Why Wall Street Is Wrong About Netflix

Last Updated Sep 16, 2011 5:11 PM EDT

Oh, Netflix (NFLX), you bad, bad company. Wall Street had the highest hopes for your conquest of video streaming entertainment. You became the single largest source of North American Internet traffic. And then you effectively raised the rates for many customers by 60 percent.

And, wouldn't you know it, about a million customers decided to leave -- more than you expected -- and made Wall Street cry. Your stock price dropped almost 19 percent. But investors are only unhappy because they got emotionally involved and didn't think rationally. You guys in Netflix management did what you had to do, and the company will likely benefit in the long run.

A tale of two lessons
Netflix found itself caught in two ways. First, its circumstances changed. The company's video-streaming business took off, and the studios that had once cheaply licensed movies and TV shows to Netflix suddenly wanted a whole lot more money. For example, Starz dropped Netflix because the video streamer wouldn't cough up enough cash for programming.

Second, Netflix came to the realization that not all its customers were good customers. I once heard a sales consultant refer to this notion as the funny-shaped door. Every company has an entryway with a distinctive outline based on its business model. Customers that don't naturally fit through the doorway are often a bad business fit and cost more than can be warranted by what they buy.

Some customers don't spend enough to make up for the cost of acquiring them. Others tie up support lines, constantly return products, or otherwise demand far more resources than the average customer. There will be customers who have high volume but insist on discounts that are too high for the business to bear. In any such case, the total cost of satisfying the customer leaves the company will too little margin at best, and may actually represent a net loss.

Needy customers and vendors
The studios want more money because their business is changing. They see a movement from traditional network and pay TV to streaming services like Netflix and Hulu, which haven't paid as much for programming. The entire DVD business has been eroding in front of studio executives' eyes.

At the same time, they have shareholders (including studio management) who want to see the businesses expand and share prices go up. Ergo, demands for higher fees.

Unfortunately for Netflix, customer expectations have also been high. People have grown used to paying only a slightly higher rate to get both DVDs and streaming video. When Netflix announced its price increase, it was unusually blunt (and probably foolishly so) for a corporation:
Last November when we launched our $7.99 unlimited streaming plan, DVDs by mail was treated as a $2 add on to our unlimited streaming plan. At the time, we didn't anticipate offering DVD only plans. Since then we have realized that there is still a very large continuing demand for DVDs both from our existing members as well as non-members. Given the long life we think DVDs by mail will have, treating DVDs as a $2 add on to our unlimited streaming plan neither makes great financial sense nor satisfies people who just want DVDs.
The even more blunt translation is that people were watching a lot more of both streamed and DVD-delivered than Netflix had expected, which meant their licensing costs were too high for the business model.

Fewer customers = more money
The stock price took a tumble when Netflix cut its subscriber forecast (click to enlarge):


"Oh, the sky is falling!" you could hear the Street say. But this was a very smart and calculated plan. Instead of trying to shake loose all DVD customers to move completely to streaming, as some thought, Netflix was looking to maximize revenue. As the company noted just a few days ago, this was a "radical change," not a simple price hike.

Let's work the numbers. At the end of July, there were 25.6 million subscribers, of which 24.1 million were paid and 1.4 million were free (introductory offers, probably). Revenue for the quarter was $789 million. Now the company expects 2.2 million DVD-only subscribers, 9.8 million streaming-only subscribers, and 12 million people getting both.

Keep the same ratio of paid to total subscribers of 94.5 percent. That means 2 million DVD-only, 9.2 streaming-only, and 11.3 million both, and that's rounding down in each case, so underestimating the totals. What revenue do you get with the new plan prices, even assuming that all the DVD-only people get the one-DVD-at-a-time plan?
DVD-only: 3 months x $7.99 x 2 million = $47.9 million
Streaming-only: 3 months x $7.99 x 9.8 million = $234.9 million
Both: 3 months x $15.98 x 11.3 million = $541.7 million
The total is $824.5 million. Netflix may have underestimated how many people would leave, but there was no way to know ahead of time. Even at that, these numbers add up, as you can see. Last quarter's subscription numbers meant people added during the quarter, and so not contributing full revenue. But even at that, chances are good that Netflix will make at least as much next quarter as it did last.

Furthermore, it's doing so on fewer customers. That means lower expenses in licensing, so operating profits should be higher. In addition, a new survey by Credit Suisse suggests that 20 percent of U.S. pay TV subscribers might cancel their service in the next five years.

It probably won't be that high, as consumers are notoriously unreliable in predicting what they will do in the future. But expect revenue pressure on Starz and other content owners, which could well drive them into the arms of Netflix, which could become the main growing game in town.

Related: Image: morgueFile user click, site standard license.
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    Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.

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