Seeking Alpha
Long/short equity, long only, short only, growth
Profile| Send Message|
( followers)  

Shares of Netflix (NFLX) rocketed higher on Wednesday after an analyst at Morgan Stanly reiterated his Overweight rating and upped his price target from $80 to $105. The analyst believes that the Disney (DIS) deal represents a vote of confidence in Netflix, and that sent shares to a multi-month high. The problem here is that the analyst also believes Netflix could raise prices again, which would deal a significant blow to Netflix's streaming subscriber growth. On Wednesday, we also got an official announcement on the Coinstar (CSTR) and Verizon (VZ) Redbox program. After reading the details of the program, one thing is clear. Netflix should seriously reconsider its decision to let the DVD segment die. I've had this stance in the past, but the new Redbox deal is the clincher. Today, I'll analyze the latest news regarding Netflix.

First, the analyst note:

Analyst Scott Devitt seems to love Netflix's deal with Disney. He thinks that the deal will allow Netflix to better negotiate with other content providers. Since content providers hold most of the leverage, Netflix needs all the help it can get. But there's a very worrisome part of the analyst's note, which is shown below:

"We believe Netflix can afford it based on its current content obligation schedule, however, Netflix has two additional options: 1) rationalize its content portfolio and cut underperforming content or 2) raise prices. A third outcome of the Disney content is that the catalog titles and direct to movie content will lower churn of existing and new subs. Raising prices is a sensitive topic, especially given the backlash from the July 2011 event, however, we believe that price elasticity is not as high as investors believe. Redbox increased its cost to rent DVDs from $1.00 per day to $1.20, which is effectively a 20% price increase. A 20% price increase for Netflix would bring the company's Domestic Streaming ARPPU to $9.59. A $9.99 price point would be a 25% price increase. As long as Netflix continues to develop a differentiated content portfolio, we believe the company has the ability to exercise modest pricing power down the road."

As I've described in past articles, one example here, those are two bad choices for Netflix. Netflix cannot start dumping content for the following reasons:

  • Subscribers come for the large content base. If Netflix starts dropping content, it will make subscribers unhappy. Always give the customer what it wants.
  • As Netflix lets exclusive deals expire, like they recently did with Epix, it allows other services to pick up content. Amazon (AMZN) snapped up Epix content once Netflix lost exclusivity. Redbox Instant will launch with Epix content.
  • Netflix lets smaller rivals gain traction in the space. It cannot allow smaller rivals to become stronger.
  • By Netflix being choosy with what content it wants, content providers could in turn ask for higher rates, because they know that they hold the leverage.

The analyst also believes that Netflix has pricing power and could raise prices again. I think this would be a devastating idea. We saw the backlash Netflix faced last year when it raised prices. Especially in this struggling economy and with tax rates potentially going up if we go over the fiscal cliff, a price raise is not smart.

The Redbox announcement:

On Wednesday, we got a formal announcement on the Redbox Instant Service partnership between Verizon and Coinstar. The main details are shown in this section from the article:

"Later this month, the Redbox Instant by Verizon beta product will launch to consumers. Priced at $8.00 per month, Redbox Instant by Verizon offers a high value subscription package that combines unlimited streaming of thousands of popular movies, including titles from premium network EPIX, with four one-night credits per month for the latest movie releases on DVD at Redbox® kiosks. For $1 more, or $9.00 per month, customers can opt to redeem their four credits for rentals on Blu-ray Disc™ at the kiosk."

So everyone sees the $8 immediately and thinks that it is the same price as Netflix. But that is completely wrong. Here's how Redbox normally prices movies, taken directly from their site:

The cost might vary a little from city to city, but in most places, DVD rentals are $1.20 a day + tax, Blu-ray Disc rentals are $1.50 a day + tax.

Whether you get 4 movies at $1.20 each, or you spend all four credits for a four-day rental, you are getting $4.80 from the DVD side of this package. So if you subtract out the $4.80 (ignoring taxes for now), the streaming service really only costs $3.20 per month, or about 40%, and that's for DVDs. If you go with 4 Blu-rays per month, then you are talking about just $3 a month for the streaming service. This assumes that you are using the four credits per month, otherwise your cost can be up to the $8 a month. But for a subscriber that uses Redbox once a week, or four times a month, a streaming service for just $3 isn't too bad. Obviously, you don't have access to as much content, but the price is much lower. For $8 a month, unlimited streaming plus 4 one day rentals seems like a good deal. Especially when Netflix charges $7.99 for the streaming plus another $7.99 for the DVD plan.

The $8 Redbox Instant idea could be a low-cost alternative for those that want to save some money, or for those that aren't glued to the TV. If you're only watching one or two movies a week, Redbox Instant might be a legitimate alternative for consumers.

Bring Back the DVD!

I showed the financial importance of the DVD segment in my latest Netflix article, where I showed just how important the high-margin DVD business is for Netflix. In the DVD segment, contribution margins are currently over 48%. In the streaming segment, it's about a third of that, a little above 16%.

Today, I'll show you some different numbers, but the story remains the same. DVD is more profitable that streaming! In the following table, I've calculated contribution profit per paid subscriber "CP/U" in each quarter.

*Q4 numbers based on midpoint of guidance range given.

A streaming subscriber generated less than $4 of contribution profit for Netflix in the United States during Q3, but a DVD subscriber generated nearly $16. That's a huge difference. Even though the gap has come down over the last year, it's still very wide.

So let's look at this a different way. Assume for now that Netflix continues it's international expansion plan indefinitely and that contribution losses from the international side of the business remain at their current level. In Q3 of 2012, Netflix generated approximately $221.6 million in contribution profit from the US side of the business, of which only about $91 million came from streaming. The other $130 million plus was from the DVD side. Let's assume the DVD business goes completely away. How many streaming subscribers would they need? Well, it might surprise you. The number actually depends on what the margin of that business is, so I put together this table below.

The table starts out by giving that contribution margin level we are at now, approximately $221.6 million. The second line is a range of contribution margin. In Q3 of 2012, the streaming contribution margin was 16.36%. Given those two numbers, you can calculate the revenues needing from streaming to generate that contribution profit. Over the last four quarters, the average quarterly revenue per paid subscriber is $23.37, because the month free trial impacts the average a little. We'll use that number going forward. The bottom line shows how many streaming subscribers they would need, in thousands. Just to recap, contribution profit, revenue, and subs numbers are in thousands.

So if the DVD business goes away, and streaming margins fall to 15%, Netflix would need over 63 million streaming subscribers in the US to make up for the lost contribution profit. For Q4 of 2012, they are guiding to approximately 25.15 million paid subscribers! Again, this is assuming no help from the international side of the business. But these numbers are staggering. Even if we assume a rise to 20% in streaming margins, Netflix still roughly needs to double its streaming subscriber base. How confident are you that they can do that?

Of course, Netflix wouldn't need as many subscribers if they were to raise prices, but that would impact subscriber growth. Netflix still needs to regain some creditability after the fiasco during 2011 and 2012, so I think the earliest they potentially could raise prices would be 2014. But again, I don't think they should.

Final Thoughts:

Netflix shares rose above $90 on Wednesday thanks to those analyst comments, and investors seemed to shake off the Redbox news. I think it is a mistake to ignore the Redbox service, because it's another competitor out there. As I stated in my last article, it's not about one competitor that prevents Netflix from gaining five million new subs. It's about each of the smaller competitors that can take shots at Netflix from any direction.

The DVD business is extremely important to Netflix right now, and they are just letting it wither away. That is a mistake. Netflix may want to reconsider what their long term strategy is. I know that they want to be the streaming king, but it's not the most profitable strategy. Without the DVD segment, Netflix may be forced to dump content or raise prices. I don't think they want to do either of those. Shares keep getting propped up, which makes this stock even more of a short candidate, now trading at 211 times next year's expected earnings. On October 5th, the valuation was only 73 times. While I haven't officially recommended a short position on the name in some time, I have told investors to keep it on the short candidate list. The number of shares short did drop from 17.2 million to 14.5 million during November, so the shorts have disappeared for now. When they return, it will be ugly. Investors not believing in the Netflix story should keep this stock in the "short candidate" bin, and should think about what level they might want to initiate an actual short position.

Source: Netflix Should Reconsider The DVD

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.