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Tuesday, February 14, 2012

From operating profit targets to contribition margin targets-the case of Netflix

Netflix transformed the USA DVD rental market by sending DVDs by mail, without late fees etc. And later, it was among the first to jump on the movie streaming bandwagon. An unlimited subscription for a pittance ensured happy subscribers, growing profits and a booming stock price. Whitney Tilson led a bear attack but finally caved in and even took a long position. But when it seemed nothing could go own, Netflix tried to cannibalize itself, and dramatically failed in what must be one of the classic PR case studies of the future. For more, read about it here(http://seekingalpha.com/article/361571-netflix-major-recapitalization-or-bankruptcy-in-2013). While reading the 10K for FY11 released in Feb12, these remarks jumped out
In the past, we have focused on operating margin targets. Going forward, we will be operating within the parameters of contribution profit targets for each of our operating segments. Contribution profit is defined as revenue less cost of revenues and marketing expenses.'

That implies they view their fixed costs as uncontrollable, as taught in Management Accounting 101. But that is true only for the short term, who will pay those costs for the long term? Thankfully, they are considering marketing costs in contribution margin as well(instead of calling that fixed), and also consider their fulfilment costs(whose wide definition seems to encompass). The below definitions explain their understanding of those costs.
Cost of revenues consists of cost of subscription revenues and fulfillment expenses.
Cost of subscription revenues consists of expenses related to the acquisition and licensing of content, as well as content delivery costs related to providing streaming content and shipping DVDs to subscribers. Costs related to free-trial periods are allocated to marketing expenses.
Content delivery expenses consist of the postage costs to mail DVDs to and from our paying subscribers, the packaging and label costs for the mailers and all costs associated with streaming content over the Internet. We utilize third-party content delivery networks to help us efficiently stream content in high volume to our subscribers over the Internet.
Fulfillment expenses represent those expenses incurred in content processing, including operating and staffing our shipping centers, as well as receiving, encoding, inspecting and warehousing our content library. Fulfillment expenses also include operating and staffing our customer service centers and credit card fees.

It seems Netflix is not considering contribution margin in the conventional sense(sales-relevant variable costs) but is defining it more like adjusted gross margin. Here, it is kind of axing its own foot because the average investor may presume contribution margin to only include content/delivery costs(of streaming), and may therefore be sceptical after seeing those numbers. Still, it is the rare company which is not (so far) gaming the proforma metrics, so its good.

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