A little over a year ago, streaming video leader Netflix (NASDAQ:NFLX) told investors that it expects its domestic streaming segment to generate a 40% contribution margin by 2020. That compares to a contribution margin of just 10.9% in Q4 2011, when Netflix first separated the streaming business from its older DVD-by-mail operations.
However, Netflix has been making faster progress toward this target than it had projected. This suggests that the 40% margin target may be overly conservative.
Domestic margin growth beats expectations
From 2012 to 2014, Netflix aimed to increase its domestic contribution margin by 100 basis points per quarter, or 400 basis points per year. During 2012, its contribution margin grew at nearly double this target rate. Netflix's domestic contribution margin growth also exceeded the target in 2013 and 2014, albeit by a smaller amount.
Netflix's management warned during 2014 that this rapid margin expansion wasn't sustainable. Late that year, the company stated that after reaching the 30% mark in early 2015, domestic contribution margins would rise by 200 basis points annually, reaching the 40% level in 2020.
However, the projected slowdown in margin expansion hasn't materialized yet. Last quarter, Netflix's domestic contribution margin reached a record 34.3%, up 630 basis points year over year. For Q1, it expects to produce a 35.9% domestic contribution margin, which would be up by 420 basis points year over year.
Netflix's guidance implies that margin expansion will peter out rapidly after this quarter. Yet the recent trajectory of strong margin growth doesn't seem consistent with this expectation.
Rising costs and slowing growth
Netflix does face some headwinds to further margin expansion in the U.S. First, the company's long-awaited output deal with Walt Disney (NYSE:DIS) goes into effect this year. That means Disney movies released in the U.S. during 2016 and beyond will appear on Netflix a few weeks after they leave theaters.
Winning this content deal -- which was signed back in 2012 -- was a big coup for Netflix. However, it came at a high price. Media analyst Michael Pachter estimated that Netflix will pay Disney about $300 million annually. For comparison, Netflix spent about $2 billion on content for its domestic business during 2015.
In addition to the cost increases coming from the Walt Disney deal, Netflix is also investing heavily in new original content. It continues to create brand new series while also making new seasons of its established shows. Netflix is even getting into the feature film business.
On the revenue side, the domestic market appears to be getting saturated. For the past two quarters, Netflix has added fewer domestic subscribers than it did in the year-earlier periods. It expects this slowdown in growth to continue in Q1. Slower subscriber growth means less of an opportunity for margin expansion, all else equal.
Margin expansion drivers remain
Fortunately, while Netflix does face some real headwinds to future domestic margin expansion, it also has two key tailwinds kicking in.
First, when Netflix raised its prices in 2014, it grandfathered in existing subscribers at the old $7.99 per month price for two years. A few months from now, tens of millions of Netflix customers will have to choose between paying an extra $2 a month or downgrading to standard definition service. This should boost Netflix's annual revenue by hundreds of millions of dollars.
Second, an increasing proportion of Netflix's content is covered by global licenses, including virtually all of its originals. For globally licensed content, as Netflix gains international subscribers, content costs get shifted from the domestic segment to the international segment.
Thus, it may be true that Netflix's domestic margin expansion will cool down in the next few years as content costs rise (especially once the Disney output deal ramps up) and subscriber growth slows. But the company's 40% margin target is starting to seem very conservative. That means Netflix investors might be in for an even bigger windfall than they already expect.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Netflix and Walt Disney. Try any of our Foolish newsletter services free for 30 days. 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 has a disclosure policy.