Netflix Breaks Streaming Record—So What?
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“Congrats to Ted Sarandos, and his amazing content licensing team. Netflix monthly viewing exceeded 1 billion hours for the first time ever in June.”
So wrote Netflix (NASDAQ: NFLX) CEO Reed Hastings last week in a Facebook post, sending Netflix shares up over 20% since the announcement. This is a big jump from the last time Netflix has released these numbers, with the company streaming only two billion hours in the entire fourth quarter of 2011. If the average amount of content consumed per subscriber stayed roughly constant, the billion hours streamed in June would imply something like a 50% gain in streaming subscribers since December. This would mean a huge increase in revenue for Netflix, and the recent price run-up indicates that many investors expect exactly that. Count me among those unconvinced. There are still two major issues I'm watching before joining the bulls.
First, in the short term I'm looking to see that an increase in video streamed actually does yield significantly higher subscriber growth. Since Netflix customers pay a flat monthly price to use the service, an increase in the hours each existing subscriber watches does nothing for Netflix's revenue. The average Netflix subscriber watched only about 30 hours of streaming video per month in December, so there's plenty of room for existing customers to increase their consumption for free. Apple (NASDAQ: AAPL) has sold about 67 million iPads in the past two years, and may have sold as many as 20 million more in the past quarter. Netflix's app is one of the most popular downloads in the App Store, and this indicates that Netflix customers are increasingly taking advantage of the ability to use the service on the go, outside the traditional television-watching windows of evenings and weekends.
Netflix may also be seeing consumers switch away from using the service as an add-on to traditional television; instead “cutting the cord” of cable subscriptions and using Netflix as their primary or sole content distributor. The average household consumes 8 hours per day of television total, compared to the average 1 hour per day that Netflix subscribers watch Netflix. Even a small number of customers who begin to watch 900% more Netflix could drastically increase the total number of hours streamed without contributing to revenue growth.
While capturing viewers away from cable seems to bode well for Netflix's ability to compete, it may not like the response this could elicit. Already, cable provider and content creator Comcast (NASDAQ: CMCSA) has taken steps to rein in Netflix by introducing tiered pricing to charge its broadband customers who use the most data—say, those who are streaming Netflix instead of watching cable—while holding its own Xfinity video streaming service exempt. Further, if Netflix threatens to take significant market share away from ad-supported television channels, it may affect the premium that studios like Time Warner (NYSE: TWX), who sell their programming to many different distributors, could get for their content. Time Warner may move to protect its pricing power by refusing to license content to Netflix, or by charging Netflix higher licensing fees. This brings us to the second issue Netflix needs to address.
Even if the growth in hours streamed really is down to new subscribers, it's not clear that strong streaming subscriber growth translates into strong earnings growth. Streaming still just isn't that profitable for the company, and it's not clear when it will be. In the first quarter, domestic streaming only contributed 31% to profits. If you consider Netflix's international streaming operations, which lost over $100 million and completely eliminated the gain from domestic streaming, Netflix's DVD service accounted for all the company's profit; subsidizing streaming. Part of this dire profitability can be chalked up to Netflix's efforts to expand internationally, which have yet to bear fruit. Should Netflix overcome the challenges of the international market—fewer hours spent watching television and a more consolidated competitive landscape—a more long-term problem is the ever-rising cost of content. The proliferation of various cable and broadband distribution systems has allowed content creators to drive hard bargains for their programming. If Time Warner and other studios are ultimately able to capture the lion's share of the profit on content, then Netflix's margins will face pressure no matter how quickly it grows its subscriber base, and it may be difficult for the company to deliver on its current price tag of around 30 times earnings.
For me, the best thing Netflix's streaming record indicates is the possibility that the company is gaining pricing power. If the rise in content viewed has been driven by Netflix's recommendation system steering subscribers to programming that is cheaper for Netflix to acquire, and viewers have enjoyed the experience so much they're watching more Netflix, the company may be able to push through price increases. When the company attempted a price increase in 2011, the results were disastrous: 800,000 subscribers left the service and the share price plummeted. Hitting upon a strategy to effectively raise prices is instrumental for the company if they're going to continue to be able to afford quality content and, ultimately, keep their subscribers interested.
Daniel Ferry owns shares of Apple. The Motley Fool owns shares of Apple and Netflix. Motley Fool newsletter services recommend Apple and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.