Netflix Earnings: Taking on Cable Costs a Whole Lot

Last Updated Jul 25, 2011 6:35 PM EDT

At first glance, it was a good-news/bad-news quarter for Netflix (NFLX). The high flier -- at least based on its new business of serving television and movies over the Internet -- reported disappointing revenue but earnings-per-share that exceeded analyst estimates. But there's a much bigger potential issue sitting in the company's financial report.

Many see Netflix as a major force surging against traditional commercial entertainment distribution -- read, cable and satellite TV -- largely because traditional pay television sucks and costs a lot. But the threat Netflix creates comes at a high price. Much like the music streaming service Pandora (P), Netflix has to learn to live with the terrific expense of simply providing its services.

The first thing we do, let's kill all the DVDs
As Dan Frommer clearly and accurately notes, Netflix wants to kill the DVD. It's pushing to get rid of the costs of physical media and force the studios to stream more content. The major argument is that the DVD has already hit its high-water mark. From now on, it's downhill for the disks in terms of market share.

It's a grand idea for those of us who have dumped traditional pay TV. But this is a dangerous game for Netflix because it's starting to look like Pandora, and the comparison isn't a compliment to Wall Street. In its most recent fiscal year, Pandora's cost of revenues was 58.7 percent of gross revenue and marketing and sales were 26.3 percent. That's a total of 85 percent.

Netflix isn't anywhere near as bad -- yet. Look at its numbers for the first six months of 2011:
  • Revenue: $1.51 billion
  • Total cost of revenue: $579 million
  • Marketing: $199 million
That's a total of $788 million in cost of revenue and marketing, or 52 percent of all revenue. That's still far below where Pandora is, and it's down from the 76 percent level Netflix hit in 2010. But it's still uncomfortably high.

But wait, there's more
Now for the kicker. The studios all want more money from Netflix. A lot more. Michael Pachter, an analyst at Wedbush Securities, thinks that in the next few years, studios might seek ten times what they get today for permission to use the material. Last year, those costs alone were 53 percent of Netflix's total revenue.

Even though Netflix had $160 million in net income, that level of profitability could quickly vanish if costs escalate. And the only option would be for the company to pass on the expenses, raising prices as it recently did.

In fact, that may be the whole aim of the video industry. After all, why shouldn't the studios try to make Netflix every bit as expensive for consumers as cable is now? That's how Hollywood makes its money. Unless all those companies are willing to cut their own profits, they ultimately want no part in making anything cheaper for viewers.

Related: Image: Flickr user Racum, CC 2.0.
  • Erik Sherman On Twitter»

    Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.

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