Netflix: A Question of Pricing Power

Jordan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors loved Netflix's (NASDAQ: NFLX) latest quarterly report. The numbers fell just where analysts wanted them to fall.

To recap:

  • Netflix added more than 2 million new subscribers to its service in the United States and 1 million internationally.
  • It announced a new $11.99 monthly service that provides subscribers with the opportunity to pay more to stream more than two movies at one time. 
  • The company launched a new series, House of Cards, which is its first true foray into creating its own content.

There is no doubt that the company is making headway toward becoming the “internet TV.” It's adding subscribers, adding new content, and focusing on acquiring exclusive to Netflix content.

Show us the money

For all the promise of Netflix's future, it still hasn't figured out how to show it on the income statement. Certainly, Netflix's goal is ambitious. It knows that scale is the most important factor to its eventual success. Thus, for right now, it's all about the top line.

The question is when can investors expect that a $12 billion valuation will be justified by the cash flow that shareholders can call their own? As a reminder, Netflix reported $2.7 million in net income on $1.02 billion in revenue. It's barely breaking even.

Low net margins aren't unheard of in internet businesses – Amazon (NASDAQ: AMZN) has gotten away with near zero margins for years – but eventually, Netflix will have to deliver fatter margins to justify its valuation.

Analysts have identified two sources for eventual profit margin:

  1. Price increases for online streaming.

  2. Slashed spending on content, specifically the “bulk deals” that executives discussed no longer having an interest in.

Netflix can increase the cost of its service. It can cut back on the content it provides for a flat monthly fee. The question is whether or not higher prices and lower spending will ultimately fall in Netflix's income statement.

The biggest fallacy in business

Warren Buffett famously shuttered the mills at Berkshire Hathaway's textile business after realizing that each dollar of invested capital was a bigger benefit to his customers than himself. New mills may make it cheaper to make textiles, but ultimately, those savings had to be passed on to the customer to make a sale. The result? More capex for the same net income, and a lower return on capital.

Netflix is a middle-man that buys licenses to one group of people and resells that license in piecemeal to millions of people. It's not the same as a textile mill, but it is a commodity business in much the same way. Its profit is the difference between what it pays for content and what it receives from customers.

It's an incredibly transparent business model. Netflix's income is money left on the table by people who make the content. Each dollar that Netflix earns is a dollar that content providers will want in the future. 

To think Netflix can get away with simple increases in pricing without paying more for content is foolish. In the same way, to think Netflix can cut content spending and post billion-dollar profits without drawing attention from content producers who it keeps in its library is equally foolish. What's to keep major players like Disney from asking for more and more money for its content each time Netflix ups its pricing?

Why price increases could jolt Netflix stock

It seems Netflix is setting the stage for higher prices and a customer revolt. A new $11.99 price point for multiple user subscriptions is a big warning sign that Netflix fears higher pricing will send customers away from its service. 

Competition is also heating up. Amazon is securing deals for its Prime service to extend its reach into online TV. Meanwhile, rumors are circulating that Amazon will launch a new proprietary set-top box to take more share from Netflix. Whereas Prime does not have the same size online library, or a DVD-by-mail option, Amazon's Prime does offer immediately available, pay-per-use streaming options for movies and content it does not have in its unlimited use library. What Amazon doesn't have, you can still watch for a small fee. What Netflix doesn't have for streaming, customers have to either order by DVD (and thus pay much more for Netflix) or, failing DVDs, simply go without.

A set-top box could further encourage members to make the switch from Netflix to Prime on higher prices for Netflix's streaming. After all, Prime also provides for free 2-day shipping for Amazon customers, another value-add that Netflix could never offer for its members.

Likewise, Redbox and Verizon are now in the streaming game. Investors have largely ignored Redbox's entry into online streaming, but it does pose a real threat if Netflix tries to push higher prices to existing subscribers. Redbox offers online streaming and four movie rentals for $8 per month. For $9, subscribers can swap DVDs for BluRays for HD viewing. If one already uses a Redbox four times per month, streaming, then, costs just $4 more per month.

Redbox's parent company, Coinstar (NASDAQ: OUTR) trades cheaply, at a single-digit multiple of free cash flow. Unlike Netflix, Coinstar generates very regular cash flow from its vending businesses. I've written about Coinstar's excellent free cash flow generation and capital allocation previously.

Bottom line

Investors should take a wait and see approach to Netflix. Given its recent rise, a parabolic 134% move year-to-date, investors are more likely to see downside when Netflix unveils a price increase. Wall Street has a pretty good memory, and it surely hasn't forgotten what happened the last time the company pushed through new pricing by haphazardly announcing the split of DVDs from streaming.

Buyers beware. Another price increase could cause large-scale subscription cancellations at worst, or higher content licensing renewal fees as content creators see more money for the taking. Either way, Netflix's business model will keep the company from realizing the future so many investors expect. At $12 billion, Netflix is priced for perfection, not another massive subscriber defection.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends and Netflix. The Motley Fool owns shares of 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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