Seeking Alpha

Will Richmond's  Instablog

Will Richmond
Send Message
Will Richmond is editor and publisher of VideoNuze, a widely-followed online publication which provides daily industry analyses and news aggregation for broadband video decision-makers available at Will is also president and founder of Broadband Directions LLC... More
View Will Richmond's Instablogs on:
  • Netflix Now Conceding Price Hike Is Also Hurting Q3 New Subscriber Acquisitions
    Just when you thought things couldn't get worse for Netflix, here's a tidbit of information that could have significant consequences for the company: in a Q&A session at the Goldman Sachs Communacopia conference on Wednesday (replay here), CFO David Wells conceded that while cancellations due to the price increase announced in July accounted for most of the 1 million downward revision in end of quarter subscribers, the change has also adversely impacted new subscriber acquisitions (though he declined to quantify by how much). I believe this is the first time a Netflix executive has acknowledged a double whammy resulting from the price increase - both higher than expected churn and a slowdown in additions.

    This is exactly the issue I called out last week in "Netflix Q3 Subscriber Loss Could be Churn AND Acquisition Related," noting that although many observers immediately concluded that the Q3 revision was entirely churn related, the reality is that a deviation from expected additions is an equally important factor in determining the final September 30th subscriber count. In his remarks, Wells attributed the impact to word of mouth and the news coverage the pricing change received (both of which presumably deterred some amount of prospective subscribers from signing up), but also added that "we're still digging in to understand it."

    I'm not surprised by the acquisition slowdown, as Netflix has been a huge beneficiary of its loyal and enthusiastic subscribers recommending the service to others, a trend that accelerated as the streaming offering became stronger over the past 2 years, connected devices proliferated, and the buzz factor grew. I have no idea whether Netflix ever quantified exactly how significant subscriber recommendations were in driving new acquisitions, but common sense suggests that if the company angered a material segment of its subscriber base (as it did with the price change), their enthusiasm to recommend Netflix to friends would falter.

    Looking ahead, a big question to ask is if the price increase caused an acquisition slowdown, what impact might the Qwikster DVD split be having on acquisitions during these last 2 weeks of Q3? Is it possible that Netflix is going to post a Q3 subscriber number south of the 24 million reforecast, as the Qwikster impact ratchets churn and further slows acquisitions? Going a step further, what will the Qwikster split's impact be on Q4 acquisitions (and of course churn)? When the price increase was originally announced, Netflix made a point of saying it expected Q4 would be back on track and could well be the company's first billion dollar revenue quarter. All of that seems completely out the window now, meaning Q4 performance is anyone's best guess.

    The key takeaway here is that there are multiple - and often inseparable - drivers of subscriber retention and acquisition. Actions like an onerous price increase that may only directly impact current subscribers and therefore be perceived as containable, can quickly turn into an out-of-control brush fire that harms brand image and new subscriber acquisitions as well. All of this is playing out in a very public way for Netflix, as the company grapples with the consequences of its actions that have thrown it into completely uncharted territory well into 2012.
    Sep 23 11:48 AM | Link | Comment!
  • Netflix To Lose U.S. Subscribers in Q3, First Loss In Over 4 Years
    Netflix revised its guidance for Q3 this morning, now forecasting that it will end the quarter with 24 million U.S. subscribers. That's 1 million less than the 25 million it previously forecast as the mid-point for Q3 subscribers (despite the loss, Netflix is maintaining its financial guidance for the quarter). Since Netflix ended Q2 with 24.59 million U.S. subscribers, it is now expecting to lose 590K subscribers in Q3, the first time the company has contracted since Q2 '07 when it lost 55K subscribers.

    The expected Q3 loss brings to a screeching halt the torrid growth Netflix experienced over the 6 most recent quarters, when it doubled in size, adding over 12 million subscribers in the U.S. The Q3 reversal can be traced to the controversial decision Netflix ham-handedly announced in July to split its DVD and streaming businesses, therefore resulting in steep monthly price increases for a large number of its existing subscribers. As seen in the chart below that Netflix released this morning, the primary driver of the 1 million downward revision from July 25th is on the DVD-only side, which is now forecast at 2.2 million subscribers vs. the 3 million expected. The 200K balance is from streaming-only subscribers. This split is a good news-bad news story for Netflix.

    On the one hand, the good news here is that Netflix, which is proactively trying to evolve itself into a streaming company, has been able to keep pretty close to its streaming forecast for Q3. A miss of 200K is only 2% off the 10 million streaming subscribers it expected at the end of Q3. It should be noted however, that the Q3 forecast anticipated virtually no net U.S. subscriber growth. Assuming, as I did in my Q3 analysis, that gross subscriber additions would stay on track, that meant that churn would jump by 2.5-3 million subscribers in Q3. However, since Netflix will only disclose gross additions when it reports Q3 results in a few weeks, it's unclear whether today's revision represents lower additions, even higher than expected churn, or both.

    The DVD-only subscriber collapse isn't that surprising in the context of Netflix's near-total focus on streaming. With the pricing change Netflix also reorganized itself to make the DVD side almost feel like a standalone division. However, it's not clear what marketing muscle is being put behind DVDs; a quick visit to shows an emphasis on streaming only (Netflix said in Q2 that 75% of additions were streaming only). Given the tough choices many Netflix subscribers faced with the price increase, many of them who didn't want to accept paying more opted for streaming-only over DVD.

    And that leads to the biggest concern of the Q3 revision - having diminished DVDs' role, Netflix has staked its future firmly to streaming, thereby throwing itself into a far more competitive, and dynamic landscape. Consumers will evaluate Netflix's streaming content more carefully against other choices from Hulu, Amazon, iTunes, pay-TV operators' VOD and TV Everywhere offerings and free online choices like network web sites/apps, YouTube, web-only content and others. Things could get even tougher for Netflix if Hulu ends up with Google, which could wage a fierce battle of attrition against Netflix, or even Amazon, which might look to give Hulu content away to support its forthcoming Kindle tablet.

    As if that wasn't enough to worry about, Netflix will lose its marquee movies from Disney, when Netflix's Starz deal expires in February (the Sony movies were already pulled). Although there's always the chance that negotiations could be revived, as I explained recently, it would almost certainly require Netflix to create a premium tier, thereby breaking its "all-inclusive" pricing approach. Licensing new, high-value content has never been more challenging for Netflix in the U.S. - between pay-TV operators flexing their muscles with TV Everywhere and retransmission consent riches restricting experimentation, there's less good stuff to be had, regardless of Netflix's willingness to pay.

    As I've suggested previously, all of this means Netflix is heading into a period of huge uncertainty. It's still a mystery to me why the company felt compelled to split its services and hike prices so quickly given the clear benefits of the DVD plus streaming value proposition that nobody else could offer. Even more puzzling was that the price increase offered zero new value as an offset. For 2 years, no company has epitomized the potential disruption of the video industry more than Netflix. Now the tide has turned and Netflix must confront its own challenges.
    Tags: NFLX
    Sep 15 11:42 AM | Link | Comment!
  • Inside Starz's Netflix Quandary
    Here's a thought experiment: Imagine you're running a major cable TV network and your fastest-growing distributor (and largest, by number of subscribers) offers to license your content for approximately $300 million each year, a sum that is about 10 times the amount it has been paying under the current deal struck less than 3 years ago. The new deal would have a very material impact on your P&L as your company's operating income last year was about $400 million. Seems like a pretty tough offer to turn down, right?

    However, there are certain catches. First, this distributor is considered a disruptive competitor by all of your other long-time distributors (who collectively paid you about $1.3 billion last year). If you proceed with this new deal, you're concerned that these other distributors may retaliate by paying you less when they renew their deals in the future. Second, this distributor wants a degree of exclusivity that limits your ability to make incremental deals with companies it deems as competitive. Third, key suppliers of your content have escalation clauses that entitle them to incremental payments if you proceed with this new deal, which would in turn erode your margins. And last, but not least, the manner in which this distributor wants to compensate you would alter the way you are positioned in the market - from a "premium" to a "basic" channel - consequently risking a perception that your content will be irreparably devalued by consumers and other distributors.

    Got all that? If so, then you grasp the quandary that Starz's executive team found itself in as it evaluated a huge license renewal offer from Netflix. Last Thursday Starz announced its decision, choosing to rebuff Netflix's rich offer, at least for now. But as the math below shows, combined with what I've learned from individuals familiar with Starz's economics, Netflix's putative $300 million/year offer was far more than Starz could generate otherwise, making its decision to walk away all the more difficult.

    In its statement, Starz said its "decision is a result of our strategy to protect the premium nature of our brand by preserving the appropriate pricing and packaging of our exclusive and highly valuable content." In other words, Starz wanted more than just big money from Netflix, it also wanted Netflix to change how it offered Starz content to its subscribers: from being part of an all-inclusive monthly fee (as it has been, starting at $8/month) to being available incrementally on a higher-level, more expensive tier. Starz's hope was that by aligning Netflix with how pay-TV providers offer Starz on various premium tiers, the above concerns would be ameliorated.

    Premium tiers for networks like Starz, HBO and EPIX are important to the studios who supply these networks because they're a cornerstone of the "windowing" model that allows the studios to monetize their films multiple sequential times. In fact, Sony and Disney already had provisions in their agreements with Starz that would trigger as Netflix grew bigger (this is the reason Sony's movies were pulled from Netflix a few months ago).

    The problem with premium tiers is that consumers have to be persuaded to subscribe to them, an increasingly difficult challenge as basic services have grown ever more expensive. Between the sluggish economy, proliferating ways of accessing films on various devices and historically high churn rates, being on a premium tier means that only a relatively small percentage of addressable homes actually become paying subscribers.

    To help understand how much revenue Starz may have made from being on a newly-created premium tier from Netflix, I've created 3 scenarios below based on potential tier prices of $7/mo, $10/mo and $15/mo at 4 different penetration levels, 2.5%, 5%, 10% and 20%. I assume Starz would keep 50% of the revenue generated, which is probably generous.

    Note that only 2 of these scenarios - full 20% penetration, at $10/mo and $15/mo - generate revenue for Starz that exceeds the $300 million Netflix was offering to keep Starz available to all of its streaming subscribers. And the likelihood of achieving these levels is practically zero, since they would entail Netflix more than doubling the total monthly fees these subscribers would be paying, significantly dampening interest. In fact, it's virtually inconceivable Netflix would even go down the premium tier path in the first place, since it would mean pulling out and charging more for prized content that has been available as part of its core service. Think about the uproar caused by Netflix's recent move to charge separately for DVD and streaming and you get a sense of the revolt that would ensue.

    Stepping back, the $300 million would have paid Starz the equivalent of about $.83 per Netflix subscriber per month, assuming an average 30 million Netflix streaming subscribers in 2012. That amount would likely place Starz in the lower part of the top 10 of basic cable networks, in a range with USA Network for example. But this would be only about 20-25% of what Starz gets from other pay-TV operators that distribute it as a premium network.

    The fundamental incompatibility of Starz being treated as a basic network by Netflix, while trying to maintain its position and value as a premium network by all other pay-TV distributors is where this renewal deal broke down. Despite the fact that Starz subscribers have actually nudged higher since the original Netflix deal went live, and that there's no tangible proof that it has actually caused any cord-shaving or cord-cutting, pay-TV operators have made no secret of their unhappiness that Starz's content is available at a far lower price point via Netflix. A big new multi-year renewal deal would have raised all kinds of risks for Starz.

    In particular, how Starz's 3 largest pay-TV distributors, Comcast, DirecTV and DISH Network, which together accounted for 56% or $744 million of Starz's 2010 revenue, might react to a new Netflix deal was no doubt upper-most for Starz's management. What if, when it was time for them to renew, they each cut their offers by 25%? That alone would mean almost $190 million in lost revenue by Starz. And if other distributors were emboldened to play hardball, the full $300 million in gains from Netflix could quickly evaporate. Then there's the ire of Sony and Disney Starz would have to contend with, plus the higher payouts to them that would be triggered. And finally there's the opportunity cost of not being able to pursue incremental deals with Amazon, Wal-Mart/Vudu, Apple and others due to some degree of exclusivity that Netflix was requiring.

    In this context, although the $300 million from Netflix was almost certainly more than a premium tiered approach would generate for Starz, by insisting on it as a renewal condition, Starz was clearly more focused on the multiple risks to its existing ecosystem of partners than on the prospect of guaranteed additional income. With the current deal not expiring for another 6 months, there's still the possibility of a resolution between Starz and Netflix. Like many other content providers these days, Starz is walking a tightrope trying to balance rich new online opportunities with the value of its traditional partners.
    Tags: NFLX, LMCA
    Sep 06 3:00 PM | Link | 3 Comments
Full index of posts »
Latest Followers

Latest Comments

Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.