Netflix Makes Itself Vulnerable

It's about time, Netflix (Nasdaq: NFLX  ) .

The DVD rental specialist is introducing a "streaming only" plan in the United States today. More importantly, it's also coming through with its first price hike in years.

Everyone probably saw this coming, but this morning's news is sending shares of the flick flinger to a new all-time high, as investors begin to reassess the value of Netflix's growing base of 16.9 million subscribers.

I was fashionably early last month when I asked whether Netflix would hiking its monthly rates, after news broke that the company was testing suspicious offers to potential subscribers.

Now, couch potatoes can pay $7.99 a month for a plan free of Netflix's signature red DVD mailers. As long as someone is satisfied with the tech darling's woefully incomplete but rapidly growing digital library, the new plan offers unlimited streaming through a growing assortment of Internet-connected devices.

The entry-level unlimited streaming and DVD plan, which allows users to rent a single disc at a time, will go from $8.99 to $9.99 a month. The $13.99 monthly plan for two discs out at the same time will get a similar buck bump.

In a gutsy move, the flagship $16.99 plan that offers three DVDs out simultaneously is going up by nearly 18% to $19.99 a month. The larger plans are going up even more.

Many existing Netflix subscribers will cringe at the new prices, but shareholders are understandably elated by the news.

There will be some pitfalls to watch out for, though, and I'll get to them after thanking Canada and Coinstar (Nasdaq: CSTR  ) for giving Netflix the flexibility -- or is that Netflixibility -- to go through with these bar-raising initiatives.

The Perfect Storm
There are certainly plenty of events that are giving Netflix the golden opportunity it's seizing today. The collapse of Movie Gallery -- and near collapse of Blockbuster -- are helping along with the bewildering lapses by typically astute Apple (Nasdaq: AAPL  ) and Amazon.com (Nasdaq: AMZN  ) to let an old school company with a chunky chain of bricks-and-mortar regional distribution centers beat it to the only digital celluloid model that's working.

However, Netflix wouldn't have been able to bump its rates higher if it wasn't for September's rollout of a streaming only plan in Canada and October's uninspiring digital strategy announcement by Coinstar's Redbox.

When Netflix launched in Canada with a $7.99 price point for a disc-less service two months ago, it was a trial balloon for the rest of the world. Would Canadians sign up for the plan in droves? Would they resent the $8.99 plan that also includes DVD delivery to their southerly neighbors?

We don't have any hard metrics in Canada, short of Netflix proclaiming it a success. However, it would have been a real slap in the face to Canadians if Netflix would have launched at a lower price point in the United States for a stream-centric offering. Once CEO Red Hastings revealed in September that his company would be rolling out a similar service for stateside users, the $7.99 price point was practically a lock.

We also can't forget the shiny Redbox kiosks. For months, Coinstar had been promising to peel back the curtain on a streaming service come October.

The hyped announcement was lame. Redbox wasn't going to roll out a service with the same cutthroat pricing that made it the lone thriving local DVD renter it is today. Instead, Coinstar would team up with a third party -- rumored to be either Amazon or Wal-Mart (NYSE: WMT  ) -- for a Redbox-branded service, eventually.

That was it. Redbox's inability to launch a digital platform at a low price point with a deep library gave Netflix all elbow room it needed to go through with today's rate hike.

The Blind Side
As a longtime Netflix shareholder, I'm loving today's move. Unfortunately, I'm also concerned. There are two things that can eat into the euphoria: the trade down and the non-streamer revolt.

Let's talk about trading down. Average revenue per subscriber has been trending lower in recent quarters. In its latest quarter, for example, revenue inched 31% higher even though its account base was 52% larger than it was a year earlier.

Are new users simply gravitating to the entry-level $8.99 plan (that is now going up to $9.99)? That's clearly happening, but it's also likely that many of those on larger plans are trading down to cheaper ones now that they have on-demand access to 20,000 digital titles.

Isn't the same thing going to happen again? I wouldn't be surprised if I find myself going from the unlimited plan with three discs out at a time to the two-disc option, and pay $2 less a month than I'm paying now, even with the price hike.

The other pothole to watch out for is the resentment that may build from Netflix subscribers who don't stream. More than two-thirds of the company's customers stream at least a little, but what about the other 34%?

They had no reason to complain when streaming was added, because it came at no additional cost. Now that Netflix is going through with its first rate hike since 2004, the "stream nots" may not be as happy as they used to be in subsidizing the streamers. 

"Creating the best user experience that we can around watching instantly is how we're spending the vast majority of our time and resources," Netflix explains in this morning's announcement. "Because of this, we are not creating any plans that are focused solely on DVDs by mail."

In other words, get on the bandwidth bandwagon, stream-nots -- or suck up the subsidization.

The Constant Gardener
Netflix will have to be careful at this point. Couch potatoes hardly relish a price hike. 

Sure, cable television bills and movie ticket prices go up every year, so why not Netflix? However, Netflix is making this move as its streaming service comes increasingly under fire. It recently added another content delivery network -- Level 3 (Nasdaq: LVLT  ) -- after a few outages. Cable giant Comcast (Nasdaq: CMCSA  ) is also promoting its Xfinity digital offering as having 20,000 titles available on demand.

Today's applause will be worth it if Netflix is able to keep churn in check and its subscriber base growing next year. That won't be easy, but Hastings wouldn't have it any other way.

Will Netflix's rate hikes work, or will churn turn substantially higher next year? Share your thoughts in the comment box below.

Wal-Mart Stores is a Motley Fool Inside Value selection. Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor picks. Wal-Mart Stores is a Motley Fool Global Gains recommendation. The Fool owns shares of Apple, and Wal-Mart Stores. 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.

Longtime Fool contributor Rick Munarriz has been a Netflix shareholder -- and subscriber -- since 2002. Rick is 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 (26) | Recommend This Article (27)

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  • Report this Comment On November 22, 2010, at 1:49 PM, Rouleur wrote:

    Rick,

    While you bring up some good points, I think you missing something substantial-revenue management. I do not mean that is a general sense, I mean it in the statistical discipline used often in the hospitality industry to determine rates. In the is case, these decisions I do not think were made lightly, and even without having the ability to look at any statistical evidence it makes sense that the pricing for streaming is a dollar less and the more expensive package is 3 dollars more. NFLX will save money at that streaming offer while drive growth in that area, and those that have the 8.99 rate will not care about a 1 dollar bump, and those at have the $3 bum are avid users of DVDs, and while some might be happy with it, it is just enough to be huge for Netflix, but not enough to get people to downgrade and sacrifice the multiple DVDs that their family is used to receiving. It is a smart move, and as a shareholder and subscriber I find the value equation remains.

    James

  • Report this Comment On November 22, 2010, at 2:01 PM, TMFBent wrote:

    It may or may not be a smart pricing move, depending on what kind of content is being watched, and what the licensing fees are for that content. In the old days, the mail delivery system provided a convenient choke on maximum licensing cost per member. Not so much with online streaming. It's a lot easier to watch a lot more content streaming, and although it's probably cheaper to deliver that digitally than through the mail, depending on what's being watched (and NFLX refuses to divulge that in CC's I've read...) we don't know what the costs will look like, especially as the library will need to expand.

    I'm surprised this article doesn't contain the word "Hulu." They are lining up with guns in this price war.

    If streaming video becomes the standard, and if this becomes a commodity business, and it appears to me to be heading in that direction, Netflix shareholders have a great opportunity to experience significant pain.

  • Report this Comment On November 22, 2010, at 2:19 PM, TMFGebinr wrote:

    I must say that is the first time I can remember reading where a 31% increase in revenue was characterized as "inched higher." I got the point being made, but it struck me as funny, nonetheless.

    Jim

  • Report this Comment On November 22, 2010, at 2:29 PM, Rouleur wrote:

    TMF Bent

    I don't think Hulu is a great competitor (at least as of now). It does not have the content- I read your article about NFLX and I think you miss the point if you see it as a commodity. Rather, it is a service, and for most people a valuable one. Obviously there are no guarantees with pricing strategy, but I think a lot of stats and research went in to how this would effect customer perception of value, and their ability to grow revenue.

  • Report this Comment On November 22, 2010, at 2:59 PM, naandrews wrote:

    TMF Bent,

    I just don't understand the claim that this is, or will become, a commodity business. Yes, the technology to stream video over the Internet is not difficult to duplicate. But to do what Netflix does -- spend decades building a brand and a distribution system, and spend billions of dollars securing rights from copyright holders to stream video -- well, could you do that out of your garage, if you decided to give up your MF gig and work on a Netflix killer instead?

    As David Gardner put it in a recent video (posted this past weekend), the competitive advantage, the moat, of companies like Netflix (and, say, Amazon) is often vastly underrated.

    As far as Hulu goes: they are lowering prices, yet Netflix is raising prices. That should tell us something.

    Finally, at least right now, Hulu and Netflix are geared towards much, much different audiences; in fact, I would argue that they have very different customers, with very different needs and wants.

    Do you really see Hulu and Netflix as doing the same thing?

    Neil (long NFLX)

  • Report this Comment On November 22, 2010, at 3:14 PM, dargus wrote:

    I own Netflix shares, and have been a subscriber for many years. I've been on the three DVD plan as long as I've been a subscriber, but I just switched to the two DVD plan. Honestly, the DVD's tend to sit in my house longer since the streaming library has increased, and I'm not going to pay the price hike. I'm probably better off in the long run with the two DVD plan.

    Will this hurt Netflix? I'm honestly not sure. I don't know what their deal with the Postal Service is, but they may be able to save money by shipping fewer DVD's. It also helps them if they can grow their subscriber base, even if their revenue per subscriber drops a but.

  • Report this Comment On November 22, 2010, at 3:43 PM, JeF4y wrote:

    I agree completely with dargus here.

    As well, I'm a 3 DVD + Bluray subscriber at $20.99/mo. A majority of what we watch is streaming, but we still enjoy the flexibility of having the dvd's in house to watch. The price hike to me is too high for the little bit of dvd watching we do, so I will knock it back to 2 DVDs per month plus bluray. Net loss for NetFlix = $3 from what I'm paying right now and $6 from what they hoped I would be paying.

    I believe the streaming plan is a great move and one that will work very well for them, but the hike on the 3DVD plan may do more harm than good.

  • Report this Comment On November 22, 2010, at 4:03 PM, hellomojo wrote:

    I agree with the trade down potential. We have been watching more and more thru the streaming service but kept our 2 dvd out a month plan. With this announcement we finally decided to drop our plan down to the 1 dvd out a month and could certainly see switching to streaming only before too long.

  • Report this Comment On November 22, 2010, at 5:04 PM, BioBat wrote:

    I don't think the 3 DVD plan price hike is going to have all that much effect. Onesie, twosie plan subscribers have been outnumber the 3 DVD out at a time plan by quite a wide margin for a fairly long time. So they'll lose a couple bucks per subscriber on the few who trade down but make up millions on those who are forced to trade up.

  • Report this Comment On November 22, 2010, at 6:30 PM, stan8331 wrote:

    Netflix wants to lose that bit of money in the trade down from 3 to 2 on the DVD's, because their larger goal is to start gradually moving closer to being a streaming-centric service. DVD's aren't going to go away anytime soon, because Netflix has a lot of resources invested in the disc distribution system that allows them to offer a vastly larger catalog than any other service that's even in their ballpark on price. There's currently still a lot of content they can't offer via streaming - there has to be some sort of glidepath to slowly wean customers away from DVD's and increase the streaming catalog. This modest price increase will raise current revenues and start the process of slowly moving toward streaming becoming the dominant method of content delivery, without creating the impression that consumers are being gouged.

    Netflix competitors currently offer either vastly higher prices or a vastly more limited choice of content, and I see nothing on the horizon that threatens to change that situation.

  • Report this Comment On November 22, 2010, at 7:02 PM, Willustop wrote:

    I'm dumping my NF plan. Streaming only for $7.99? I go to Redbox and get what I want for a buck.

  • Report this Comment On November 22, 2010, at 8:23 PM, ompompanoo wrote:

    Don't forget to add the cost of gasoline to that one buck.

  • Report this Comment On November 22, 2010, at 11:32 PM, teebeecan wrote:

    Hi: From Saskatoon, Saskatchewan, Canada..I only know of a few people who have signed up for streaming videos at $8 a month..cheap enough even for me, an occasional video watcher BUT, unless you want to watch on a laptop, it requires buying an XBox 360 or a Playstation 3, an expensive item, in order to get the video to a HD TV. Should be a simpler way!

  • Report this Comment On November 22, 2010, at 11:38 PM, justingg wrote:

    I don't need the movies, and I don't stream. I do frequent stores with redbox, so if I need a movie, I will get it while I am at the store. They should keep current customers where they are and give the bump to new customers.

    Netflix has entered into some high cost contracts to add streaming content, and now I have to pay for it. How about they now add a no streaming option. I have a feeling there are plenty of other current customers who feel like I do. I think I will do without DVD rentals to my home from now on.

  • Report this Comment On November 23, 2010, at 6:41 AM, afamiii wrote:

    Netflix ARPU (average revenue per users) will continue to drop as it increases penetration into its addressable market, this is the reality for all consumer businesses (with the exception of really basic stuff like nappies and toothpaste.

    Netflix strategy is classic. The DVD business is a dying business and should be milked for the cash it can produce (no one is going to launch a competitive product in the physical sector again EVER - the non streamers have to be managed with as much integrity as possible, but can't be allowed to hold the train back.) Streaming is the rising star and the whole organisational focus now needs to be on making sure they occupy a defensible competitive position in this sector going forward. They do this by taking surplus from DVD and effectively deploying it in streaming. The US streaming market will be 10 times the box DVD market AND it will be much easier to expand globally (which needs to be their next priority.) They should not do an Apple (and leave it too late - that guy Steve is a genius, but his blind spots qualify to be plains)

  • Report this Comment On November 23, 2010, at 10:00 AM, bridomuga wrote:

    Don't necessarily need a 360 or PS3. You can get a Roku for about $100.

  • Report this Comment On November 23, 2010, at 10:10 AM, TMFConch wrote:

    Thanks to this thread I just dropped my plan to 2 DVDs plus streaming for $14.99, so that's $2.00 less per month than I have been paying. I can see that being something that lots of people might choose to do.

  • Report this Comment On November 23, 2010, at 10:14 AM, TMFABnormal wrote:

    If you have a more modern television, you can hook your laptop directly to it for streaming.

  • Report this Comment On November 23, 2010, at 11:49 AM, hellerbrewing wrote:

    I think the continued success of Netflix is going to depend it locking in exclusive deals with content providers. Take HBO for example, if it were able to secure the deal with them, I think people would be ditching cable en masse. Currently, 19 of the 147 movies I have in my queue are available for streaming, and the majority of them aren't ones I am really itching to see right away. If they are going to dedicate all of their resources to their streaming services, they need to be able to ink some big time deals.

  • Report this Comment On November 23, 2010, at 11:58 AM, Rouleur wrote:

    heller-I could not agree more, that is the future. In the meantime, they are leveraging their existing model. Watch their existing (and growing) relationship with Apple.......

  • Report this Comment On November 23, 2010, at 12:21 PM, Borbality wrote:

    It seemed too good to be true to stream and get one DVD for 8.99 per month. I am still more than happy with the value of this plan. My wife is streaming stuff all the time and I always have something to watch if I want. I'm about to add blu-ray.

    i would complain if they had another price increase soon, but I could see myself gladly paying as much as $15 per month for the current service. This is still worth so much more to me than cable. Only thing I miss is baseball.

  • Report this Comment On November 23, 2010, at 12:34 PM, Rouleur wrote:

    Hopefully Netflix read your comment Borb-MLB-tv teams with NFLX-not far-fetched, and a great idea.

  • Report this Comment On November 23, 2010, at 1:03 PM, chrestomathy wrote:

    Couldn't pass up the $7.99 deal. So I switched from 1 DVD to stream only. I've had a PS3 since it came out so adding NF was a no-brainer. DVDs were a pain. I just gave away most of my DVDs and pretty near all my CDs to charity. For the few movies on DVD but not on streaming I go to the library or Redbox.

  • Report this Comment On November 23, 2010, at 9:17 PM, TMFTomGardner wrote:

    Hulu reminds me of Prodigy back in the day. Whooaaa, look out. Because large corporate giants are lining up behind this winner. (In that case, it was Prodigy and Sears, cough cough.)

    I am not saying that Netflix has endless running room. Although I have held Netflix as a recommendation in Stock Advisor from $21 to $188 -- so I at least deserve some credit for having been right thus far!

    In my estimation, Hulu has a unsteady commercial model, uncertain long-term leadership, and a primary programming master to serve. I wish Hulu luck -- because the more competition, the better it is for consumers.

    But I think this short piece has it right:

    http://lalawag.com/2010/11/23/netflix-and-hulu-plus-prepare-...

    One raises prices, the other shaves prices down...and in this battle, that tells me who's winning (and by a lot). - Tom

  • Report this Comment On November 24, 2010, at 9:27 PM, Rouleur wrote:

    I bought NFLX with Tom way back when and have been and out of it a few times. I currently hold it and I like the company's prospects, but it is a frothy valuation and the risks I think lie mostly in the execution from DVD to streaming, a lot of which they do not have total control over. Many powerful studios and cable companies will not make it easy because they make a lot less from NFLX then they do from cable subscribers and dvds. Assuming NFLX continues to grow at its current pace they will have leverage and if growth is more in streaming (less dvd) larger margins should allow for the money and leverage to negotiate distribution deals. It will be a challenge, and something to watch...... Then again, while possibly prohibitively expensive I think it makes an an attractive take over candidate from the likes of Apple, or maybe even an AMZN.

  • Report this Comment On November 26, 2010, at 12:51 PM, nitedawg wrote:

    Not mentioned in the article was the fact that the new streaming only plan will be at a HIGH profit margin. No Postal fees (2 way), no warehousing of DVDs for these folks, no costs associated with shipping and receiving (people and equipment).

    So Netflix will benefit in profit margin with new subscribers AND with subscribers moving from a DVD plan. It almost looks like (to me) Netflix is looking forward to building up the "Streaming plan" not only with new subscribers to that plan but from subscribers already in A DVD plan that move to the new "Streaming plan". Build profit margin then concentrate on increasing the installed base of custromers.

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