Netflix, Inc. (NFLX)’s Horror-Flick Sequel

Whereas before the company had only to pay the price of the DVD and take care of shipping and handling charges, it now must cough up enough dough to pay for steep licensing agreements. Recently, the rap on Netflix has been that overseas marketing and development costs are eating away at margins, but its cost of revenue (i.e., licensing fees) has increased disproportionately, as the table below shows.

Source: Netflix shareholder letters.

As you can see, despite incremental improvements in revenue, gross profit has barely gone up, and gross margin has dropped every quarter. The effects of shifting to the new model are clear, and even though the market cheered the quarter, profits still dropped 80% from a year ago, before the streaming service pushed into the U.K. It will take at least several quarters to return to that level.

We’ve seen this pattern before. Pandora Media Inc (NYSE:P) , the Internet radio service, has won much acclaim from its listeners, but profits have been evasive as content costs outpace revenue growth. Like Netflix, it doesn’t have the leverage it needs to negotiate effectively with content providers. For Netflix, this was not a problem under the DVD model. Netflix has something Pandora doesn’t in its trove of paying subscribers, but the Qwikster debacle showed that its customers are a price-conscious bunch. Any attempt to squeeze its viewers for more than $8 per month will likely send them running to Amazon’s a la carte offerings or to Redbox’s kiosks.

Foolish bottom line
Margins in its streaming segment continue to improve, but the gains Netflix makes in that area will be erased by the depletion of its DVD subscribers. Like Pandora, it’s easy to like the service, but the nature of the business doesn’t seem to justify its current valuation. With international losses racking up and DVD subscribers dwindling, it may be curtains for Netflix shares once again.

The article Netflix’s Horror-Flick Sequel originally appeared on Fool.com and is written by Jeremy Bowman.

Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix.

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