Why There Won’t Be A Notable Improvement In Netflix’s Domestic Contribution Margin In The Future

Netflix‘s domestic contribution margin (profit margins after factoring in cost of services and marketing expenses) increased substantially between 2012 and 2015 due to operating leverage gain. However, going forward, we expect the expansion in the company’s domestic contribution margins to slow down considerably as variable expenses centered on its business model and content costs rise, thereby suppressing the positive effect of operating leverage gain and lower marketing expenses. Netflix’s domestic contribution margin increased from just 20% in 2012 to 35% in 2015 and we expect the figure to expand a little further and stabilize at just over 40%.

Increasing Variable Costs To Offset Operating Leverage And Lower Marketing Expenses

The most significant cost component dictating Netflix’s domestic streaming contribution margin is content cost. Netflix negotiates streaming content deals for fixed costs, which it pays over a period of time. Therefore, good subscriber gains can lead to revenue growth which can outpace the growth in costs. Though subscriber gains have slowed down a little, they are still running ahead of expectations, as was the case in the recently  concluded quarter. Another factor that can benefit Netflix’s contribution margin are its marketing expenses. These expenses have come down (as % of revenues) over the past few years, with the brand gaining substantial visibility through referrals and word-of-mouth. The image is such that even the recent price hike to $9.99 a month was not able to deter subscriber growth.

Even though Netflix is likely to benefit from the aforementioned factors, getting additional content and re-negotiating older deals is getting more expensive. In addition to this, the company is also focusing on bringing more original content to its subscribers, and the growing competition is bidding up content prices. Netflix recently announced that it is going to produce 1,000 hours of original content programming in 2017, up from 600 hours this year, with spending on content planned at $6 billion for 2017, up 20% year-over year. In addition to the fixed content costs, some variable costs such as bandwidth costs also impact contribution margins and these costs will increase in line with the growth of the subscriber base.

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