Why I Think Netflix Got Its Pricing Hike Right

(Note: I am neither a Netflix employee, nor an investor. I do not anticipate to own Netflix stocks and am not related to that company. Please do not take my commentary below as an investment advice. Everything I have written below is purely my personal opinion.)

This past week has been marked by lots of chatter in print media and the general web about Netflix’s updated Q3 2011 guidance. In essence, lots of investors got jittery about Netflix’s revised subscription numbers and the stock price went down. While I can see how a revision to the expected top line growth may push a stock price downward, I believe Wall Street is over-reacting. And perhaps the over-reaction is primarily due to the way the updated guidance was presented to the general public by the mainstream media (click here, here and here for a few examples of a bit over-rushed posts in several online sources that I typically read and respect a lot).

Prompted by this hysteria, I did some back-of-the-envelope analysis, which makes me even more confident that Netflix did the right thing with its pricing. Here are the facts that make me think so:

(Note: All numbers below are for domestic subscribers only, because the released updated guidance concerns domestic subscribers only.)

  • On June 30, 2011 Netflix had (domestically) 18.5 million paid hybrid subscribers (both DVD and streaming), and 4.8 million paid streaming subscribers. This sums up to 23.3 million paid subscribers. (Source: Q2 Quarterly Filing. This same source provides most of the numbers in the bullets below, as well.)
  • The price plans on June 30, 2011 were as follows: Unlimited Streaming (non DVDs): $7.99; Streaming plus 1 DVD: $9.99; Streaming plus 2 DVDs: $14.99. Using this, I estimate the weighted average price to be $12.49 for both plans with DVDs and $11.56 across the 3 segments of customers.
  • As of June 30, 2011, Netflix was making $231.1 million per 1 month of usage from hybrid subscribers plus $38.35 million per 1 month from streaming-only subscribers. The total revenue per 1 month of usage from all 3 segments of customers was $269.4 million.
  • Given the new Q3 guidance, Netflix expects to have 12 million hybrid subscribers, 9.8 million streaming-only subscribers, and 2.2 million DVD-only subscribers. Let’s call the hybrid subscribers “whales” – because they pay the high price, and subsidize everyone else.
  • Netflix will lose 35% of its “whales” (12 million vs. 18.5 million) but will charge the remaining “whale” customers 28% more. Thus, “whale” revenue per 1 month of usage will decline by 17% to $191.76 million.
  • But Netflix will gain 150% more regular subscribers who will continue to pay the same price as before ($7.99). Thus, “non-whale” revenue per 1 month of usage will increase by 150% to $95.8 million.
  • Total revenue per 1 month usage will thus increase by 7% to $287.56.
  • In comparison, between Q1 and Q2 2011, Netflix grew its hybrid (“whale”) customers by a mere 0.4% and its streaming-only (“non-whale”) customers by 59%. Total revenue per 1-month usage grew by 6%, from $253.79 million to $269.42. (Additional source: Q1 Quarterly Filing.)
  • So, top-line growth is in line with previous quarter growth.
  • The big difference is in the bottom line. By increasing the price, Netflix is churning voluntarily its less profitable customers (i.e., those who were ordering DVDs). At the same time, it has more than doubled its more profitable customers (i.e., those who only do streaming). And its “whales” group has remained pretty sizeable, but now paying more. I think this aligns the company’s profitability much better than before.
  • So despite the increase in streaming rights, which was forced on Netflix by the big TV and movie studios, Netflix should be able to keep its costs in line (and maybe even cut some costs) by getting rid of unneeded DVD inventory and warehouse space, plus reducing postage and handling fees (which accounted for approximately 50% of the company’s COGS in 2009). I’ve put together a quick graph (see first graph below) that shows how postage and handling fees rose for Netflix from 2006 to 2009. You can expect that trend has continued upward since then. And in case you doubted how many resources warehousing the DVDs required, take a look at the second graph below.

I believe the confusion among journalists and the general investors comes from the downward revision of the subscribers’ guidance. Netflix initially forecasted 25 million total paid subscribers, but now expects 24 million – 1 million fewer. But all of these 1 million “lost” subscribers are paying at the low price point ($7.99) => $7,990,000 less revenue per 1-month usage. What is important to me is that Netflix got the number of “whales” right – this is most likely where they make the highest margins. And, Netflix will also see a bigger cut in DVD-handling costs than expected. If Netflix did something wrong, it is that the company communicated its optimistic scenario forecast in July, but should have communicated its pessimistic scenario instead. Thus, it set the wrong expectations. While we are on the topic, I came across an interesting article on lessons learned in communicating price hikes (again using Netflix as an example). Take a read – a pretty interesting post.

After having said all that, I want to make one important point. Please don’t get me wrong. I am not a “Netflix fanboy” and have my reservations about the viability of the company’s business model. But these reservations relate to other areas – not the price changes from this past summer.

If you’re curious what my reservations about Netflix are, here is a quick summary:

  • ISPs may re-evaluate their “unlimited usage” terms and conditions. This will directly affect Netflix’s customers’ ability to consume its streaming products. This is a very real threat – if you are a Comcast user, pay closer attention to your online bill. I am sure you’ll notice somewhere a mentioning that you have consumed X% of your monthly quota of 20GB or something similar (and that is on an “unlimited” plan).
  • Streaming video content may prompt ISPs to charge Netflix high “long-haul internet traffic” fees. If this happens, it will make streaming movies expensive and unattractive to Netflix as shipping DVDs now is. If you want to see why Netflix may qualify for “long-haul internet traffic” fees, take a look at the graph below.

So what do you think? I look forward to reading your comments.

Update: September 19, 2011

Netflix’s CEO Reed Hastings just came out with a blog post that describes the company’s decision to split its businesses into two divisions (and potentially into two separate companies down the road).  Since I just wrote my opinion above a few days ago, I thought I’d drop a few lines to comment on this latest development. I think Netflix is doing this split as more than just an excuse for the price hike. So if you are interested, please read my new post, Netflix’s Move to Separate the DVD Business Is More Than a PR Excuse for Price Hike.

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