Curtains for Netflix

By Phil Cutajar - June 5, 2012 | Tickers: AMZN, DTV, NFLX, WMT | 0 Comments

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The leader in streaming movies over the Internet has certainly made a lot of headlines in the past year, many of which have been critical of pricing changes announced by Netflix (NASDAQ: NFLX) last July. The adjustment has been painful for Netflix and they have yet to demonstrate they can successfully navigate the transition. While domestic subscriptions seem to be picking up again, Netflix hasn’t quite regained the momentum it had last year before the changes, but more importantly; profitability seems to be slipping away.

Streaming or DVD?

The new pricing structure, announced in July and fully implemented in September, raised the price of the unlimited combo DVD and streaming subscription from $9.99/month to $15.98/month. At the same time, Netflix began offering streaming-only plans priced at $7.99/month, and DVD-only plans also priced at $7.99/month. Andy Rendich, Netflix Chief Service and Operations Officer, justified the changes stating “By better reflecting the underlying costs and offering our lowest prices ever for unlimited DVD, we hope to provide a great value to our current and future DVD-by-mail members.”

The changes sent the share price into a tailspin, from over $300/share in July, 2011, with a P/E ratio of 68, to the recent price of $62/share, with a P/E ratio of 21. To some observers the correction seems grossly overdone, to others it was a long anticipated fall from unsustainable heights. But what is really happening behind the curtain?

DVD is more profitable

As demonstrated in the graph below, over the past two quarters the domestic DVD business has proven to be much more profitable than the streaming business.

The much higher cost and lower profit margins of streaming versus DVD seems to contradict the idea proposed by Netflix that the new pricing better reflects the underlying costs. Clearly, streaming is costing Netflix a lot more than DVDs, so it doesn’t quite add up why both subscriptions are identically priced. But maybe Netflix was anticipating something else.

Since unbundling the subscriptions in September, 2011, global paid streaming subscriptions have risen from 21.5 million to 24.4 million, while DVD-only subscriptions have fallen from 13.8 million to less than 10 million. This shift from DVD media to streaming seems to be a universal trend according to Dan Cryan, senior principal analyst at IHS Screen Digest. He is predicting the market for physical discs to shrink while the streaming of films via the internet will more than double by the end of the year." We are looking at the beginning of the end of the age of movies on physical media like DVD and Blu-ray," Cryan claims.

I have to assume Netflix saw this sea change coming as much as they contributed to it. But if they were expecting it, wouldn’t it have made more sense to continue with the $9.99/month bundled price instead of offering the $7.99/month streaming-only service? The most likely choice for subscribers seems to be to switch from the $9.99/month combo plan or the new $7.99/month DVD plan to the $7.99/month streaming-only plan, leading to higher cost and lower profit for Netflix.

International is more expensive

For some time now the Netflix growth strategy has been centered on international expansion.  Despite growing international subscriptions from 674,000 to 2.4 million in the past year, 89% of subscribers remain domestic. Although Netflix is gaining subscribers outside the US, it is costing them significantly more. As you can see in the graph below, the cost per international subscriber is much higher than US subscribers.

Over the past seven quarters, the cost of acquiring domestic subscribers has averaged about $25 per subscriber, whereas the cost of acquiring international subscribers has risen from $20 to over $47. And we can see those acquisition costs have significantly increased in the past two quarters. Bear in mind the domestic costs in the graph above include DVD as well as online streaming subscribers, but Netflix only offers online streaming outside the US, which also bears higher costs for Netflix.

As demonstrated in the next graph, costs abroad are rising rapidly, significantly outpacing revenue. In fact, to date Netflix has yet to turn a profit in any quarter from international operations.

Dire consequences

The shift towards online streaming and international expansion has not been a beneficial one for Netflix thus far. Since the changes were announced, revenues went up slightly from $788 million to $870 million, but free cash flow has fallen from $77 million down to $14 million, net income has gone from $68 million down to a loss of $4.5 million, and profit margins have fallen from 8.65% to -0.53%.

Meanwhile, as shown in the next graph, liabilities have ballooned from $814 million to $2.8 billion as Netflix adds more non-current content.

Streaming is here to stay

Streaming video is revolutionizing the industry. Already, approximately 50% of all Internet traffic currently is from streaming video, and approximately 30% of all Internet traffic is attributable directly to Netflix. Consumers don’t seem to be collecting DVDs any more. Thanks to improved bandwidth and higher quality HD video streaming, delivered by Netflix, Amazon (NASDAQ: AMZN), Wal-Mart (NYSE: WMT), Hulu and other streaming service providers, consumers are simply renting content instead of collecting it.

Netflix is continuing to acquire more streaming content specifically for international subscribers. Netflix and 20^th Century Fox recently signed a deal to deliver streaming TV and movie content to Netflix subscribers in Latin America and Brazil. News of the deal came on the heels of DirecTV’s (NASDAQ: DTV) quarterly report earlier this month, in which the satellite TV provider reported they had added 593,000 new subscribers in Latin America.

But the competition is equally aware of the trend and the opportunities, and they are not standing still.

What to expect

In December, Amazon.com launched its streaming and DVD service Lovefilm in the U.K., pricing the service very aggressively. Amazon claims to have 2 million U.K. subscribers. Netflix rapidly followed suit launching its streaming-only service in the U.K. and Ireland. However, Netflix is still hunting for content deals to improve its offerings in the U.K. Similarly, Wal-Mart is planning international expansion for its VUDU streaming service, starting with Mexico and 30 other Latin American countries. VUDU is also expected to launch in Europe and Asia later this year. With over 5,000 retail stores in 26 countries, Wal-Mart expects VUDU to gain a sizable share of subscribers based on its retail presence.

CEO Reed Hastings, named Fortune Magazine’s "Business Person of the Year" last December, has disclosed he doesn’t expect Netflix to post a profitable quarter in all of 2012. It's difficult to predict if and when Netflix may return to profitability. Liabilities to acquire international content are mounting, and given the pace of international broadband adoption and the difficulty of setting up recurring credit card billing in countries outside of the US and Europe, it could be a back-breaking gamble.

With competition heating up, liabilities growing large, cash flow slowing down and profit being absent, it may be curtain time for Netflix.

Invest wisely, my friends.

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