Why Netflix is Broken and How to Fix it

Netflix Inc. (NASDAQ:NFLX), the online DVD rental firm, is in trouble as it is losing subscribers since it raised its prices in September, a move that will force it to spend more on marketing and report a loss in 2012, triggering investor concerns over its business model.

In our view, the company's business model was broken when it raised prices for its hybrid customers, and continued customer defections will require it to invest ever increasing amounts on marketing, Wedbush Securities analyst Michael Pachter wrote in a note to clients.

In late 2010, Netflix announced that more than half of its total activity was streaming, and the company's management stated that it henceforth would be known as a streaming company. It seems this is where the real problem started as many of its customers migrated to streaming, where Netflix has very limited control over its streaming content costs.

The company also faces tough competition from Google's YouTube, Amazon and Apple's iTunes as they have provided competition on the pay-as-you-go front. Hulu has provided a subscription alternative for new television, and its existence caused the television networks to revisit the value of their content in the over-the-top Internet streaming market.

Pachter, who downgraded Netflix stock to underperform from neutral, expects Netflix to spend $800 million on streaming content in 2011, and expects streaming content costs to rise to at least $1.7 billion in 2012, partially offset by about $200 million in DVD and postage savings.

As Netflix saw its streaming content costs rising, and acknowledged limited ability to negotiate rates, the company decided to raise prices in order to cover higher costs. In retrospect, it probably would have made sense to raise prices for those customers who benefited from streaming. However, Netflix chose to increase prices only for those customers who rented DVDs as well as streaming.

In order to cover its escalating content costs, Netflix chose to raise the price of its popular $9.99 hybrid plan (one DVD at a time plus unlimited streaming) by 60 percent to $15.98, affecting an estimated 20 million hybrid subscribers (out of 25 million total domestic subscribers).

The price raise triggered mass defections and trade downs, and tarnished the attractiveness of the service to new customers.

Netflix compounded its pricing decision by announcing and then withdrawing its Qwikster service. The company had intended to split itself into a streaming-only company called Netflix with its own dedicated Web site and billing, and into a DVD-by-mail company called Qwikster, also with its own dedicated Web site and billing.

The Qwikster decision was universally panned by subscribers, and it clearly led to higher-than-expected defections. Netflix withdrew its plans for the split into two sites and officially abandoned the Qwikster idea Oct. 10.

Meanwhile, Netflix ended the September quarter with 13.93 million DVD subscribers (no split was given between hybrid and DVD-only), lower than its recently revised 14.2 million figure; its ending domestic subscriber count was 23.79 million, also slightly below its 24 million forecast.

It was clear that the company's subscriber count would be dramatically lower by year's end, particularly for its hybrid plan.

Now that the company's growth has slowed, investors are not so sure that growth at any cost is worth the lofty prices paid for Netflix stock just a few months ago. The company recently announced that it expects to generate a loss for all of 2012 in order to fuel its international expansion efforts.

Recently, Standard & Poors downgraded Netflix credit rating to BB- from BB.

What Netflix Should Have Done

It appears that Netflix shot itself in the foot with a price increase on its hybrid customers and it should have hiked prices across the board.

Any 5-year-old can tell when something isn't fair, and raising prices on the DVD plus streaming customers only to acquire more content for all streaming customers wasn't fair, Pachter said.

He said Netflix should have raised prices by $2 monthly across the board, and offered a DVD-only plan at the new $9.99 single plan price point. Using Netflix's targeted $296 million in monthly revenue, it appears that the company could have achieved its target by raising prices $2.25 per month across the board with no attrition or trade-downs.

While some customers would have quit and others would have traded down, we estimate that the combined impact would have been only 10 percent trade down (2 million customers) and 10 percent quit (2.5 million customers), the analyst wrote.

If these estimates are close to the mark, Netflix would have ended 2011 with 8 million to 9 million single-plan customers paying $10 per month, and 16 million hybrid customers paying $12 per month, yielding revenues of $272 million to $282 million monthly, or $3.264 billion to $3.384 billion annually. At the midpoint of this range, the company would have been better off by $250 million annually, not enough to offset its rising content costs, but positioned to better handle those costs.

Netflix should have tempered its international expansion plans. Though, the company's strategy of growing its operating margins and reinvesting any excess profits in content or subscriber acquisition was a sound one, but its zealous pursuit of international expansion at the cost of all profits appears irrational to many.

Where Does That Leave Netflix?

Netflix is expected to continue losing more hybrid customers than it adds, and those who remain will not be particularly profitable.

The analyst estimates that the average Netflix hybrid customer rented around four DVDs per month, and think it is patently obvious that the majority of the 11 million who traded down or defected rented fewer DVDs than the average.

To the extent that these customers traded down to streaming-only, Netflix will save on DVD purchases plus postage, but will lose an average of $8 per month; to the extent that they quit the service altogether, Netflix will see the same DVD/postage savings, but will lose an average of $16 per month.

Meanwhile, the low-frequency hybrid customers were Netflix's most profitable, and the almost 60 percent price increase alienated them the most.

On the other hand, content owners welcome Netflix's international push as an opportunity to squeeze even more revenues from the company. Netflix must obtain content for each region it conducts business in, increasing its streaming content costs by an estimated $200 million to $400 million annually.

At the current juncture, the strategy appears jaded as company's pricing for streaming-only limits its profitability and the rising content costs would pressure margins.

The company's decision to forgo profitability altogether to chase international expansion appears particularly ill-advised, as losses in 2012 make it impossible to determine Netflix's steady state earnings power.

For 2012, the analyst expects Netflix to report a loss of 35 cents a share, while analysts, on average, polled by Thomson Reuters expect a profit of 59 cents a share.

We acknowledge that the company's loss could well be an order of magnitude higher. In reality, if Netflix does not make changes to its spending and pricing strategies, we think that the company might lose $2.00 or more in 2012, and may not make a substantial profit in 2013, Pachter added.

California-based Netflix's shares, which peaked at nearly $305 in mid-July, closed Wednesday's regular trading session at $64.53. Since July 12, when the company announced the price raise, shares have plunged more than 75 percent. Analyst Pachter has a price target of $45.