If you are a reader of Netflix's quarterly shareholder letters, you know that the company likes to tout a metric it calls contribution profit as an indicator of the performance of its various segments. The total contribution profit from streaming operations rose 49% year-over-year in the first quarter, with the U.S. segment growing its contribution profit by 55%, more than making up for contribution losses in the rapidly expanding international segment.
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Meanwhile, total operating profit was down slightly, and its net income was more than cut in half. Company guidance calls for continued profitability issues: Operating profit is expected to decline by more than 50% year-over-year in the second quarter, and net income is expected to contract by more than 75%. Yet, streaming contribution profit is still expected to grow.
When there is a big discrepancy between traditional profitability numbers and the non-GAAP figures that a company wants the market to see, it is usually a good idea for investors to fully understand what these numbers actually mean. In the case of Netflix, the picture it is trying to paint with contribution profit is quite a bit rosier than reality would suggest.
What, exactly, is contribution profit?
Contribution profit is a non-GAAP figure, meaning that Netflix can define it however it wants. Typically, when a company touts its own non-GAAP figures, the goal is to show its performance in the best light possible. Contribution profit is no exception -- the company defines this metric in its most recent 10-Q:
We define contribution profit as revenues less cost of revenues and marketing expenses. We believe this is an important measure of our operating segment performance as it represents each segment's performance before global corporate costs.
Cost of revenues include both content rights and content delivery costs. Netflix allocates these content costs along with marketing expenses between each segment, but it does not allocate technology and development costs or general and administrative costs. Both of these costs are necessary to run the business, and it seems a bit strange to exclude them.
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Technology and development costs include the maintenance and improvements of its streaming technology, user interface, and infrastructure. These are necessary costs for Netflix services to function properly as the company scales its operations, and excluding them from the calculation of a number supposed to represent the operating performance of each segment does not make much sense.
General and administrative costs are also necessary to run the business. In fact, the only cost included other than those related to content and marketing is the only cost not required to actually operate the business. What exactly, then, is contribution profit supposed to represent?
During the first quarter, the U.S. streaming segment managed a contribution profit margin of 31.7%, up from 25.2% during the first quarter of 2014. What does this actually mean? It is certainly not what's left over after taking out all necessary costs to run the business. It is essentially just the gross profit minus marketing, which does not seem to carry any special meaning to me.
It would be much more useful for investors if Netflix allocated all of its costs across its segments and reported segment operating profits. Regardless, what is clear is that the 31.7% contribution profit margin for the U.S. streaming business greatly overstates the true profitability of the segment. And the contribution losses of the international segment greatly understate the true losses of the international business.
In addition to contribution profit being a poor representation of the true profitability of its segments, the way in which the company allocates marketing dollars and content costs for global originals skews the numbers even further.
During the first quarter, Netflix shifted some marketing money into international markets. While total marketing expense rose by 42% year-over-year, marketing costs in the U.S. streaming segment only rose by 11.6%. Whether this lower marketing spending will ultimately lead to slower growth in future quarters remains to be seen, but for now, it effectively shifts contribution profit from the international segment to the U.S. segment, boosting its apparent profitability.
Increasingly, Netflix is licensing content globally when possible, as opposed to licensing content in each market individually. The company allocates these global content costs by geography, using a method which the company provided a vague explanation of in the most recent conference call. As the international segment grows, more of this global content cost will be allocated to the international segment, again providing a boost to U.S. contribution profit.
What this all means is that the size of the improvement in the U.S. contribution profit during the first quarter is not what it seems. Shifting marketing dollars and an opaque method for allocating certain content costs casts even more doubt over how useful contribution profit is as a measure of Netflix segment performance.
The article Netflix, Inc: The Truth Behind Its "Contribution Profit" originally appeared on Fool.com.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Apple and Netflix. The Motley Fool owns shares of Apple and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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