Netflix Points a Way Forward for Streaming's Success (Analysis)

How does a streaming company turn a profit? There's one good example: Netflix, which released second-quarter earnings Monday.

Netflix is the only publicly traded company that deals almost entirely in the streaming of licensed digital media. Streaming accounted for 85.5% of the company's $1.34 billion of revenue last quarter. The remainder, $195 million, came from the legacy DVD rental business.

It's important to ask how a streaming music company can succeed. Streaming is the next important business segment. It will one day overtake downloads and CDs. But profits are elusive. There are reasonable fears that streaming music is too difficult for a standalone company. As with CDs and downloads, streaming music could be merely a means to an end -- Google search queries, an iPhone or an Amazon Prime account.

Scale is mandatory for any streaming company. Netflix has it. Figure 1 offers a quick glance at revenues and expenses for Netflix's domestic streaming business. It depicts a company that was able to turn the corner and achieve profitability in spite of considerable expenses. Last quarter, cost of revenue was $546 million and marketing expense was $65 million.

With more subscribers come better metrics. From Q2 2012 to Q2 2014, Netflix's domestic streaming grew from 22.7 million to 35.1 million subscribers. As a result, cost of sales as a percent of revenue fell from 71.1% to 65.2%. This means the direct costs of running a streaming media service became more manageable as more subscribers were acquired. (A shift to proprietary content could have also had an effect.) Similarly, marketing expense as a percent of sales fell from 12.5% to 7.7%.

That jump, from 22.7 million to 35.1 million subscribers, caused contribution profit to increase 160%, from $87 million two years ago to $227 million last quarter.

Netflix's domestic streaming division is a best-case scenario for a music streaming company. In reality, today's music streaming services probably resemble something like Netflix's international streaming division, shown in Figure 2. Where domestic streaming generates big profits, international streaming is deep in the red.

Having too few customers wreaks havoc on a streaming company's financials. Although subscribers grew from 3 million two years ago to 12.9 million last quarter, the corresponding increase in revenue hasn't been enough to overcome expenses. While cost of sales improved to 87% of revenue last quarter from a whopping 167% two years ago, the international division still returned a $15 million loss.

But 300% subscriber growth brought some positive changes to international streaming. The $15 million loss was a vast improvement from the $89 million loss two years earlier. Gross margin improved from -167% (a negative number because cost of revenues exceeded sales) to 87%. Marketing expense as a percent of revenue improved to 18% from 71% in two years even though grew only 22% in dollars. These are the kind of improvements also available to a music streaming company that's able to significantly grow subscribers.


Note two key similarities between Netflix and music streaming services. Two years ago, the cost of sales at Netflix's domestic streaming division was 71.1%. A music streaming service that pays rights holders 70% of revenue will have a similar cost of sales. And like Netflix, a music streaming service could decrease cost of sales, as a percent of revenue, as it becomes bigger. In addition, Netflix generates an average of about $8 a month from each subscriber. That's in line with subscription services' per-subscriber revenue.

So what's preventing music streaming services from being profitable? Subscription services have too few subscribers. The margins of the music subscription business model are obviously difficult, but Netflix shows it's not impossible to turn a profit on a 30% gross margin. Internet radio, namely Pandora, is in a different situation. It attracts large audiences, but revenue has lagged listenership.

For both subscription services and Internet radio, the final ingredient will be time. Netflix needed time to amass the tens of thousands of streaming subscribers to make its business model work.