Don't Expect Netflix's Margin Improvement to Last Forever

Video rental service Netflix (NASDAQ: NFLX  ) spiked as much as 75% in three days last week after reporting better-than-feared Q4 earnings. Netflix added nearly 4 million streaming subscribers during the quarter, which beat the company's guidance. Even more impressively, the "contribution margin" from Netflix's domestic streaming business improved by 210 basis points sequentially, to 18.5 %.

Over the next year or two, Netflix should be able to grow its domestic streaming contribution margin a little further. However, Netflix relies heavily on third parties for content, and these content owners have significant pricing power. If Netflix's revenue rises, content providers can (and will) demand a raise. This will probably prevent Netflix's streaming margin from rising much beyond 20%.

Streaming is tougher than DVD rental
There is one critical difference between the streaming business and the DVD by mail business: the First Sale doctrine. As Netflix has detailed in various SEC filings, federal law permits whoever buys a DVD to rent and/or resell that DVD (but not to copy it). This means that Netflix and competitor Redbox have a trump card in negotiations with studios over DVD license agreements. If the DVD rental companies cannot come to a satisfactory licensing agreement with the studio, they can always walk away and buy DVDs from a wholesaler. This "exit option" keeps licensing costs down.

By contrast, the First Sale doctrine does not apply to streaming content. Quite simply, if Netflix cannot come to an agreement with the content owner, then it cannot provide those movies or TV shows to its subscribers. All of the negotiating leverage is in the hands of content owners in the streaming business. This will be a permanent drag on Netflix's margins.

Competition rising
Netflix's difficulties are compounded by the rise of competing streaming services. In 2011, Amazon.com (NASDAQ: AMZN  ) launched its Prime Instant Video service. Amazon has rapidly improved its streaming selection, more than doubling the content available over the past year. In some cases, Amazon has won exclusive agreements with content owners that used to provide content to Netflix. Recently, Coinstar (NASDAQ: OUTR  ) and Verizon (NYSE: VZ  ) have teamed up to offer a new service called Redbox Instant Video. The service will offer a variety of streaming content as well as vouchers for 4 DVD rentals for $8/month.

The rise of competitors will have two impacts on Netflix's business. First, customers will have more choices of where to get streaming content, which will put pressure on Netflix's domestic streaming growth. Second, the competition for content between Netflix, Amazon, and the Coinstar-Verizon joint venture will drive up content costs. Both developments will put pressure on Netflix's domestic streaming contribution margin.

A way out?
Netflix is turning to original content in hopes of finding a way out of its current dependence on third-party content owners. Netflix's first original series, House of Cards, premieres this week, and a variety of other original series are scheduled to debut this year. This strategy may be Netflix's last hope of creating a moat for itself in the streaming business. Success will depend heavily on the popularity of its original shows.

While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have attracted 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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