Netflix’s $1 Billion Dig at Amazon

Nothing stings quite so much as a backhanded compliment.

Netflix (Nasdaq: NFLX  ) CEO Reed Hastings recently dished out some of his trademark faint praise, this time for streaming rival Amazon.com (Nasdaq: AMZN  ) . In an interview last week with Dow Jones, Hastings labeled the e-commerce giant "the best competitor we've ever faced." That's a high honor considering Netflix has gone toe-to-toe with the likes of Wal-Mart, Blockbuster, and Comcast, just to name a few. But Hastings' compliment came attached to a less friendly statistic which also has a ring of truth to it: He figures Amazon is losing up to $1 billion a year on its streaming service.

He should know
After all, Hastings is in a good position make that kind of estimate. Netflix and Amazon are increasingly bumping into each other as rival bidders on streaming video content that they hope to add to their own libraries. Whenever Netflix loses one of those bids to Amazon, it has a good idea about the price that the winning bidder must have paid.

And Netflix knows exactly what it costs to maintain a sprawling, national streaming service. The company's current plans call for spending more than $2 billion on streaming content over the next year. In last year's Q3, that annual commitment for spending sat at just over $1 billion. So, as Amazon ramps up its library to rival that service, spending in the neighborhood of $1 billion annually seems about right. It would put the company behind Netflix in terms of commitment to the streaming market, but not by much.

Secrets lost in the Amazon
Amazon doesn't share details about its streaming content spending, except to say that the trend is toward "more." For example, when asked for specifics about the company's outlay to support the Prime Instant Video service, CFO Tom Szkutak recently said this: 

We have added a lot of content. We like what we see so far. We'll continue to monitor it very carefully. You should expect us to add more content going forward.

So, streaming expenses join Kindle sales figures as yet another metric that Amazon prefers not to share. Since Prime customers get access to that content as part of their membership at no extra charge, all that investment isn't directly helping Amazon's profit. There's no doubt that it makes the company's ecosystem stronger and helps lift Prime subscriber figures. But we don't know by how much.

What we do know is that Amazon's spending, including on content, has been on a tear lately. In Q3 Amazon reported spending on technology and content that rose to 8.6% of sales, from 7.1% in the year-ago quarter. That bump in costs helped push expenses to over 100% of revenue, leading to Amazon's first operating loss in years. And all indications are that Amazon's push into the tablet space comes with virtually no profit on hardware sales, which should keep the pressure up on those operating margins.

Still, Netflix shouldn't expect Amazon to get skittish on its content spending and fold up the streaming shop anytime soon. With revenue growing at faster than 20%, and a market cap of over 20 times Netflix's, Amazon can afford to play this game for a while.

And that's not the last of Hastings' problems. Netflix will soon have to deal with a brand-new competitor. The streaming venture between Coinstar's (Nasdaq: CSTR  ) Redbox and Verizon (NYSE: VZ  ) is set to launch any day now. That service has been in the works for years, but it finally looks set to be rolled out to customers as early as Christmas.

Foolish takeaway
You might expect that rising competition would depress margins in the broader streaming market. But there's no evidence of that happening to Netflix right now.

In fact, the company's contribution margin from its domestic streaming segment has ticked up, from 13% in Q1 to 16% in Q3. And Netflix says it expects that trend to continue, as marketing and content spending is projected to grow slower than revenue over the coming quarters. That strong domestic profitability is being wiped out by losses on the international side right now. But Netflix is aiming to make that a temporary condition. Amazon can identify with that strategy, even giving its rival a compliment of its own: Netflix, you might be smarter than you look.

Learn more
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 aspirations toward international growth 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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