Here's Why Netflix Inc. Bears Shouldn't Panic Over Content Costs


Will raging content expenses topple Netflix's house of cards, or are these costs "bad, for a greater good"? Image source: Netflix.

Netflix (NASDAQ: NFLX  ) bears often complain that the company's content costs are rising too fast. Besides, the next international expansion push will surely kill the company, right? If nothing else, Amazon.com (NASDAQ: AMZN  ) is moving in for the kill.

Hold your horses, Netflix critics. Have you really looked at the numbers you're complaining about?

First off, Netflix has always faced off against at least one major rival, and often several at a time. After all, Amazon launched its digital video service before Netflix. Amazon's Instant Video service bowed in 2006, one year before Netflix served its first digital video stream. Much has been made of Amazon's greater financial assets, but that advantage has not crushed Netflix so far. Netflix commands about 20 times the American-market video traffic that Amazon does today.


Source: Sandvine.

So it's not like Amazon's cash reserves and Hollywood connections are killing Netflix so far.

But what about Netflix's internal cash-crunch problems?

Netflix has increased its cost of revenues in the streaming business by 66% over the last two years. There's a growing pile of unpaid license obligations piling up -- outside Netflix's balance sheet.

And the international segment is even scarier. Whenever this company manages to make money abroad, those profits are immediately reinvested in the next expensive market stretch. For example, Netflix recently said that its existing international markets will turn a profit this year and then presented its largest European venture yet.

Sure, these rising expenses can look scary. But then you forget that Netflix is financing them with an even faster rise in streaming sales.

Yes, content and delivery costs jumped 66% in two years, but global sales soared 93% higher at the same time. Internationally, cost of revenues increased by 160%. Meanwhile, overseas sales more than sextupled with a 510% increase.

As a direct result of these trends, domestic margins are rising while international ones are about to swing into positive territory. Contribution profits (and losses) here include all the costs of operating Netflix's streaming business, while gross profits exclude marketing budgets. Every line in these charts accounts for current content costs:

Looking at the available data and the charts they produce, I see no reason to worry about Netflix's content costs.

It's true that costs are rising. It's also true that you have to spend money to make money, especially in a business built on content licensing decisions that were made years ago.

Without high-quality content, Netflix would be an empty vessel indeed. That's why the company is eager to invest in top-notch streaming licenses, preferably of the exclusive variety that sets Netflix apart from the competition.

The final rallying cry from the bearish camp is that everybody is out there bidding on the best content libraries, which is why licensing costs are sure to spiral out of control... at some point. If all else fails, this is how Amazon and friends will kill Netflix in the end -- Amazon's deep pockets will let it buy content when Netflix is dead and gone.

The thing is, I've heard this argument since the very first days of streaming movie services. And yes, content costs are rising (see charts above), but again, the underlying market is growing even faster. And Netflix runs at the very front of this assault, as shown in the trends and figures discussed in this article.

There may be many reasons to avoid Netflix shares today, but galloping content costs are not among them.

In fact, these cost-of-business trends provide a solid foundation for the bull case on Netflix.

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  • Report this Comment On June 09, 2014, at 6:48 PM, tom2727 wrote:

    But there is an upper limit for the amount of subscribers Netflix can have. Yet I don't see any upper limit for how much their content will cost (other than how big of a number the content owners can write on a piece of paper). And we've seen the pushback they get when they raise subscription prices.

    So the question is at the end of the day, why should Netflix ever make large profits?

  • Report this Comment On June 09, 2014, at 9:20 PM, 24penny wrote:

    And let's not forget that they depend on 3rd parties to deliver the content. Here they seem to be biting the hand that feeds them.

  • Report this Comment On June 09, 2014, at 9:52 PM, AceInMySleeve wrote:

    Excellent post. I don't want to read any analysis by someone unless they've absorbed these graphs.

  • Report this Comment On June 10, 2014, at 8:54 AM, TMFZahrim wrote:

    "I don't see any upper limit for how much their content will cost (other than how big of a number the content owners can write on a piece of paper)."

    That argument quickly becomes ridiculous. If the studios want to monetize their content, it makes no sense to price themselves out of distribution channels.

    Also, this:

    http://what-if.xkcd.com/96/

    Thanks for the kind words, Davis.

    Anders

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