Netflix Should Not Get Too Comfortable

According to Digital Entertainment Group, in 2010 total revenues from DVD, Blu-ray, and digital sales of movies and television shows in the U.S. fell 3% over the year to $18.8 billion. In 2010, sales and rentals of standard DVDs fell 11% over the year to $14 billion. In the same period, Blu-ray sales and rentals grew 53% over the year to $2.3 billion, while downloaded and streamed content revenues grew 19% over the year to $2.5 billion.

Netflix’s Financials
For Q4, Netflix (NASDAQ:NFLX) saw revenues grow 34% over the year to $596 million. EPS of $0.87 was also significantly ahead of previous year’s $0.56 and the market’s target of $0.71. The company added 3 million subscribers during the year to end it with 20 million.

For Q1, Netflix projects revenues of $684 million–$704 million with EPS of $0.90–$1.13 on a subscriber base of 21.9 million–22.8 million. The market was expecting revenues of $677.8 million with EPS of $0.87. Netflix expects to end the current year with 27 million subscribers.

Netflix’s Rising Costs
Since the beginning of last year, Netflix’s revenue per customer has fallen steadily from $12.90 in the first quarter to $11.64 in the recently reported quarter. Declining revenues per customer and the increasing cost of content have also translated into lower margins per customer. In Q1, Netflix’s gross profit per customer was $4.96, and it fell to $4.01 in the recent quarter.

In their domestic business, Netflix spends 65%–70% of revenues on content and postage. The company does still have competitive rates for some of their content. However, as these contracts expire, Netflix will need to renew them at significantly higher prices. Last year, they had signed an expensive $1 billion content agreement with Epix. Netflix currently has a content agreement with Starz which lets them stream content from Sony Pictures and Walt Disney for $30 million a year. This contract is set to expire in the first quarter of 2012, and analysts expect that it may be renewed at a significantly higher cost of $300 million.

Netflix’s CEO, Reed Hastings, believes that the company will be able to tackle the rising cost of content by increasing the subscriber base. As streaming consumers grow faster than DVD shipments, Netflix will be able to “afford to pay for the existing streaming content we have, and also get more content.”

Netflix’s Focus on Streaming
As part of their vision to become a streaming company that also ships DVDs, recently, Netflix announced the removal of the DVD queue option from streaming devices. Users will now have to go the website to prepare the DVD queue instead of being able to do it from their gaming consoles, DVD players, and iPhones. Netflix hopes to free resources and focus on streaming content by claiming that queuing “from a streaming device complicates the instant watching experience and ties up resources that are better used to improve the overall streaming functionality.” Netflix also expects this will slow the growth of DVD shipments, thus helping them to manage costs.

They also recently tied up with major consumer electronics manufacturers such as Panasonic, Samsung, Sharp, Sony, Toshiba to incorporate a streaming button on remote controls for connected TVs, Blu-ray players and other devices. According to NPD Group’s Connected TV Owners Study, nearly half of connected TV owners use their TVs to connect to the Internet, and 57% of these users access Netflix through these devices. Netflix is surely looking to increase access to their sites through the new remote.

Netflix’s Competition
Netflix should also be worried about growing competition. Amazon is becoming a strong contender. It is expected that Amazon will begin to offer streaming access to Amazon Prime members at no additional cost. In fact, at $79 a year, the Amazon Prime membership is cheaper than Netflix’s streaming option, which is priced at $7.99 a month.

Further, Amazon’s recent takeover of LOVEFiLM will also impact Netflix’s international expansion plans, especially in Europe. Last year, Netflix entered the Canadian market to test international waters. They are pleased with the market results and are looking to expand into other countries. By the end of the current year, Netflix expects to earn $10 million–$13 million revenues from international markets with a subscriber base of 750,000–900,000.

Competition is also coming in form of Sears, a retailer that has shown considerable adaptability in its more than 110-year history. Sears has entered the online movie market; Alphaline Entertainment lets Sears and Kmart customers download movies and shows, including new titles on the day they are released on DVD and Blu-ray. Sonic is also working with Sears on a multi-phase roll-out that will make the service available from a range of connected devices.

But for 2011, Netflix is not too worried about competition. Amazon’s library of online streaming titles has 5,000 titles compared with Netflix’s streaming library of close to 20,000, and I imagine that it will take Sears a long time to catch up with Netflix’s expanding reach.

Netflix continues to expand their subscriber base and now wants to migrate from the current one account per physical address to personal accounts. Personal accounts will enable multiple streams to users in the same household. Netflix believes that streaming of content to devices such as laptops and tablets has made TV and movie watching more of an individual activity. With Netflix’s tie-up with Facebook, users will also be able to post reviews on their Facebook accounts. This shift implies that Netflix will view their market as the number of “active mobile phones in a territory, rather than the number of households” as that would be the number of people who would be able to subscribe to their service.

Netflix’s stock is trading at $211.26 with a market capitalization of $11.15 billion. It touched an all-time high of $218 earlier last week.