Content Costs Aren't the Problem You Think They Are

This is the second of a series of articles this week outlining my long-term bullish perspective for video content provider Netflix (Nasdaq: NFLX  ) -- certainly longer than the three- to six-month "long term" mentioned by one analyst in a Netflix earnings preview. (Maybe that means, as one person said, that "short term" is between now and 4 p.m.?) Yesterday, I covered the information Netflix has on viewing habits and how that is a huge competitive advantage. Today, I'll discuss the power flexible spending gives Netflix.

I've owned Netflix shares for more than four years and covered the company for our Motley Fool Stock Advisor service for 11 straight quarters. Last night's earnings report was what I've come to expect from this company. It beat estimates on both earnings and revenue, as well as management's own guidance for the number of subscribers. However, management guided to lower-than-hoped-for earnings this quarter, which put a damper on the stock price after hours.

Sing the chorus with me
While that's a short-term response to one quarter's predictions, I'm a long-term investor. Let me lay out the second reason why I believe that Netflix still is a good long-term investment today. Don't worry, it won't hurt.

A common comment from many shorts is some version of, "Higher content acquisition costs will squeeze margins, making Netflix less profitable in the future." There are three misunderstandings of the dynamics of the company in that statement.

Virtuous cycles, mmm
First, Netflix is in the middle of a virtuous cycle: More subscribers leads to more revenue leads to more spending on content leads to better content leads to more subscribers. Management highlighted that in last night's release: "The virtuous cycle we've mentioned previously of increased investment in streaming content, strong word of mouth and an expanding device ecosystem truly worked for us in the quarter." A similar virtuous cycle has led Amazon.com (Nasdaq: AMZN  ) to become the retail powerhouse it is today.

Second, Netflix has relatively little in fixed costs. Salaries and overhead, research and development, interest and taxes, delivery costs, and a target for operating income. Once the other costs are met, management can adjust its marketing and content acquisition spending as needed to meet that target.

Last night, management reported a higher-than-expected level of marketing spending in the first quarter. That led to a higher subscriber acquisition cost that spooked some analysts. CFO David Wells said that the higher SAC was an artifact of the higher marketing thanks to the shifting balance between content acquisition and marketing.

Regarding content acquisition, as the company gets more subscribers, it can write bigger and bigger checks. That means Netflix becomes an ever-more-important source of revenue for content producers. And it's getting easier for Netflix to get content, not harder.

In the fourth-quarter 2010 conference call, there was a question: "Do you believe it will get harder to acquire incremental films and TV shows from major Hollywood studios?" Wells answered, "No, it's not gotten harder. It's gotten easier as we pay more. Three, four years ago, we couldn't pay much, it was very hard, and, now, because we've got significant dollars to spend, we've got people coming to us, and that makes perfect sense."

It spends what it needs to
Third, Netflix is not after every piece of content out there, especially the high-priced, new releases. Apple (Nasdaq: AAPL  ) and Amazon are more than welcome to have those available on pay-per-view. Netflix's strength lies elsewhere. Management said in last night's release, "Recently, the CEO of an MVPD [e.g., cable and satellite] characterized Netflix as 'rerun TV' ... [and] he is fundamentally correct. Our focus for TV shows is on prior season TV and completeness of series, because this class of content enables us to license content broadly and provide consumers a differentiated experience." And with its informational edge, it knows what to buy.

From a recent company presentation: "Netflix's goal is content so broad, engaging and affordable that everyone subscribes. Despite the fact that consumers also do pay-per-view for new releases, go to movie theatres, buy DVDs, and subscribe to cable/satellite/telco TV. New release movies are not available for subscription streaming to us (or others), and are reserved for higher-margin pay-per-view and DVD. We are more movie-catalog and prior-season TV-show focused." (emphasis in the original)

All in all, I was quite pleased with the earnings release. If you're interested in the company, I suggest that you read the letter from management available on the company's investor relations Web page. Netflix spent a fair amount of time describing the dynamics that are driving this company.

Come back tomorrow for the third part of this series, where I discuss more on Netflix's focus on content and the type it's after.

Amazon, Apple, and Netflix are Motley Fool Stock Advisor selections. Alpha Newsletter Account LLC has bought puts on Netflix. Try any of our Foolish newsletter services free for 30 days.

Fool analyst Jim Mueller owns shares of and has an option position in Netflix, and he owns shares of Amazon and Apple. He works for the Stock Advisor newsletter service. 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's disclosure policy is never messed up.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 26, 2011, at 11:52 AM, MKArch wrote:

    Since 2002 NFLX has signed up ~59M subs out of a potential ~70M broadband households in the U.S. and only have 23M subs to show for it. They consistently lose ~90%+ of the number of new subs they signed up the previous year.

    The numbers above suggest they have to be near maxing out new sub growth and when they do existing sub continuing to walk away in droves will drive down total subs which will force NFLX to cut back on content which will result in a death spiral.

    With projections of sub growth of 1.3M-2.25M in Q2 sub growth will have substantially slowed. It won't be long before it goes backward. Look out below when that happens. I predict if NFLX is still around in five years they won't offer a subscription based streaming service. It's not sustainable.

  • Report this Comment On April 26, 2011, at 12:01 PM, Henry3Dogg wrote:

    You say

    "Content Costs Aren't the Problem You Think They Are"

    You arrogant little toe-rag.

    What makes you think you have any idea how big a problem I think they are.

    I think an apology is called for here!

  • Report this Comment On April 26, 2011, at 12:28 PM, verylargelarry wrote:

    MKArch

    I see you are still spreading your panic. To wit:

    "Since 2002 NFLX has signed up ~59M subs out of a potential ~70M broadband households in the U.S. and only have 23M subs to show for it. They consistently lose ~90%+ of the number of new subs they signed up the previous year."

    Another way of saying this is that NFLX is now the largest entertainment channel to the household anywhere, based on subscriber counts, as I predicted after last quarter's report. (You poo-pooed that then, what now?)

    From the NYT, April 25, "Netflix gained an average of 1.1 million subscribers in the U.S. each month in the first quarter of this year, for a total of 22.8 million. Globally, the company has 23.6 million subscribers. The biggest cable operator in the U.S., Comcast, reported 22.8 million subscribers at the end of last year."

    Please tell me how they lose 90% of their new subs while maintaining the very low churn rate? And while they continue to grow rapidly?

    I still feel you just don't get it.

  • Report this Comment On April 26, 2011, at 12:32 PM, verylargelarry wrote:

    And while I'm at it, Henry,

    "What makes you think you have any idea how big a problem I think they are."

    Uhhhh, please share with us your reasoning here. Base it on financial information. Why do you think this is a big problem for NFLX???

    Until then, I'll avoid the name-calling you employ.

  • Report this Comment On April 26, 2011, at 12:58 PM, MKArch wrote:

    http://seekingalpha.com/article/252310-the-netflix-churn-cha...

    I have no idea how they calculate the churn rate that they cite but they consistently lose 90%+ the number of subs they signed up the previous year only masked by new subs taking their place.

    To date they have signed up ~59M sub out of a potential ~70M broadband households. Sure some may be repeats but they looked to be near maxing out new sub growth and their projections for net subscriber additions in Q2 being way under Q1 it looks like new adds is slowing down. Next step after a slow down in new sub growth is rapid loss of total subs as existing subs continue to walk away in droves. Then that virtuous circle Jim lauded in his article works in reverse.

    Why do you think Hastings will no longer detail standard subscriber churn metrics after 2011? That should have been a dead give away that he sees trouble ahead. It looks like the analyst covering NFLX have all turned into Henry Blodget in 1999.

  • Report this Comment On April 26, 2011, at 2:48 PM, medicalquack wrote:

    Netflix is ahead of the game with video streaming as back in 2008 they were one of the first to use Server 2008 HPC and use virtual servers which gave a nice lift to bandwidth among other things and then they added Silverlight to the configuration so a good technology solution that others are doing now as well along with other solutions. They also run a good algorithm to find out what people like too so just good smart technology here. I wrote about how healthcare should look at some of this too with behavioral analytics back in 2009 and now everyone is doing it and we have privacy issues in healthcare that don't exist with the entertainment business.

    http://ducknetweb.blogspot.com/2009/10/whats-next-for-health...

    They were ahead of the game pushing streaming but smart enough to keep DVDs around for the luddites so they didn't miss that market which is getting smaller but it still there:)

  • Report this Comment On April 26, 2011, at 4:15 PM, dvena wrote:

    Hi MKArch,

    You said:

    "Next step after a slow down in new sub growth is rapid loss of total subs as existing subs continue to walk away in droves."

    If you look further down in the article that you site, the table shows the author's estimates for subscriber growth. He shows beginning subscribers of 20M at the beginning of 2011 and 41M by the end of 2014. How he comes up with his churn figures aside, the author indicates that subscribers will double over the next 4 years. Slower growth yes, but in reverse - not any time soon.

    Two extremely important points from a customer perspective: Netflix allows me to put my account on vacation hold (lost subscriber) and pick up where I left off later. That breeds a great deal of loyalty from your customer base. Second, Netflix counts free trials in the subscriber counts. This means that every time someone takes a free trial (new subscriber) and decides not to sign up (at that time) - lost subscriber - which adds the the net churn numbers.

    Both of those are important, as they make it appear as if Netflix has lost many more full time subscribers than the evidence suggests. If they continued to lose subscribers at the rate the author suggests, why do their subscriber numbers continue to grow?

    Let us not forget about entry into new international markets - more subscribers means more money, which means more content, which means more subscribers.

    I have been an investor in Netflix since August of 2007 and have been extremely well rewarded. I will not sell my shares.

    Danny

  • Report this Comment On April 26, 2011, at 4:48 PM, MKArch wrote:

    Danny,

    The author of the article was doing an academic exercise in projecting what would happen if they continued to add subs at 20% a year for the next 4 years with 65% of beginning year total walking. I don't think he meant this as as an actual estimate of what he thinks will happen.

    In reality the number of subs they have already signed up is almost equal to the entire number of broadband homes in the U.S. and international expansion is a whole different ballgame that will not make up for U.S. any time soon if ever. For instance they project ~100K-250K sub additions from International in Q2.

    The free trials are 30 days so 2/3 of the people signing up for the free trial but not opting to become a paying sub should never show up as subs. It also makes logical sense given Hastings own admission that they are a TV. re-run service that is an additional cost on top of cable not an alternative to cable that their sub base is not going to hang around for long.

  • Report this Comment On April 26, 2011, at 4:56 PM, MKArch wrote:

    I forgot to add that based on already having signed ~59M subs with total broadband households of ~70M it would seem they are near saturating the U.S. market. They signed 3.6M net sub additions in Q1 but are only projecting ~1.3M-2.25M net sub additions in Q2. Too me this is a clear sign that they are near saturating the U.S. market and soon total sub count will start going backward as they won't have enough new subs coming in to offset the droves of subs walking. I know they are touting international growth but IMHO this is a hail mary attempt to address their churn problem. Smaller markets, local content, no brand recognition and existing competition with higher costs will all make international expansion a lot tougher, less profitable and much slower process than the U.S. if it succeeds at all. And then they have the same problem of retention if they do sign anyone up.

  • Report this Comment On April 26, 2011, at 5:07 PM, MKArch wrote:

    <<<This is starting to present a problem in that these assumptions are potentially inconsistent. In order to meet the above numbers, Netflix would require another 90+ million new subscribers or, from doing the math from 2002, 140+ million subscribers -- which would represent more households than the U.S. and Canada combined, even assuming some modest growth in households from 2009 to 2014.>>>

    *********************************

    I should have noted this before as well. His academic exercise has NFLX signing up more total households than the U.S. and Canada combined. He even forgets that only a broadband enabled household could use NFLX service which is only 70% of U.S. households. So NFLX needs to sign up every household in the U.S. and Canada plus some serious growth from a standing start with existing competition in other international markets to meet his academic projections.

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