Netflix: Strike 2 Or is Hastings Being too Hasty?
Pam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Netflix, Inc. (NASDAQ: NFLX) has been investing heavily in content for its streaming operations. CEO Reed Hastings during their October 24, 2011 conference call stated that: “The future is brightest by focusing on streaming,” comparing DVD-by-mail rentals to AOL's dial-up service a few years ago.
Despite Hastings' disdain for their DVD business, it is still, by far, the most profitable segment, keeping their streaming dreams afloat. In this article, I will examine the growth and profitability of Netflix's 3 business segments, discuss the plan to eliminate its DVD rental business, the recent degradation of DVD customer service and the likely near-term, unpleasant consequences for shareholders.
The DVD Rental Business is the Cash Cow
Netflix's business is divided into 3 segments: Domestic DVD Rentals, Domestic Streaming and International Streaming. As of the quarter ended December 31, 2011, the operating margin for their DVD business was 52.3% vs. 10.9% for domestic streaming and -199.2% for international streaming. For the quarter ended June 30, 2012, the operating margin for DVD's dropped to 45.9% due mainly to the loss of nearly 2 million additional DVD customers in the first half of this year. But DVD's still accounted for 104.9% of operating profit vs. 104.1% last December. Streaming gained over 4 million customers, but is still operating at a loss due to the international business. The domestic streaming margin improved to 15.6%.
Netflix knows that DVD's are the backbone of its business. In its most recent 10-K filing under Risk Factors, it was stated:
If subscriptions to our domestic DVD segment decline faster than anticipated, our business could be adversely affected
...The contribution profit generated by our domestic DVD business will help provide capital resources to fund losses arising from our growth internationally. To the extent that the rate of decline in our DVD-by-mail business is greater than we anticipate, our business could be adversely affected. Because we are primarily focused on building a global streaming service, the resources allocated to maintaining DVD operations and the level of management focus on our DVD business are limited. To the extent that we experience degradation in service in our DVD-by-mail business, subscribers’ satisfaction with our service could be negatively impacted and we could experience an increase in cancellations, which could adversely impact our business.
The Plan is On Track, But is it a Good Plan?
Was the loss of over 17% of its DVD customers year-to-date expected? According to the guidance provided, yes. Netflix expected to lose 16-20% of its DVD customers. Moreover, guidance for Q3 is for a loss of another 6.4-9.6%. Since splitting its domestic DVD and streaming busnesses, Netflix's TTM earnings have declined from $3.94 for the June 30, 2011 period to $1.83 for the June 30, 2012 period. Meanwhile their P/E (based on the closing price following the day after announcing their earnings) has been linearly increasing from 17.6 after the September, 2011 announcement to 32.9 following the most recent report as shown in the graph below.
At first blush, this looks good. The market is apparently rewarding Netflix for their streaming vision. But, with its latest guidance for a loss of $0.10 to a profit of $0.14 for the coming quarter, its TTM earnings would decline to $0.57 to $0.81/share. If the share price remained at its close on August 31, 2012, $59.72, the P/E would have to expand from about 33 to 74-105. Since the forecast is just for more of the same, this 2-3+ fold increase in the P/E is not justified.
Extrapolating the linear trend seen in Netflix's P/E over the last year to the next quarter, leads to the expectation for a P/E of 40. Assuming their guidance proves accurate, and it has been eerily so the last 2 quarters, I would expect their share price to fall to $23-32. While Mr. Hastings is happy with the progress of plans to eliminate DVD only customers, I as an investor, am not and neither is the market. It is too much too fast.
Strike Two—Wring More Profitability from DVD Customers by Reducing Customer Service?
Sometime during the current quarter, Netflix quietly changed their customer service policy for their DVD subscribers. Long time subscribers probably have this number programmed into their phones: 1-866-643-0020. After receiving a DVD last Thursday with a deep, 1-inch scratch on it, I called for a replacement. Instead of a live person answering in less than a minute, I got a mechanical voice asking me to enter a 6-digit “Service Code.” I was never asked to do this before. Accustomed to waiting less than a minute, I just stayed on the line. Eight minutes later, Becca answered my call. Becca required all sorts of “security information” before she would help me. It was like calling your favorite health insurance company on Monday morning.
Curious about this “service code” I logged onto my Neftlix account and indeed found it. But, more importantly, I also found that there was a new phone number to call for everything: 1-866-579-7172.
I called this number and was immediately presented with a choice: press 1 if you are an existing DVD customer, if not, stay on the line. I pressed 1 and waited nearly 5 minutes until Heather answered the call. I repeated the process and just stayed on the line and someone answered in 35 seconds. Sunday, I called again and waited 7 minutes to speak with a rep who told me that problems with their website had increased call volume. Yes, but this does not explain the difference in wait times for DVD customers (5-8 minutes) vs. all others (less than a minute).
Netflix has been shedding DVD customers fast enough with great customer service. Why do something to accelerate their defection to Coinstar, Inc. (NASDAQ: CSTR) and Blockbuster, which was acquired by Dish Network Corp. (NASDAQ: DISH) last year? First, they must believe that they have the defection rate under control. Second, meeting the projected DVD profit contribution of $14.37 to $15.26 per DVD customer, up from last quarter's $14.48, will likely require cutting costs.
Unfortunatey, they are not the king of the mountain anymore. Blockbuster also offers over 100,000 titles and plans which are very compeitive with Netflix's. For just $2 more a month, Blockbuster's DVD customers have access to the newest movies 28 days earlier than Netflix's customers and they also offer games. Plus their customer service is better. My calls to Blockbuster's customer service line: 1-877-829-9003, posing as a DVD customer were answered in just 2-3 minutes vs. 5-8 for Netflix, and they even apologized for the wait due to high call volume.
Coinstar and Verizon Communications, Inc. (NYSE: VZ) have teamed up to offer streaming. Test marketing began in late July, 2012. Moreover, Coinstar now accounts for 42.5% of the DVD-rental market having picked up 8 percentage points last quarter, probably ex-Netflix customers. Finally, Netflix's Epix content exclusivity contract just expired and now Amazon.com (NASDAQ: AMZN) has started offering it.
Netflix's streaming plans are on track. While I understand the vision, I believe it is foolish not to take full advantage of the over 100,000 existing DVD titles in Netflix's library, many not available elsewhere. By instituting annoying practices like long phone waits and requests for personal information, Mr. Hastings is gambling with the cash cow while competitors are appearing everywhere for their streaming business. Projected TTM earnings already lead to the conclusion that Netfilix's stock is in for a big drop. I advise anyone who doesn't currently own Netflix stock to just say no for now. A much better buying opportunity is coming soon.
p366 owns shares of Netflix. The Motley Fool owns shares of Netflix. Motley Fool newsletter services recommend 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.