Netflix Earnings: Management Has A Trick Up Its Sleeve

| About: Netflix, Inc. (NFLX)

Summary

Netflix's price hikes are indeed substantially impacting subscriber trends.

Q4 will see at least as large an impact from un-grandfathering as Q2/Q3.

Both assertions are refuted by Netflix, but supported by strong evidence.

Netflix may have quietly pushed some un-grandfathering into 1Q2017 to avoid missing subscriber projections.

Look for the company to hit its subscriber projections this quarter and either hold steady or rise by end of week.

Introduction

Netflix (NASDAQ:NFLX) earnings are just around the corner for 4Q2016. Netflix has been one of my best stocks in 2016 as un-grandfathering has been repeatedly misunderstood by the market. In this article I will first address the criticisms of those who continue to insist my thesis is wrong, and then explain my strategy going into fourth quarter earnings later this month.

My Own Track Record

For the past several months, I have been formulating trading strategies for Netflix stock on the basis of incorporating account-sharing effects and management-controlled staggering into subscriber projections,. This trading strategy has been highly successful. My recommendation was to buy Netflix on a dip following 2Q earnings and hold it. If someone followed that advice and bought at the bottom, they are up almost 60% in less than six months, a 120% annualized rate of return.

Of course, I thought Netflix had peaked at $120 right after the earnings release for third quarter, while it has risen another 10% since then. So my advice only netted investors a 50% gain in four months. A lower amount, although the rate of return was actually higher at 150% annualized. Still, not bad, no matter how you cut it.

Netflix's Claims

My account-sharing thesis has been strongly criticized by not only commentators here on Seeking Alpha but also by Netflix CEO Reed Hastings himself, who insists that account-sharing has not increased and that its impact on Netflix revenue and subscriber count are minimal. In fact, CEO Reed Hastings made the somewhat bizarre claim during the conference call that the media was to blame for his missing subscribers, insisting that their news articles had "misrepresented" the price hike to his customers.

This is, to me, a rather odd claim to make. First of all, Netflix always has the ability to communicate with its customers directly, and if it thought there was confusion, from any source, it had more than enough time to clarify it. But secondly, its interpretation of its own churn data seems almost deliberately contorted, as if management is stretching to justify a conclusion it has already reached before it looks at the data. Viewed dispassionately, the best interpretation of Netflix's own churn data is that account sharing is one of the primary factors in subscriber levels today.

The Media And The Price Hike

Begin with the one thing that is beyond dispute. Netflix first began to notice the spike in cancellations the same week that it first began sending out notices that it would be ending grandfathering for certain customers the following month. In other words, the cancellations started before the price hike actually did. Hastings' explanation for this is that customers misunderstood what they were told or how the media characterized what they were told.

But that is actually very hard to reconcile with the data. In the first place, according to analysis done by Business Insider, about 80% of the people affected by the price hike did not know it was coming. They either forgot about the email or simply ignored it. So they would not have had any reason to cancel that early.

And even if the 20% who did know it was coming misunderstood it, that would only account for cancellations between the period of April 9th when notices started going out and supposedly being misread, and May 9th, when people saw how the change actually worked. Presumably as the media coverage died away and Netflix reworked whatever part of their own messaging they thought wasn't clear, the effect would have died away. But Netflix has consistently said it projects higher churn levels to continue through the end of the year. Churn isn't tailing off. That only makes sense if it is how the price hike actually works that is turning off customers.

Lots Of Subscribers To Go

The reason this matters is because Netflix is not done un-grandfathering yet, despite what the experts say. A lot of people seem to be forgetting that Netflix actually has two groups of grandfathered customers. The original set is the $7.99 crowd who were guaranteed two years of low pricing in May of 2014. But when Netflix raised prices that month, it only raised them to $8.99. When it enacted the second $1 increase in October of 2015, it told everyone who had signed up in the intervening period that they could keep their $8.99 price for one whole year. So one whole wave of customers wasn't even eligible to be un-grandfathered until October 2016.

When I did the math on this six months ago, I found that Netflix had categorized about 27 million of its subscribers as subject to some sort of price adjustment following the price normalization. Of that amount, 22 million were in the US.

When Netflix initiated the first price hike up to $8.99 it had about 50 million subscribers. By 3Q2015, when the second price hike took effect, the subscriber count stood at 69.2 million. If the 27 million are prorated evenly over those two groups, roughly 27% of the total grandfathered pool is already part of the $8.99 group and wasn't even eligible to have their prices raised by the end of the third quarter. And yet Netflix says 75% of the grandfathering is done.

It's always possible that they don't prorate evenly, of course. A variation of just a few percent would leave the $7.99 group wrapped up and the $8.99 group teed up next. The problem is that interpretation is a little hard to reconcile with Netflix's own statements. Management indicated from the beginning that their "longest-tenured subscribers (would get) the longest benefit." Those longest tenured subscribers would of course be part of the $7.99 group. So the minimum size is more likely 35% of the total group. This may in fact make 4Q2016 the biggest un-grandfathering quarter of them all.

Netflix's Sneaky Escape Clause

There are two other factors that must be considered here. The first is that at $8.99 the price hike is not as large, so the churn rate may be lower. But remember also that the effect of the price hike is to cause customers to re-evaluate account-sharing as an option and that effect will probably stay the same since the Premium plan is always the cheapest on a per-stream basis.

The second is staggering, which I believe management already used to such great effect in third quarter. Netflix has seen what subscriber shortfalls do to its stock, and presumably wants to avoid a repeat. This effect actually becomes larger with the $8.99 group, since delaying their price hikes only costs Netflix half as much per account to keep it open.

Of course, this quarter is supposed to mark the end of grandfathering, which would mean management could not stagger any longer and would have to take its licks in the fourth quarter. But I have believed ever since the third quarter earnings release that management has left itself an opening here.

The letter, where management cites its 75% figure, is actually phrased very carefully - far more carefully than some seem to have read it.

By the end of Q3'16, we had un-grandfathered 75% of the members that are being un-grandfathered this year

This is, so far as I know, the first indication the company had ever given that there were any members who wouldn't be un-grandfathered by the end of the year. It's possible this is simply a reference to subscribers in a single, forgotten international market where prices were hiked less than a year ago. But it's also possible it opens the door to another massaging of the figures through staggered price hikes, this time for the $8.99 group who only cost half as much per account to stagger.

Investment Recommendation

I have been working, among all my other projects, to get some clarity on this ever since the 3Q earnings came out. I have to say I am somewhat surprised it has not been followed up on by the analysts who were on the earnings call. I will update readers if I make any new breakthroughs before the earnings release, but with that now so close I wanted to both flag it for investors who will take positions this week, and offer my own interpretation.

Which is simply this: management has decided to massage again. Given the wild fluctuations missed projections cause, and the lower cost of massaging this quarter compared to last, I believe we will see Netflix hit its mark again, despite the churn of the price hike.

Make no mistake, however, this conclusion is entirely dependent on Netflix having the flexibility to delay price hikes if needed to avoid undershooting subscribers, especially in the US. Investors should do their own research on this rather murky issue and if they truly believe that all customers were un-grandfathered in Q4, that would probably push Netflix below its projections and cause another sell-off. It all depends on what clarity, if any, we can get about the $8.99 subscribers and whether management will stagger their price hikes if needed.

Conclusion

I believe Netflix has quietly decided to punt some of its $8.99 subscribers price hikes into the new year, foregoing a very small slice of its revenue to keep the subscriber trends on track. There is some potential for misinformation here as Netflix offers no color on who these 2017 un-grandfathered subscribers are. I intend to focus on this question the next few days and will report back any developments, but right now I believe Netflix will hit its mark Wednesday. I rate Netflix as a Hold.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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