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Netflix's Expanding Contribution Margin is Evidence of an Exceptional Business

Netflix (NASDAQ: NFLX) continues to prove to investors that it is an exceptional business.

The most potent argument in favor of this is Netflix's contribution margin performance. Essentially the gross profit margin for each of Netflix's segments (domestic streaming, international streaming, and domestic DVD), contribution margin subtracts costs attributable to that segment from its revenues. By adding the contribution profits of each segment, you get the gross profit of the entire company.

Image Source: Getty Images.

Domestic streaming generated $553.9 million in contrition profit in Q3 FY 2017, and companywide contribution profit amounted to $679.4 million. Domestic streaming has managed to improve its margins from 23% of revenues in 2012 to 36% as of last year. Netflix's ability to raise prices ahead of increased content costs is a testament to Netflix's strength as a business.

Data Source: Netflix.

Netflix has plenty of competitors, including Hulu, Alphabet-owned Youtube, Amazon Prime Video, and soon Disney's own streaming service. In spite of this, Netflix has managed to raise prices and expand profit margins, all while consistently adding subscribers.

Data Source: Netflix.

Netflix is the leader in the on-demand streaming industry. Bulls believe that it will maintain this lead, grow its membership, and raise prices as appropriate.

Importantly, the value of its subscription is growing along with its prices. Netflix's management is not raising prices and resting on its laurels. On the contrary, the company continues to invest in content, thereby expanding its value proposition. A Netflix subscription with more content choices should cost more. Netflix is aware of this dynamic and intends to spend between $7 and $8 billion in 2018 on content, up from approximately $6 billion this year.

Of course, there are risks to Netflix's growth story. The streaming-video giant's member growth will inevitability slow. Indeed, Netflix's decelerating member growth is already evident domestically. Much of the low hanging fruit has simply already been picked. And price increases may not be sustainable over the long haul. As bears point out, higher prices could eventually alienate some current and future subscribers.

Despite these risks, Netflix ultimately stands out as a solid business. As the market leader in online streaming content, Netflix continues to expand its business moat (in this case its content library). Its durability as a business is already strong, as evidenced by its ability to raise prices. Investors should have companies with this capability on their radar. True, Netflix's shares are pricey at 149 times forward EPS estimates, and a bet on its shares today is a bet that it will expand its current subscriber base well beyond its current base of 109.25 million. But, for now -- thanks to its proven ability to grow its contribution margins -- the weight of the evidence lends itself to the bull case. 

True, Netflix's shares are pricey at 149 times forward EPS estimates, and a bet on its shares today is a bet that it will expand its current subscriber base well beyond its current base of 109.25 million. But, for now -- thanks to its proven ability to grow its contribution margins -- the weight of the evidence lends itself to the bull case. 

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Sean O'Reilly has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Amazon, Netflix, and Walt Disney. The Motley Fool has a disclosure policy.