Internet streaming video leader Netflix(NASDAQ:NFLX) is scheduled to report first quarter earnings this week. Investors will be eager to learn whether Netflix met its subscriber growth guidance -- as of January, the company expected to add more than 4 million subscribers during the quarter.
But while driving continuous subscriber growth is clearly of the utmost importance for Netflix, keeping costs down is also crucial. After all, while Netflix revenue rose 72% between 2011 and 2014, its operating profit rose only 7% over the same period. Thus, when I look through the first quarter earnings release, I will be paying close attention to its cost management.
Domestic content costs: Relief at last?
Perhaps the most important cost metric will be the domestic "Cost of Revenues." This is a rough proxy for domestic content costs, though it also includes smaller items like content delivery, payment processing, and the costs of running customer call centers.
Domestic cost of revenues rose 19% in 2013, from $1.57 billion to $1.86 billion, and then by another 18% in 2014, reaching $2.20 billion. This rate of spending is not sustainable as domestic subscriber growth slowed to 17% last year and is likely to moderate further in 2015.
However, domestic cost of revenues rose by just $8 million, or 1.4%, sequentially in the fourth quarter, after rising by a total of $69 million over the prior three quarters -- an average quarterly increase of about 4.4%.
Only time will tell whether this is the start of a new, more benign trend or just a fluke. But first quarter results will provide some additional context that could help investors understand its future content cost trajectory.
Technology and development costs and general and administrative costs together represent the overhead necessary to keep the company running. Ideally, over time, Netflix would be able to leverage these costs by growing its revenue faster than the costs rise.
So far, this has not been the case. Apparently, Netflix has needed to invest in more overhead expenses in order to drive its global growth. Technology and development costs have remained at 9% of revenue from 2012 through 2014, while general and administrative expenses have risen from 4% to 5% of revenue during that time.
The overhead costs -- also referred to as "other operating expenses" in its financial statements -- often rise significantly during the first quarter, in part because of annual pay increases. For example, other operating expenses rose 15% sequentially (from $144 million to $166 million) between fourth quarter 2013 and first quarter 2014.
Hopefully, Netflix will be able to limit the increase in its other operating expenses to a smaller amount this year. That would allow it to start leveraging these overhead costs to support margin expansion.
International content costs
International content cost growth is less of a red flag for Netflix investors, as the company has entered a number of new markets in the last seven months. Netflix needs to improve its content offerings in these new international markets in order to attract more subscribers, and this will undoubtedly be expensive.
Still, it is worth keeping an eye on how fast international content costs rise relative to subscriber growth. Netflix spends almost 50% less on content for its international markets than it spends domestically, despite now serving countries with a combined broadband subscriber base that is far larger than the U.S.
It seems logical that international content spending will eventually overtake domestic content costs. The question is how soon that will occur. If content costs continue to rise at the 2014 rate of nearly 50% annually for the next few years, it could be a while before Netflix's international operations turn profitable.