Once Upon a Time Netflix Rented DVDs

By j.a. graham - June 25, 2012 | Tickers: CSTR, NFLX | 0 Comments

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Netflix (NASDAQ: NFLX) is in metamorphosis/transformation. Without looking at the history and the recent results, it is tempting to think of it as a huge bargain in the mid-$60s down from $300 last summer.

If you do spend some time with the company pre-and post-streaming, it is clear Netflix will never again be the fast-growing king of content rental it was. Not only are subscriber additions slowing, but also high content costs are likely to permanently pressure margins. That impacts earnings and ultimately cash flow. NFLX is now a lower margin, slower growing ex-momentum stock with a future that is not guaranteed to reflect its past. The biggest asset they have is Reed Hastings who has shown prescience and adaptability in a changing market.

The legacy DVD business

The DVD business is in decline and Netflix has no plans to either resurrect it or try to compete with other DVD rental businesses. They will keep what they have. DVDs create cash flow and investments in titles (capital spending) are minimal. Integration with streaming will affect gross margins with high shipping and handling costs. Distributing streaming content allows more economies of scale. DVD S&H does benefit from scale and gross margins may begin to feel the strain of DVD cost spread over less volume as the service continues to lose subscribers.

Reed Hastings has conceded growth in DVD rentals to kiosks—good news for Coinstar.

From 2010:

If Blockbuster liquidates this year, like Movie Gallery did last year, we may see a modest boost in shipments, but we think the bulk of the remaining video store customers will tend to visit kiosks for $1-a-day DVDs, and they will get streaming from Netflix.Even though we expect DVD shipments to decline this year, we want to be clear that we intend to continue to offer great DVD-by-mail service for many years to come.

While not predicting the death of the DVD business for Netflix, Hastings has consigned it to a reliable source of cash, albeit a static one. Costs to ship and handle are still material but it still pays its way.

The DVD Business

The fee structure has undergone changes over the years and that was a tool NFLX was able to use to increase revenue/and or customers. The flat fee streaming business is rigid. Until recently Netflix had 9 separate plans for subscribers to choose from.

A brief recap of the company’s history:

http://answers.yourdictionary.com/answers/business/netflix-company-history.html

The first plan was a limited plan at $15.95 for 4 DVDs with no late fees per month in 1999. It was the no late fee that was the hook for subscribers. Later, unlimited rentals capped only by the turnaround in shipping brought in more subscribers.

In 2007, Netflix began offering streaming content bundled with the DVD plans and again kept numbers growing.

November 2010, the company introduced streaming only for $7.99 unbundled from DVDs.

From Netflix November 2010:

We are now offering a new $7.99 a month plan, which lets you instantly watch unlimited TV episodes and movies streamed to your computer or TV. This plan does not include any DVDs. All the titles you can watch instantly on your current plan are also available on this new plan, and as a reminder, not all titles on DVD are available to watch instantly. This new plan is available immediately

Second, we are increasing the prices on our unlimited plans that offer both watching instantly and DVDs by mail. On our two most popular unlimited plans – the 1 DVD out at a time and 2 DVDs out at a time – the price is increasing by $1 a month. We’ve also included below the changes on all the plans.

Why the changes? Our selection of TV episodes and movies available to stream has grown dramatically, and as a result most members want us to deliver unlimited TV episodes and movies two ways: streaming instantly over the internet plus DVDs by mail. The price increase will allow us to continue to offer the popular plan choice of unlimited TV episodes and movies streaming instantly along with unlimited DVDs. The new plan, which does not include DVDs, is a great option for the increasing number of members who only want to watch instantly. The $7.99 a month price reflects no DVD shipping costs on this plan.

You might also wonder why we haven’t introduced a new plan that includes only DVDs by mail. The fact is that Netflix members are already watching more TV episodes and movies streamed instantly over the Internet than on DVDs, and we expect that trend to continue. Creating the best user experience that we can around watching instantly is how we’re spending the vast majority of our time and resources. Because of this, we are not creating any plans that are focused solely on DVDs by mail.

That lasted about one year. The separation into two services in 2011 did not go over well and for the first time in its short history, Netflix lost subscribers.

The bundled deal available until July 2011:

Streaming only $7.99

With streaming unlimited DVD prices 

                     Old price        New price

• 1 DVD    $8.99               $9.99
• 2 DVDs  $13.99            $14.99
• 3 DVDs  $16.99            $19.99
• 4 DVDs  $23.99            $27.99
• 5 DVDS  $29.99            $34.99
• 6 DVDS  $35.99            $41.99
• 7 DVDS  $41.99            $48.99
• 8 DVDS  $47.99            $55.99

Limited 1 DVD $4.99 (2 DVDs per month limit) 

Since it was possible to get movie plans with unlimited streaming at $1 more in 2010 over 2009 prices, it’s easy to see why subscribers reacted ferociously when the price increases were announced in July 2011--$7.98 for streaming and $7.98 for 1 unlimited DVD with no streaming.  Customers would be paying $16 for what had cost them $10.

In September 2011 Hastings only made matters worse with a planned separation of business names, billing and physical structures with Netflix DVD becoming a wholly owned subsidiary called Qwikster. Netflix lost an estimated 800,000 subscribers by raising prices and then announcing the DVD service would be a separate business. Qwikster was quickly shelved, but the price increases and the physical separation remain. Streaming has become the company’s focus and gets most of the attention and investment dollars. Reed Hastings’ nightmare scenario is getting left behind in the streaming content wars and going the way of Borders – irrelevant and out of business. It may have blinded him to the remaining value of the Netflix DVD service even in a streaming content world. Netflix will keep the DVD business, but will not invest heavily in it to create growth. Those days are over. 

Coinstar (NASDAQ: CSTR) is thriving:

April 12: Coinstar Inc. raises its first-quarter and full-year revenue guidance on the popularity of its Redbox movie business. Coinstar says recent price hikes didn't dampen movie rentals during the period as much as it thought they might. And consumer demand jumped on the popularity of movies such as "Moneyball" and "Puss and Boots."

Subscription numbers and revenue increases

The increase in paid subscribers is not an accurate indicator at a 1:1 ratio for predicting increased amounts in revenue. The two rates often diverge.

Netflix can grow revenue two ways – more subscribers and/or raise prices.  Before streaming, Netflix had tiered pricing that could be adjusted to raise revenue or build a subscriber base. When Netflix cut prices in 2005 to boost subscriber growth, revenue lagged in 2005 and 2006, but subscriber increases were some of their highest.

Churn makes it difficult to predict revenue growth as a function of subscriber increases. When customer’s leave and new customers are counted is important. Losing a customer the first month of the quarter and adding a customer the last month is not equivalent to keeping a subscriber all three months—one month of revenue has been lost but customer count remains unchanged. High churn can decrease revenue, but subscriber growth can and does increase.

Subscriber growth will be mainly streaming content. The price at present is fixed at $7.99 and pricing increases will not be used to increase revenue. Revenue and profit growth will be based almost completely on expanding the subscriber base. 

From the table, the percentage of subscriber increases most often fails to predict increases in revenue at a 1:1 ratio and the percentage change in revenue lags subscriber numbers by as much as 40% in some years. Some of the recent divergence is a decreasing revenue per subscriber and higher churn rate in 2011.

This same trend applies to Q1 2012 -— average number of subscriber’s increased 21% and domestic revenue grew 17%. International subscribers increased by 257%, revenue increased 252%. While it’s tempting to try to predict revenue using subscriber numbers, it’s not practicable and that makes estimating future revenue numbers difficult even if the company estimates new subscribers.

Paid subscriber growth hit a 5-year high in 2010 and was a response to the free bundled streaming deal. It only lasted a year and by 2011 paid subscriber growth was dropping. Before streaming content, DVD subscriber adds climbed between 2004-2006 and then slowed by 2007 indicating some saturation. Streaming returned Netflix to high growth and record prices per share and explains Hastings’ preoccupation with becoming the streaming king and DVD’s demotion to a second-class citizen.

In July 2011, DVD and streaming were separated into DVD-only and streaming-only payment plans. Customers have opted out of paying for both over the last three quarters and most of the new subscribers are streaming only.

Subscribers that paid for two separate accounts—DVD and streaming:

• September 8.5 million
• December  5.6 million
• March        2.5 million

DVD subscriber losses  

Streaming-only continues to expand while DVD numbers are shrinking. DVD is expected to continue to lose members but at a slower rate of decline. Unfortunately, domestic streaming appears to be decelerating and international may be the best chance for Netflix to resume high growth. International is not a proven business plan and Netflix is entering unknown territory. Case in point— there are difficulties finding an easy way to get paid in Latin America since credit cards are not as ubiquitous a payment method as in the states.

The DVD business still generates profits even with high shipping and handling costs. The future of DVD has been conceded to the competition and at some point if numbers drop enough, shipping and handling will not be cost effective.

DVD rentals accounted for 37% of Q1 2012 revenue and contributed 45% adjusted operating margins (only cost of sales and marketing deducted).

Streaming content is the future for Netflix, but it's going to create a Netflix that is unrecognizable from the mighty DVD presence they were. Streaming content does not come cheaply and studios are now able to control who gets what content and at what price. The competition for programming is fierce and Netflix is in a battle for its future as a relevant source of content and entertainment. 

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