NetFlix 2006 Annual Report Download - page 43

Gross Margin
Year Ended December 31,
2004 2005 2006
(in thousands, except percentages)
Gross profit .......................................... $168,899 $216,438 $369,675
Percentage change over prior period ...................... 28.1% 70.8%
Gross margin ........................................ 33.8% 31.7% 37.1%
The increase in gross margin in 2006 as compared to 2005 was primarily due to a decrease in revenue
sharing cost per paid shipment, which includes a decline in the percentage of DVDs subject to revenue sharing
agreements mailed to paying subscribers, as well as an increase in revenue per paid shipment as a result of a
decline in overall usage and the continued popularity of our lower-priced plans. The increase in postage rates by
2 cents effective January 8, 2006 negatively impacted gross margin, however, this impact was offset by a decline
in fulfillment costs as a result of increased operational efficiencies.
The decline in gross margin in 2005 as compared to 2004 was primarily attributable to the increase in cost
of subscription, offset in part by a decrease in fulfillment expenses as a percentage of revenue. Cost of
subscription increased due to a decline in revenue per paid shipment as a result of the price decrease of our most
popular service plan implemented in the fourth quarter of 2004, offset partially by the change in estimate related
to the useful life of our back-catalog DVD library and the rapid growth of lower priced plans which produce a
higher margin than our most popular subscription plan of $17.99 per month. In addition, the gross margin for
2004 was favorably impacted by certain credits received from studios resulting from amendments to revenue
sharing agreements.
If movie rentals per average paying subscriber increases or if we see more shipments of DVDs subject to
revenue sharing and the revenue sharing cost per shipment does not decline, erosion in our gross margin will
occur. Additionally, in 2006, the U.S. Postal Service proposed an increase in the rate of first class postage in the
amount of 3 cents. If approved, the increase is expected to take place in mid-2007. The anticipated increase in
postage rates is expected to reduce our gross margin.
In January 2007, we introduced our instant-viewing feature which is being made available to subscribers in
a phased roll-out. During 2007, we anticipate incurring at least $40 million in additional expenses related to our
instant viewing feature. As a result, we anticipate that cost of subscription will increase as a percentage of
revenue, resulting in a decline in gross margin in 2007.
Operating Expenses:
Technology and Development
Year Ended December 31,
2004 2005 2006
(in thousands, except percentages)
Technology and development .............................. $29,467 $35,388 $48,379
As a percentage of revenues ............................ 5.9% 5.2% 4.9%
Percentage change over prior period ......................... 20.1% 36.7%
The increase in technology and development expenses in absolute dollars for 2006 as compared to 2005 was
primarily the result of an increase in personnel and facility-related costs, as well as to the development of our
instant-viewing feature. As a percentage of revenues, technology and development expenses decreased from 2006
as compared to 2005 primarily due to a greater increase in revenues than technology and development expenses.
The increase in technology and development expenses in absolute dollars for 2005 as compared 2004 was
primarily the result of an increase in personnel-related and systems infrastructure costs. As a percentage of
revenues, technology and development expenses decreased in 2005 as compared to 2004 primarily due to a
greater increase in revenues than technology and development expenses.
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