Netflix -- Subscriber Acquisition Costs and Churn (NFLX)

Customer acquisition costs have been a key issue for e-commerce companies, particularly as the cost of Internet advertising has risen. Churn is also a critical -- and related -- issue for companies with subscription-based models. Here's an insightful discussion of customer acquisition costs, churn and the trade-off between them and other metrics for Netflix (NFLX) from Citigroup analyst Mark Mahaney's initiation of coverage report:

SUBSCRIBER ACQUISITION COSTS

SAC is calculated as the total marketing spend divided by the gross subscriber additions for the same period. Although NFLX continues to spend less than $40 for acquiring a sub (which is at the lower end of the historical $30 to $50 spent to acquire each sub), there has been a steady rise since 2002 when SAC bottomed out at $31.39. We believe the increase reflects the cash infusion from the company’s 2002 IPO in conjunction with the heightened competitive threat that has been poised by BBI andWMT. Looking ahead we anticipate NFLX will spend less to acquire customers (e.g., we project SAC to fall just below $37 for 2007) based on the diminishing need to educate consumers about the availability and attractiveness of DVD subscriptions as an alternative to rental and the increasing word of mouth advertising that is common among new compelling services.

CHURN

We view NFLX’s churn rate as one of the most important indicators for the company as it represents the:
1) level of customer satisfaction;
2) impact of competitive services; and
3) willingness to pay a monthly fee for an extended period.

This metric will have a direct impact on revenue and margin, and could lead to more drastic changes if NFLX is required to change its business model to retain customers (see the Tradeoff Analysis Section below). Churn can be triggered by increased competition, poor customer service, or billing/technical errors. More importantly churn can be triggered by a perceived lack of value in the company’s offering. We believe this latter risk is why it is paramount NFLX continues to invest in back catalog and its analytical software. By doing so, NFLX will be in a position to effectively offer compelling content (i.e., value) to its consumers who were previously unaware of its existence, thereby benefiting from the long tail theory. NFLX cites that most of its customers leave due to: 1) lack of usage (e.g. can’t find enough good movies); 2) household budget decisions; and/or 3) relocation. We see these reasons as a positive attribute, since it would appear more likely that NFLX could win lost customers back longer term.

TRADE-OFF ANALYSIS -- PRICING, UTILIZATION, SAC, CHURN, AND MARGINS

We believe the balance between customer satisfaction and variable cost control is at the heart of NFLX’s business model. While a price increase may help NFLX generate more revenue it may increase churn if consumers feel their is not enough value to the NFLX service, which may require NFLX to broaden its catalog of DVDs or adopt more lenient rental terms (i.e., faster rental turnaround time or more titles for a given price point) to avoid higher churn rates that would cause NFLX to increase its marketing spend. The higher utilization would lead to higher fulfillment (e.g., postage) and revenue sharing costs that will impair margins. Conversely, investments in back catalog and service upgrades may hurt gross margins but should reduce churn and the need for marketing expenditures. Any decision NFLX makes with regards to pricing or service utilization will require the company to do a tradeoff analysis, whereby the company will hope that the net change in pricing or utilization more than compensated for by improvements in revenue or margin. Given that any action NFLX takes has a number of tradeoffs with other metrics, we see NFLX being deliberate and slow to make notable changes to its business model. The company appears to be focused on continuing to build its DVD library until it feels that improvements in churn are no longer noticeable. It also appears that the company is committed to improving efficiency so that it will be able to lower pricing longer term, creating more value to consumers while building a higher barrier to entry. One way of looking at the trade off NFLX faces is by looking at the breakeven points on various changes to pricing. While pricing is a major driver of NFLX’s earnings growth, we would note that SAC and Churn also have a material impact on the company’s earnings. For example, a 10% pricing increase in 2004 would have contributed $0.78 to EPS, while a 10% reduction in the number of subscribers churned and SAC would have increased EPS by $0.50 and $0.14, respectively (all else constant).