Grab some popcorn and read the following excerpt lifted from the Seeking Alpha transcript of Netflix's (NFLX) Q4 conference call:
Ellie Mertz: Looking at your Q1 guidance and utilizing the midpoint, it seems that your guidance is suggesting that a DVD subscriber is contributing about 6x more to profits than a streaming subscriber, or around $15 per DVD customer but only $2.50 for a streaming customer. Do you still feel it is a wise strategy to push customers towards the streaming service? And if so, what effects do you anticipate on long-term margins?
David Wells: The analysis is well intentioned, I'm sure, but it's looking -- not looking at the marginal cost and the marginal increment, which is the important one. So a marginal streaming subscriber is almost pure contribution margin. There's a little bit for credit cards, CS and CDMCs [ph], but it's pretty modest. A marginal DVD subscriber has a number of variable costs, the postage and DVD fees in particular. So actually, it's the opposite, which is the profitability of a new streaming subscriber, the contribution margin is almost twice what it is for a DVD subscriber. So that's the way we think about it. And we're -- we'd like to have someone use both services because obviously, that's both more revenue and more profit. But if they were only going to use one, we'd much prefer them use the streaming service.
I made a mistake in a previous article. I attributed the words of Netflix CFO David Wells to the company's CEO Reed Hastings. The last thing I want to do is associate Hastings with any more illogic. Some NFLX bears have commented or written me noting that Wells flat out lied in that blurb. That's not true. He did not tell a lie, but he was, in my opinion, being unbelievably disingenuous.
Wells counts beans. And he's probably very good at it. That said, I could be completely misunderstanding what he said. If I am, I encourage him to use his CEO's Seeking Alpha account or create his own to write an article setting the record straight.
When discussing the value of DVD versus streaming subscribers, Wells compares the costs associated with servicing each type of user. I dislike using Wikipedia as a source, but it provides a pretty accessible definition of a potentially confusing concept Wells discussed - marginal cost:
In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs that vary with the level of production, and other costs are considered fixed costs...
Marginal Costs are not affected by changes in fixed cost. Marginal costs can be expressed as ?C(q)/?Q. Since fixed costs do not vary with (depend on) changes in quantity, MC is ?VC/?Q. Thus if fixed cost were to double MC would not be affected and consequently the profit maximizing quantity and price would not change.
Wells, in the earlier quote, classifies postage, DVD fees and credit card fees as variable costs, in that they change as subscriber habits and usage changes. He notes that DVD subscribers rack up considerably more variable costs (postage, DVD fees) than streaming subscribers who only trigger "pretty modest" variable costs.
Netflix realizes a considerable chunk of its digital content expenses as an asset when it hits the balance sheet. The company categorizes the money it pays for streaming content as a fixed cost, "Thus if fixed cost were to double MC would not be affected and consequently the profit maximizing quantity and price would not change."
To call streaming content expenses fixed is what triggers some observers to call out Netflix executives out as liars. Again, I do not think they are lying, per se. I do not think it's quite that clearcut. The words misleading and disingenuous come to mind, however, when I consider Wells' case that "the profitability of a new streaming subscriber, the contribution margin is almost twice what it is for a DVD subscriber." That part is simply untrue.
TechCrunch's Erick Schonfeld set it out as plain as plain can be in his post-earnings NFLX article, Netflix Streaming Margins Are 11%, DVD Margins 52%. Schonfeld's piece could not be anymore clear. It reconciles like a glass of ice cold water in the face with the numbers Netflix itself publishes (but not with what Wells said):
Click to enlarge
So, Wells - and by association and extension, Hastings - says that "the profitability of a new streaming subscriber, the contribution margin is almost twice what it is for a DVD subscriber." That's simply not the case. The data Netflix provides, without even the slightest hint of a question, proves this.
Until Wells or Hastings offers an alternative explanation all I can think is that the CFO was making a "forward-looking statement." Like his incredibly confident CEO, Wells was confusing Netflix's long-term vision of how things should be with how things really are. This is not the first time the company resided in a reality that's distinct from the rest of the world. If Hastings' DVD flip flop over the course of six months does not call into question anything and everything spokespeople for this company say, I am not sure what does:
Here's what Netflix had to say about DVD in its Q2 shareholder letter from July:
In addition to separating the plans, we are setting up a dedicated DVD division, led by twelve-year Netflix veteran Andy Rendich, to focus on running a successful DVD by mail service in the U.S. for a long time. Andy and his team will be located nearby in San Jose, and are already planning some great improvements for the DVD service. Because we believe we can best generate profits and satisfaction by keeping DVD by mail as a division, we have no intention of selling it. In Q4, we'll also return to marketing our DVD by mail service, something we haven't done for many quarters. Our goal is to keep DVD as healthy as possible for as many years as possible.
In early December, here's what Hastings had to say:
DVD will do whatever it's going to do. We're not -- we're going to try to not hurt it, but we're not putting a lot of time and energy into doing anything particular around it ...
And then on Wednesday's Q4 call, I turn things over to the Twitter feed of AdAge's Jeanine Poggi, where I first heard the latest:
Think about this. In July, Hastings presumably promotes a "twelve-year Netflix veteran" to head up DVD with "some great improvements" planned. In December, Hastings flat blows DVD off. And then, on Wednesday, he says he has no intention of marketing the DVD segment, even though in July he noted that "In Q4, we'll also return to marketing our DVD by mail service ..." Q4 was a month ago.
I still cannot get over that turn of events. But, amazingly, it pales in comparison to the falsehood that streaming subscribers are, as of Q4, more profitable than DVD subscribers as well as the hope that they will be in the future. They are not today (see the chart from Netflix) and it's little more than a pipe dream to think they will be in the future. Let's dig into that.
Technically, at some point, streaming subscribers will be more profitable than DVD subscribers, assuming that eventually DVDs fade into oblivion. If nobody buys DVDs and rents or sells them to consumers, it becomes a non-business with no margins. Streaming could then command a 10, 11, 15, 20 percent margin, whatever, and be more profitable. Of course, the dynamics of a slowing DVD business could change, causing margins to plummet (e.g., only heavy users who are expensive to service remain) and come in below that of the streaming segment. But, to reiterate, that simply is not the case now.
Again, Wells or Hastings will need to correct me if I am off the mark, but they, one more time, play loose with reality by arguing that streaming content licensing is a fixed cost. To the extent that Netflix says we will spend between $1 to $2 billion per year on streaming content, I guess it is. Netflix's long-term vision seems to contend that streaming subscriptions will grow alongside these fixed content costs and "pretty modest" variable costs and, in turn, increase the streaming contribution margin. The notion that streaming content, in practice, represents a fixed cost is where misleading and disingenuous comes in.
In theory, Netflix can control its costs. It can very easily say we will only spend X this year on content. Thinking dynamically, however, as the business flows, it might not be able to work out that way if the company expects to grow its subscriber base to the extent necessary to grow margins.
What happened between Netflix, Sony (SNE) and Starz (LMCA) provides the ideal case in point. You might remember the "temporary removal" of Sony movies from Netflix streaming that took place in June of last year. That "temporary removal" quickly became permanent and led to two events that will prove pivotal when historians look back on the collapse (my prediction) of this company.
The Associated Press was one of the first to immediately debunk the notion of a "temporary contract issue" between the parties:
A person familiar with the matter said Netflix's explosive growth triggered a clause in Sony's deal with Starz that resulted in the stoppage.
Several months later, Starz completely cut Netflix off, noting,
This decision is a result of our strategy to protect the premium nature of our brand by preserving the appropriate pricing and packaging of our exclusive and highly valuable content. With our current studio rights and growing original programming presence, the network is in an excellent position to evaluate new opportunities and expand its overall business.
All of this had to do with something I yelped about throughout 2011 - Netflix diluting the studios' premium content by charging just $8 a month for it, on an all-you-can-eat plan. That turn of events implies that, at least if you want to keep the type of premium content you need to attract more subscribers, you'll have to be willing to pay more for that content, raise the price you charge for your service or both.
When you consider context and the reality of the streaming business, it's incredibly disingenuous to refer to content costs as fixed alongside the contention that you'll grow the revenue the segment generates enough to increase margins at any meaningful rate. This assumes a world where Netflix can keep a cap on content costs, while acquiring the content it needs to attract larger numbers of subscribers. This also assumes that Netflix has some amount of leverage in its negotiations with premium content creators and owners. Sony and Starz made it quite clear that Netflix has very little, if any, bargaining power.
If you're an investor considering a long play on NFLX, realize that any upside you'll see comes as a result of the irrational momentum that has, historically, lifted this stock on air. That's why it makes it incredibly dangerous to short. However, in a rational world where reality emerges and eventually prevails, the whole streaming operation can, short of an extraordinary turn of events, do nothing but fail, particularly as Netflix kills the DVD business that has helped subsidize it.
Disclosure: I am short NFLX via a long position in long-dated, out-of-the-money put options.
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