Why the Economics of Netflix's Streaming Business Is Likely to Fail

Aug. 3.11 | About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) has generated significant controversy regarding the recent separation of their streaming plan from their DVD by mail plan and the effect it will have on the business going forward. By offering a bundled service, they viewed this as the customer paying $7.99 for the streaming portion of the service and an add-on of $2.00 for the ability to have 1 DVD out at a time (or $4.00 for 2 DVDs out at a time). They claimed they were losing money on the DVD portion of the bundle, thus the need for the separation of the plans and an effective price increase of 33%-60%.

Whether the customer actually valued the bundled offering this way will be seen by which plan customers migrate to: streaming only, DVD only, or a combination package. The company is forecasting that 22 million, or almost 90%, of their customers will take the streaming only or a combination package with streaming. As the company has been transitioning to the streaming model, there hasn’t been enough data provided to determine the economics of that business. Until now.

For the first time, Netflix detailed the subscribers that are streaming only. With this data, as well as comments from their second quarter Letter to Shareholders (.pdf) that “nearly 75%” of new subscribers sign up for the streaming only option, a churn rate for streaming customers can be calculated:

(in thousands)

Beginning Streaming Subs at 3/31/11 (A)

3,745

Domestic Gross Additions

5,315

Percentage of Gross Additions Streaming

75%

Gross Streaming Adds (B)

3,986

Ending Streaming Subs at 6/30/11 (C)

5,738

Total Churned Streaming Subs (A+B-C) (D)

1,993

Streaming Churn Per Month C / (A+B) / 3

8.6%

Click to enlarge

Source: Netflix 6/30/11 10Q & 2Q 11 Letter to Shareholders. Calculation of monthly churn consistent with company disclosures.

At a churn rate of 8.6% per month, the average life of a streaming subscriber is just under one year. Even adjusting for new subscribers churning at a 10% rate (based on company comments that approximately 9 out of 10 free subscribers will become paying subscribers), the churn rate for existing streaming customers would still be 7% per month, or an average subscriber life of only about 14 months.

In its 3rd quarter 2010 commentary (.pdf), the company management stated the following as it related to streaming -related subscribers:

Lower churn, which drives greater lifetime value, and more organic growth, which drives lower SAC (subscriber acquisition costs), are two of the ways in which we expect to recoup our investment in licensing more streamed content.

On their 2nd quarter 2011 virtual conference call (.pdf), Reed Hastings said that “it’s very easy to get distracted by SAC and churn”. Since lower churn and SAC were expected to pay for increased content costs, perhaps a little distraction would be warranted.

Over the average lifetime of a subscriber of 1 year, at $7.99 per month, the company will receive about $96 of revenue. Their marketing cost to acquire a domestic subscriber in the 6/30/11 quarter was $15.06. As of 6/30/11, total Current Content on balance sheet due within the next 12 months was $499 million plus Content Obligations within 1 year off balance sheet were $625 million or a total of $1.124 billion, which is $46.62 per ending paying sub (which assumes that all current subscribers become streaming subscribers).

The annual cost to stream content is estimated at about $4 per sub. General & Administrative expenses and Technology costs have totaled about $1.28 per month per average paying subscriber, which is $15.36 per year. Adding it all up, you get the following economics of a streaming customer over its entire average life, rounded up to one year:

Revenues

$ 96

Less: Marketing Costs to Acquire (SAC)

$ 15

Less: Content Costs

$ 47

Less: Content Delivery Costs

$ 4

Less: General Admin & Tech

$ 15

Total Pre-Tax Profit

$ 15

Tax Rate

40%

After-Tax Profit over the average life of a streaming subscriber

$ 9

Click to enlarge

The total after-tax profit over the lifetime of a streaming subscriber is only $9 - not thousand, just $9. At the current market value of $14.3 billion, it would take almost 1.6 billion new streaming subscribers (without discounting to the present value) to justify the current market cap.

With obligations for streaming content estimated to increase to $1.8 billion to $2.0 billion per year in order to keep the existing level of content, Netflix would need to have 38.3 to 42.5 million average paying streaming subscribers to maintain the $47 per year of content costs per subscriber. They haven’t shown an ability to leverage marketing, general and administrative, or technology costs, so the only solution to obtain higher profitability would be to eventually increase the price of the streaming only subscription from $7.99. But, how much pricing power do they have in the streaming business if 8.6% of their subscribers are currently leaving every month at the existing price?

CEO Reed Hastings has rushed headlong into his gambit of becoming a high growth, internet based, game changing, streaming media company even though the economics of the business as detailed above show that it is likely to fail. He has expanded this failing model to Canada and is spending upwards of $100 million to export it to the prosperous 43 countries of Latin and South America in a desperate attempt to continue growth.

Hastings’ theory of the “virtuous cycle” is in the process of being transformed into a death spiral. Fewer subscribers means less dollars to license content which leads to fewer subscribers, price increases means less word of mouth which drives fewer subscribers, fewer subscribers means less dollars to enhance the customer experience.

Hastings publicly rebutted Whitney Tilson’s article about why he was short Netflix stock. Hastings said that at Netflix they ”focus on building the business and letting the numbers do the talking”. Well, Reed, the numbers are talking but I’m not sure you are listening. I would welcome a similar rebuttal from you with facts instead of platitudes, as to how the streaming business will be economical.

Disclosure: I am short NFLX.