The One Thing Netflix Is Doing Wrong

Short of one problematic metric, Netflix (Nasdaq: NFLX  ) hit another homer in its latest quarter.

First-quarter revenue climbed by 25% to $493.7 million. It closed out the period with 14 million subscribers, 35% ahead of where it was last year and 1.7 million more couch potatoes stronger than it was three months earlier.

Net margins rocked. Earnings soared by 44% -- up 59% on a per-share basis, given the company's voracious stock buybacks over the past year. Its quarterly profit of $0.59 a share blew past analysts' targets of $0.54 a share.

The favorable tidbits don't end there. Churn and subscriber acquisition costs improved, both sequentially and year over year. Free cash flow also spiked during the quarter.

Netflix's streaming -- a high-margin feature that become even more compelling after cutting a discounted content delivery deal with Akamai (Nasdaq: AKAM  ) last month -- is also a-rocking. A whopping 55% of Netflix subscribers streamed at least 15 minutes from the company's digital library during the quarter, compared with 36% of its accounts a year earlier. That's an impressive metric of migration, but it gets even better once you consider that Netflix's base is a lot larger today. In other words, 55% of the nearly 14 million users today are more than twice as many wired movie buffs as 36% of 10.3 million subscribers a year ago.

The downfall of giants
Apple (Nasdaq: AAPL  ) , Amazon.com (Nasdaq: AMZN  ) , and Blockbuster (NYSE: BBI  ) weren't digitally born yesterday. They all had the inside track to Web-delivered flickery.

Since the 2001 birth of the iPod, Apple has grown to dominate the digital-music market. Four years after the first iPod hit the market, video playback functionality led Apple to begin offering digital video through its iTunes platform.

Amazon has been selling DVDs since the media's inception, so it didn't need to be told about the chunkier profits to be had in replacing a physical disc with all of its inventory logistics, handling, and shipping baggage. Amazon Unbox was born in 2006.

Blockbuster had more of its eggs riding in the optical-disk basket, but the company has always been a realist. Copying a DVD is piracy, but copying a model that works is a pirate's life for thee. When Netflix took off, Blockbuster Online cloned it in 2004. When Coinstar's (Nasdaq: CSTR  ) Redbox began to gain traction in the real world with its $1 overnight rentals through automated kiosks, Blockbuster teamed up with NCR (NYSE: NCR  ) to launch Blockbuster Express. Naturally, it also followed Apple and Amazon into digital delivery, when it bought Movielink in 2007.

Yet the head-scratcher here is that all three giants have seen Netflix's streaming buffet grow in popularity with every passing quarter since 2007, while all three are only committed to selling or renting individual titles.

It is, ironically enough, Coinstar -- a player with no real skin in the digital game at the moment -- that has been surveying renters on a discounted unlimited streaming service.

How did this happen? How did Netflix sneak up on 14 million subscribers, with most of them now taking advantage of the unlimited streaming that's included with most service plans, without waking up the digital copycats?

The downfall of Netflix?
Streaming has been Netflix's not-so-secret weapon in this fight, but it might also catch the company in friendly fire.

I mentioned that there was one problematic metric in the flick renter's quarter. What does it tell you when the subscriber count is 35% higher, but revenue climbs by just 25%? Yes, Netflix is milking less revenue per subscriber.

There hasn't been a price war since the early Blockbuster Online days. Netflix hasn't had to slash prices over the past year. It's pretty clear what's happening here. Since unlimited streaming is available through both the $8.99 monthly plan that allows for one physical DVD out at a time and the $16.99 plan that provides three discs out at the same time, new members are either gravitating to the lower-priced plan or existing members are trading down. And why not? Streaming means that they'll always have something to watch, so they can save the DVD requests for new releases that aren't on the streaming list.

The selection of new releases is also thinner now that Netflix has agreed with three different studios to hold back new releases for 28 days after they're released through retailers, Blockbuster, and video on demand. In other words, there are fewer reasons to pay for extra discs to rest on top of your DVD or Blu-ray player -- especially if they need a new source for releases that won't be available through Netflix (like today's release of Avatar or Tuesday's Crazy Heart).

Netflix is urging users to stream. The company brags about the push in its quarterly earnings releases. It's even providing a small financial incentive as a migration bonus. Strategically, the move is brilliant, because Netflix is rounding up its users in the one place where no one else can get to them.

However, is it worth the similar migration to lower-priced plans? For now, yes. Earnings are soaring and net margins are widening, even though subscriber growth is outpacing top-line gains.

Folks keep coming, too. Netflix raised its guidance last night. It now sees having as many as 17.3 million subscribers by year's end -- a million more than the high-end estimate just three months ago. The streaming smorgasbord and the lower price points are working.

My only concern is that once Netflix saturates the market -- and one day, it will -- and it can no longer lean on subscriber growth or wean its users off entry-level subscription plans, there will be a price to pay for today's downmarket success.

Will Netflix ever stop growing? Will international expansion save the day? Share your thoughts in the comments box below.

Akamai Technologies is a Motley Fool Rule Breakers pick. Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor selections. Try any of our Foolish newsletter services free for 30 days.

Longtime Fool contributor Rick Munarriz has been a Netflix shareholder -- and subscriber -- since 2002. He's also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 22, 2010, at 11:46 AM, Midlana wrote:

    Don't forget that next year, when the USPS stops Saturday delivery, it means another increase in Netflix's profit. Because they receive fixed monthly payments by subscribers, they'll soon be delivering product less often: 5/7 days instead of 6/7. An increased profit of 14% by doing exactly nothing. Pretty sweet for them.

  • Report this Comment On April 22, 2010, at 11:47 AM, BioBat wrote:

    I think it's pretty clear they can't grow forever but I think they still have quite a ways to go before growth starts slowing down. With US expansion still going strong and international growth within the year, Netflix will get bigger and better.

    I do think at some point they may have to revisit their pricing structure to get more out of their online users or perhaps have an online only subscription in the US (like they're doing for international expansion) - which would actually lower their mailing costs significantly. If and when they do, I'll pick the plan that works best and still be happy subscriber.

  • Report this Comment On April 22, 2010, at 12:15 PM, TMFMoby wrote:

    Rick - do you think that the lower revenue per subscriber is the price they pay for the 10% lower churn compared to the same quarter last year?

    Obviously Netflix will take a trade-down over a cancellation.

  • Report this Comment On April 22, 2010, at 1:44 PM, 21820b wrote:

    So.....are you all holding, buying or selling. I am holding a position of nearly 2000 shares. Rock on

  • Report this Comment On April 28, 2010, at 8:56 AM, wanderlust52 wrote:

    Netflix is doing exactly the right thing by growing its online streaming userbase. Increasing their revenue will be easy by following the Comcast on-demand model: offering a lot "free" content plus charging modest additional fees ranging from $2 to $10 for just released content.

    Netflix had better start offering the just released/premium content on its streaming service soon though, because right now people are being forced to use other services such as Amazon Unbox when they want to watch content that is not available from the limited streaming choices offered by Netflix. Netflix better watch out if their competitors adjust their entry price downward to be more competitive with Netflix ... cable's on-demand entry level price is still high compared to Netflix but offers a much deeper range of streaming content.

  • Report this Comment On April 28, 2010, at 6:25 PM, oldengineer wrote:

    Usually I consider most of the daily articles to be a waste of time to read, but not this one.

    This is an excellent article with lots of content. It is a very impressive compilation of facts.

    OE

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