Netflix Subscriber Numbers Up, but Streaming Still Short on Profits

Netflix’s fourth-quarter earnings show that the company has staunched the bleeding of total domestic subscribers that sent it into a tailspin last quarter. But gains in streaming subscriber numbers in the U.S. and worldwide can’t hide that the bulk of the company’s profits still come from its U.S.-only DVD-by-mail business, where subscribers are sharply down.

Netflix’s letter to investors contains even more information than last quarter’s, when the company was first able to separate out domestic streaming and domestic DVD customers. (Before its controversial pricing change, all Netflix subscriptions included both DVDs and streaming.)

Total domestic subscriptions are now 24.4 million, up from 23.79 million last quarter (and 19.5 million a year ago). But total domestic subscriptions don’t actually offer a terrifically helpful picture of Netflix’s business. It’s a little like if Apple only touted how many total device customers it had, without breaking down sales of iPods, iPhones, iPads or Macs.

That 24.4 million includes 21.67 million streaming subscriptions in the US (just slightly up from 21.45 million last quarter) and 11.17 million DVD-by-mail subscriptions — which is quite sharply down from 13.93 million last quarter. Still, those DVD-by-mail subscriptions contributed $194 million of profit on only $370 million in revenue. Streaming, meanwhile, brings in $476 million in revenue, but only nets $52 million for Netflix’s bottom line.

In other words, the company’s pricing changes are still causing them to lose customers — and its most profitable ones at that. Subscribers who once had packages of up to four DVDs are either scaling back to inexpensive streaming-only plans or leaving Netflix altogether.

Meanwhile, Netflix’s expensive content deals, plus infrastructure and software costs, eat up the bulk of the revenue that the huge number of streaming subscriptions brings in. And those comparatively tiny profits certainly can’t cancel out the huge loss in potential profit those extra 2.76 million DVD subscriptions would have brought in.

Outside the US, meanwhile, Netflix is streaming-only — and still not profitable at all. Netflix lost $60 million on its international streaming business last year, with slightly under 2 million subscribers — a loss that more than cancels out its total profit from all 21.67 million US streaming customers.

Netflix is still in a powerful position relative to its competitors in video streaming. The company’s letter to investors thinks its commercial-free streaming offerings are more attractive than Hulu’s or Amazon’s — although Netflix’s CEO Reed Hastings and CFO David Wells reveal that they “expect Amazon to continue to offer their video service as a free extra with Prime domestically but also to brand their video subscription offering as a standalone service at a price less than ours.”

You can also see the gain in streaming subscriptions and loss of DVD subscriptions as an affirmation of Hastings’ strategy. Clearly, more of Netflix’s customers are gravitating towards streaming and away from discs-by-mail. And Netflix contends this will only continue to be the case.

“We expect DVD subscribers to decline steadily every quarter, forever,” said Netflix CEO Reed Hastings in a conference call with analysts on Wednesday.

The open question is whether Netflix brilliantly anticipated this trend or helped to elicit it through its pricing changes and Qwikster-sized marketing blunders.

Ultimately, though, Netflix isn’t competing with itself or even with Hulu and Amazon — it’s competing for your all TV viewers’ last $8-10. This is why, as Hastings and Wells’ letter notes:

This is a powerful vision of the future of entertainment, and it’s one that many of us would welcome.

Netflix’s problem is that, just like HBO, ESPN or Amazon, its core business has also historically been tied to legacy media, albeit one delivered and managed in innovative ways. And while the number of HBO linear TV subscribers, ESPN linear TV viewers, and Amazon Prime shoppers have remained strong, giving each of those companies a solid, profitable base they could use to fund innovation, Netflix’s DVD subscribers are dropping.

Unless Netflix can find a way to get its streaming subscriptions back to the same rate of revenue and customer growth it enjoyed for most of 2010 and 2011, the profit loss from slumping DVD subscriptions will be an albatross around its neck. Netflix, the great innovator of streaming video content, could win the argument and lose the war.

http://www.wired.com/epicenter/2012/...ix-q4-results/

We know the bear thesis well – we wrote about it extensively a little over a year ago – and it just doesn’t hold much water anymore. The key pillars of the current bear thesis are that Netflix permanently damaged its brand last year with the price increase and Qwikster debacle, so subscribers would continue to flee, thereby reducing cash flow at a time when the cost of content commitments (which are fixed) are skyrocketing, triggering a cash crisis and a collapse of the stock. We couldn’t rule out this scenario, which is why we sized this position in the 5-6% range, but the odds of it just dropped a lot in light of yesterday’s earnings report. It shows convincingly that the furor over last year’s missteps is fading, subscribers are once again flocking to – and heavily using – the streaming service, the international opportunity is robust (who knew that Netflix is available in 47 countries?), and that the company is in good shape financially to weather this year’s small expected losses. All of this didn’t change the mind of one analyst, Michael Pachter of Wedbush Securities, who appeared on CNBC’s Fast Money just after me and said, “The company was more out of touch than I thought they were before. They’re making light of their diminishing content quality.” We think he’s the one out of touch, as Netflix is hugely focused on streaming content quality and this topic is discussed at length on pages 2, 3, 7 and 8 in the attached earnings release. In addition, Netflix’s streaming content is increasing in quality, even with the loss of the Starz titles. In fact, Starz is the big loser here: they turned down what was surely a very generous offer and instead tried to extort Netflix, so Netflix walked – and then went around Starz and got back many (most?) of the lost titles by negotiating directly with the content owners. This is a very important development that undermines of the key pillars of the bear thesis –namely, that Netflix’s streaming business will never be very profitable because content providers hold all of the cards. This would be true if Netflix had to offer all movies and TV shows, but it doesn’t. One of the key insights from our survey a year ago of 500+ Netflix customers is that they don’t expect a huge selection of the latest, most popular movies and TV shows for a mere $7.99/month. They only need to find something enjoyable to watch for one hour a day on average. This gives Netflix the power to play content providers off against one another. If Starz tries to extort Netflix, Netflix can walk and buy other equally good content from someone else. Netflix is providing a huge, brand new revenue stream to all sorts of content providers, which gives it a lot of negotiating power. And here’s the key: nobody else has even a tiny fraction of the number of subscribers that Netflix has (Hulu has a bit over 1 million, less than 5% of Netflix), so nobody else can bid anything close to what Netflix can. How much is Starz is going to get for its content that Netflix walked away from? Likely only a tiny fraction of what Netflix was offering. (It remains to be seen whether Apple, Amazon, HBO, Verizon, and the cable providers, who obviously do have tens of millions of subscribers, can become effective competitors – this is a risk we’re monitoring closely. But these are all much bigger companies, with 10x-100x Netflix’s market cap, so if they wanted to make a serious push in this area, it would be logical for one of them to buy Netflix, rather than spend billions trying to dislodge it.) For an analogy of how important it is that Netflix doesn’t have to provide all content, consider Costco and Wal-Mart. How does Costco buy at lower prices than Wal-Mart (and pass greater savings along to its customers), despite being a fraction of the size? Costco and Wal-Mart stores are roughly the same size, yet Costco only carries approximately 5,000 SKUs, whereas Wal-Mart carries 100,000+. Take light bulbs, for example. I’m making this up, but let’s say that the average Wal-Mart carries Sylvania, Phillips and GE bulbs, 40, 60 and 100 watt, in packages of 4, 8 and 12. That’s 27 SKUs (3 x 3 x 3). Let’s say that Costco, on the other hand, sells a 12-pack of 60- and 100-watt bulbs made by one company – that’s 2 SKUs. So when the buyers for Costco and Wal-Mart go to the three manufacturers to negotiate the best price, the Costco buyer says, “We only want two SKUs and we’ll give you more volume in those SKUs than anyone else – and we’re only going to carry one of you, so whoever has the lowest price gets 100% of our business.” The Wal-Mart buyer can’t say that – all three know they’re going to share Wal-Mart’s business, plus each manufacturer has to incur the added cost of supplying nine SKUs – so guess who gets the lower price? Netflix has similar advantages of being able to play suppliers off against each other to get a good price. Regarding position sizing, Whitney disclosed on CNBC last night we trimmed our Netflix position going into the earnings report, yet said we’re as bullish as ever and think the stock is a good bet to double this year. The explanation for this apparent inconsistency is that we have to carefully manage Netflix’s position size for risk management purposes because of the wide range of potential outcomes, including some severe downside scenarios. When we purchased the stock last year, we decided that we were comfortable with a 5-6% position, which is where it was entering this year. As the stock quickly ran up 40% prior to the earnings report, it became larger than a 7% position at the same time that the margin of safety had shrunk (our estimate of intrinsic value didn’t go up 40%), so logic dictated trimming a bit, which we did (back to the 5-6% range). Our selling didn’t reflect any change in our bullishness on the company – rather just the sharp rise in the stock price with little change in the underlying fundamentals. So with today’s run-up, will we be trimming it back to the 5-6% range? No. We’re now comfortable with a somewhat larger position because we have a lot of new information that changes the odds of the various possible outcomes: for the reasons discussed above, the likelihood of a severe downside scenario has declined significantly, while the upside scenarios are both more likely and more robust. In terms of safety, this is no Berkshire Hathaway to be sure, but it’s much safer today than it was yesterday.

Netflix is understating the impact of losing Starz on the quality of streaming content. Netflix described the remaining content available for streaming under the deal as fifteen Disney Pay 1 titles and Encore catalog titles, dismissing the Disney content as constituting only 2% of domestic viewing, and the Encore content as easily replaceable. We disagree with Netflix and view the Disney movies as some of Netflix’s most desirable streaming content, and the Encore content as a diverse catalog that enhances the depth of the streaming offering. • The loss of Starz reflects the difficult trade-off between content quality and content costs that Netflix currently faces. Netflix has to make a choice: either it will have high subscriber growth due to high-cost, high-quality content, meaning profits will be small or nil; or it will have lower subscriber growth due to low-cost, low-quality content, meaning it will make money but not be a growth story. In our view, the high-growth, high-profit story is not going to happen.

Can I get DVDs by mail from Netflix?
Yes. During sign up, you can add unlimited DVDs (1 DVD out-at-a-time plan) for only $7.99 more a month. With DVDs by mail, you'll get an even broader selection of movies & TV episodes. You can exchange each DVD as often as you want with no due dates or late fees — ever! You can add access to Blu-ray discs to your account at any time for an additional $2 a month.