it-before feeling. Netflix won the hearts of movie-watchers for disrupting the brick-and-mortar model championed by Blockbuster, which came with endless debates and fits of indecision over which movie to take home. But as technology moves forward, Netflix has been forced to reinvent itself. Streaming is supplanting the mail-order model, which makes Netflix more vulnerable to the likes of rivals such as, Hulu, and Time Warner's HBO GO. But perhaps more important, streaming doesn't give Netflix the leverage it had with the mail-order model, as the contribution margins above indicate.

Whereas before the company had only to pay the price of the DVD and take care of shipping and handling charges, it now must cough up enough dough to pay for steep licensing agreements. Recently, the rap on Netflix has been that overseas marketing and development costs are eating away at margins, but its cost of revenue (i.e., licensing fees) has increased disproportionately, as the table below shows.


Q4 2012

Q3 2012

Q2 2012

Q1 2012


$945 million

$905 million

$889 million

$870 million

Cost of Revenue

$696 million

$663 million

$643 million

$624 million

Gross Profit

$249 million

$242 million

$246 million

$246 million

Gross Margin





Source: Netflix shareholder letters.

As you can see, despite incremental improvements in revenue, gross profit has barely gone up, and gross margin has dropped every quarter. The effects of shifting to the new model are clear, and even though the market cheered the quarter, profits still dropped 80% from a year ago, before the streaming service pushed into the U.K. It will take at least several quarters to return to that level.

We've seen this pattern before. Pandora , the Internet radio service, has won much acclaim from its listeners, but profits have been evasive as content costs outpace revenue growth. Like Netflix, it doesn't have the leverage it needs to negotiate effectively with content providers. For Netflix, this was not a problem under the DVD model. Netflix has something Pandora doesn't in its trove of paying subscribers, but the Qwikster debacle showed that its customers are a price-conscious bunch. Any attempt to squeeze its viewers for more than $8 per month will likely send them running to Amazon's a la carte offerings or to Redbox's kiosks.

Foolish bottom line
Margins in its streaming segment continue to improve, but the gains Netflix makes in that area will be erased by the depletion of its DVD subscribers. Like Pandora, it's easy to like the service, but the nature of the business doesn't seem to justify its current valuation. With international losses racking up and DVD subscribers dwindling, it may be curtains for Netflix shares once again.

The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why we've released a brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.

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Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends and Netflix. The Motley Fool owns shares of and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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