Netflix's Price Hike Suggests DVD Segment Divestiture

Jul.13.11 | About: Netflix, Inc. (NFLX)

Yesterday, Netflix (NASDAQ:NFLX) announced that it planned on raising rates for its DVD-by-mail services, requiring customers to pay for streaming and DVD-by-mail services separately. While customers have expressed their disapproval, there are clearly some legitimate business reasons behind this move.

For starters, Netflix’s $9.99 plan that included unlimited streaming and one DVD by mail was overwhelmingly popular, in part because it was selling it for below-market rates. It’s highly likely that Netflix was losing money on the DVD-by-mail aspect of the package.

Even using the most optimistic estimate and assuming the average customer only rented 2.5 DVDs per month and that NFLX incurred 90 cents in shipping and handling on each DVD, that would suggest incremental costs of $2.35 in exchange for $2.00 in incremental revenues. This ignores overhead and other costs that any real business would face, so it’s no stretch to say that Netflix was using its DVD-by-mail service as a loss leader in order to convince customers to switch over to the more profitable streaming service.

Yet at the same time, if Netflix was losing money on its DVD-by-mail business, it does not necessarily stand to reason that it should split the two services. To the contrary, bundling would be a more attractive option for customers and NFLX could probably reduce DVD-by-mail losses by merely raising the rates on its bundled packages. A $12 to $13 streaming + 1 DVD package could probably break-even on the DVD side. Instead, NFLX decided to completely separate the businesses, charging customers $16 for a package that used to be $10.

Divestiture of DVD-by-Mail

Such a dramatic price hike risks alienating customers in multiple ways. Not only is it steep and sudden, but it also seems completely unnecessary if NFLX wants to continue along its current path. The one and only way this move makes sense is if Netflix is planning to divest its DVD-by-mail business.

In many ways, this is a risky move. However, Netflix’s executives may feel they have no other choice to achieve their goals. While NFLX had run a profitable DVD-by-mail operation for several years, you have to wonder what would happen once potential suitors came around to look at its books and realized that its DVD-by-mail was now bleeding cash. Certainly, potential buy-out parties would understand that some of this was due to Netflix’s business model, but from their perspective, it’s also a risky proposition to buy into a shrinking business when you have no idea what the true level of profitability should be.

Netflix was going to have a difficult time getting any sort of reasonable value out of the DVD business unless it could prove to potential suitors that it was profitable. Hence, Netflix’s attempt to completely separate its two business lines is an obvious attempt to show that DVD-by-mail is still profitable.

Cracking the Door Open?

While Netflix’s price hike makes sense if it plans to divest the DVD-by-mail segment, it unfortunately does not come without major risks. Now that prices on the DVD plans have been hiked once again, Amazon’s (NASDAQ:AMZN) instant video services suddenly look more attractive. It’s clear that the cable companies and Dish Network (NASDAQ:DISH) want a piece of this game as well.

With the increased availability of streaming, one has to wonder if DVD-by-mail is as economical of a business as it was three years ago. Netflix’s new one DVD plan costs $8 per month. If the average customer rents three DVDs per month, that’s a little over $2.60 per rental. This essentially means that if other movie streaming services can get the costs down to around the $2-3 price point, they become competitive with Netflix. This would seem well within grasp for a company like Amazon.

Of course, Netflix’s DVD services become more economical the more DVDs the customers uses in the month, so heavy users will certainly still find some value here. Of course, the heavy users are the ones that Netflix has never liked all that much to begin with, lest we forget Netflix’s infamous practice of throttling in the mid-00s. From Netflix’s perspective, heavy users have never been good customers. Yet, from a customer perspective, you are interested in more affordable options out there, so Amazon and other streaming services suddenly become more worthwhile to check out.

In a sense, Netflix may be gambling on DVD-by-mail still being a profitable business segment, but in actuality, it’s likely a dying industry. It may still be able to turn a profit in the short-run, but in the long-run, it’s highly likely that other streaming services would be more economical and convenient for most customers. Maybe Netflix is hoping to turn a quick profit this year and then hope some sucker still thinks there’s some real value in DVD-by-mail.

The Downside for Netflix

The upside for Netflix is that the DVD segment is still profitable, so it's quickly able to sell it off to an outside party, and then can use the proceeds to invest back into the more lucrative (and growing) streaming business. This is completely possible, since Netflix won’t have to invest much in this business to keep the cash flows coming in.

The downside is that DVD-by-mail could prove to be uneconomical and this move by Netflix merely alienates streaming customers. In fact, the DVD-by-mail service is still a great perk if you subscribe to steaming. It certainly makes Netflix more attractive to many customers, and it’s one unique selling point that no one else in the market can replicate. With the new set-up, Netflix is forcing customers to determine how much they value DVD-by-mail; the answer might be less than they imagine.

One thing is clear, however: Netflix’s price hike is great news for Amazon, Dish Network, Redbox, cable companies, and even the movie studios. It’s less clear whether it will be good for Netflix.

Why This Isn’t the Best Move for Netflix

While I would in no way, shape, or form claim to know how to run Netflix’s business as well as Reed Hastings has, I have to question the wisdom of this move. Certainly, it makes sense to try to separate out the two segments, so that the DVD-by-mail segment’s profitability is clearer. However, from a business economics perspective, it seems highly unlikely that any other party would gain nearly as much value from Netflix’s DVD service as Netflix does.

Once this business is separated from Netflix, it could easily be ignored by mainstream consumers; that’s even assuming it provides a reasonable value. Moreover, due to the economies associated with bundling, Netflix can charge lower rates and still make a profit when bundling with streaming than other companies would be able to make running the DVD segment alone. In a sense, NFLX is destroying economies of scope associated with running both business lines.

So how would this segment have more value for an outside party than it does for Netflix? The answer is that it probably doesn’t, and whoever ends up buying is a sucker, unless it can get it for a rock-bottom price. Maybe that sucker will come along, but I think it makes more sense for NFLX to extract as much value out of it now and let it die when the time comes.

My Positions

For the record, I am a Netflix subscriber and I also own a small amount of ’13 puts on Netflix. As you might have suspected, these positions have been big losers since NFLX’s stock price has moved dramatically upwards over the past few months. I’ve given up on these puts, more or less. Lucky for me, my position was small enough that it didn’t put much of a dent in my portfolio.

My belief is that Netflix is much overvalued, but I have no plans to initiate any new puts on it.

Disclosure: I am short NFLX.

Additional disclosure: I own a small number of '13 puts on Netflix.