Why Netflix Stock May Churn Lower

Netflix (NASDAQ: NFLX  ) stock has staged a strong performance since last fall, tripling in value.  Most of those gains came in the week after its most recent quarterly report:

NFLX Chart

Netflix 1-Year Price Chart, data by YCharts.

Investors were glad to see Netflix add more than 2 million domestic subscribers in the fourth quarter while also achieving record subscriber growth internationally. Yet for all of Netflix's recent successes, investors seem to be overestimating the company's ability to maintain that rate of subscriber growth.

Right now, Netflix seems to be winning back some of the customers who left after the 2011 price hike/Qwikster fiasco. However, in the next few years, I expect Netflix's high churn -- the percentage of subscribers dropping the service each month -- to become an increasingly significant drag on domestic subscriber growth. Slower growth will ultimately sink Netflix stock, simply because it is priced for massive earnings growth at 57 times forward earnings.

The importance of churn
All subscription-based businesses have to worry about churn, but the problem is particularly acute for Netflix. Analyst Michael Pachter, a longtime Netflix bear, has estimated that 58 million people have quit the service in the past 10 years -- nearly 6 million per year on average. That's more than Netflix's total worldwide subscriber base today! Furthermore, the churn rate is significantly higher now than it was previously. Management has stated that the streaming-only service has a higher churn rate than Netflix's legacy DVD-by-mail business. Moreover, churn is calculated as a percentage of total subscribers; since Netflix has a much larger subscriber base now than it did five or 10 years ago, it is also losing many more subscribers each month.

Netflix's management has tried to downplay this issue; in fact, CEO Reed Hastings has stated, "We don't focus on churn because we really want to make it easy to quit." The idea behind this strategy is that if customers have a good experience even while leaving the service, they will be more likely to come back later. Regardless, as the subscriber base grows, high churn will have a progressively stronger dampening effect on Netflix's growth. High churn probably explains why the company missed its original goal of adding 7 million domestic streaming subscribers last year, which caused Netflix stock to lose more than half its value in 2012 (before the recent run-up).

By the numbers
To get a better sense of the impact of churn, it will be helpful to look at some hypothetical numbers. Netflix no longer reports churn statistics, but the monthly churn rate was 3.7% in fourth quarter 2010, rising to 3.9% in first quarter 2011 and 4.2% in second quarter 2011. Furthermore, in last year's first-quarter letter to stockholders, Netflix used a 5% churn rate in several illustrative examples. I will therefore assume that 5% is a good ballpark figure for Netflix's monthly churn rate in the domestic streaming business.

If 5% of domestic streaming subscribers are leaving every month, that means the service has to replace 1.36 million departing members every month just to stay in place! If Netflix's subscriber base grows to 40 million and churn remains steady, the company would need to add 2 million subscribers a month to stand still. Stated another way, growing the domestic subscriber base by 5 million this year seems fairly manageable for Netflix until you realize that the company actually needs to sign up at least 20 million new (or returning) subscribers to hit that target.

Foolish conclusion
The current lofty Netflix stock price implies a level of long-term growth that seems far-fetched to me in light of the service's high churn rate. While improving the quality of content may have some positive impact on churn, much of this will be offset by rising competition from Amazon, Hulu, and even Redbox Instant (a new joint venture between Coinstar and Verizon). Even if Netflix has the best streaming video service, it will still see a steady stream of members leaving to try other services that might (or might not) provide better value.

Netflix stockholders need to understand that the more Netflix grows, the harder it will be to keep growing. With a larger subscriber base, more people will be quitting each month, while there will be a smaller pool of nonsubscribers from which to replace them. In fact, Netflix's domestic subscriber growth peaked in 2011, and has already dropped from a peak rate of 9.6 million domestic subscriber additions per yearto 5.5 million net additions in 2012.

As growth rates continue to moderate over the next few years, I expect Netflix stock to undergo radical multiple contraction. While it's hard to say just how low Netflix could go, a replica of the 2011 and 2012 crashes is very plausible. Do you think I'm wrong? Sound off in the comments box below!

More about Netflix
The tumultuous performance of Netflix shares since the summer of 2011 has caused headaches for many devoted shareholders. While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why The Motley Fool has released a premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. The report includes a full year of updates to cover critical new developments, so make sure to click here and claim a copy today.


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Comments from our Foolish Readers

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  • Report this Comment On April 10, 2013, at 7:07 PM, AceInMySleeve wrote:

    Another way to look at it is that small improvements to churn could radically improve growth.

  • Report this Comment On April 10, 2013, at 7:35 PM, TMFGemHunter wrote:

    Thanks for the comment. I don't think that's really true, though. If churn drops from 5% to 4% over the next year and Netflix adds another 5.5 million users in that same time period, the net effect would be roughly neutral. (1.36 million cancellations per month today, vs. 1.31 million cancellations per month next year)

    A major improvement in churn (say 5% to 2%) could lead to a major uptick in growth. I doubt that Netflix can manage that, though. HBO has been in this game for a long time, has more compelling content than Netflix, and still has very substantial churn.

  • Report this Comment On April 10, 2013, at 8:12 PM, AceInMySleeve wrote:

    Yeah and the parallel argument is that churn could go up.

    If this business just happens to be one where the same customers enter and exit frequently, this isn't a 'bad' situation per se. That's the steady state situation.

    Who's to say they can't have 60M customers with 30M coming and going every year? You don't want the situation where people are trying it, leaving, and never coming back, but we have no data to help us determine that.

  • Report this Comment On April 10, 2013, at 8:18 PM, AceInMySleeve wrote:

    They were asked at one point how many total households they had 'touched' and dodged the question, I would note. Something about the same person signing up with multiple accounts in order to get the free trial account. Fine. But I doubt they internally just threw up their hands in pursuit.

    At any rate, I don't think any customer ever is in the boat of 'I will NEVER go back'. The entire country may have tried and quit, and said that, and it still isn't worth believing them.

    Growth trends though aren't that erratic because they are averaged over so many millions of people. Once you factor in seasonality in particular. They won't go from +25% last year to 0% this year suddenly without some outside event causing it: qwikster, price increase, apple alternative, or whatever. All of which are judging the future by something other than this metric alone.

  • Report this Comment On April 10, 2013, at 8:39 PM, trdr2012 wrote:

    Look for a stock to drop (in this case initiated and spurred on by a false rumor) and bears are all over it.

    As "cord cutting" (foregoing cable channel subscriptions) increases so to will subscriptions in NFLX as an alternative. At this point, competition considered, is not a significant threat.

    In good times or bad, people want to be entertained. Word of mouth, social media, software and hardware apps; = growing subscriber base = increasing $revenue$.

    2 year subscriber and very happy; beats paying a cable bill for worthless channels.

    Netflix is the “go to” place for entertainment and "is the best deal in town."

  • Report this Comment On April 10, 2013, at 8:43 PM, AceInMySleeve wrote:

    The bottomline argument that just doesn't ever get covered is that Netflix spends 70% of your 8$ on content. HBO costs 15$ to the consumer, of which cable takes half, of the 7.5$ remaining HBO has profit margins closer to 50%. So about 25-30% of your payment goes to content.

    That's not even the full story. Content typically is contracted via a set charge, not related to your total # of members. Starz may pay 300M$ or Netflix pay 300M$ for an output deal, but Netflix splits it over more customers (or will if they keep growing). Therefore, each customer pays a smaller fraction of their pricetag for the same content.

    That's not even the full story. On Netflix you watch anything in the library at any time, on any device.

    We have a complete revision of television going on and no one is even remotely close to Netflix yet, and the entrenched players can't make their moves without sacrificing margins or alienating partners. It's classic disruption.

  • Report this Comment On April 10, 2013, at 8:44 PM, AceInMySleeve wrote:

    And that's not even the full story. When Netflix creates original programming they distribute the cost over domestic and international, a total # that will surpass HBO this year, and grow dramatically past it in the years to come.

  • Report this Comment On April 10, 2013, at 9:22 PM, TMFGemHunter wrote:

    @AceInMySleeve: For the most part, domestic and international content deals are totally separate. Netflix pays a fixed cost for the rights to certain content in the U.S. and/or pays for those rights in various other countries. But a lot of content available domestically cannot just be split with int'l users as well.

    HBO has an incredible franchise. Netflix is nowhere near replicating that, and I don't think it can become the next HBO just by throwing money at the problem. People are only willing to pay $15 for HBO (and I bet most HBO subscribers have discount deals and pay less) because it has a number of very high quality exclusive shows. Maybe Netflix can eventually get to that level with its exclusive content, but it's nowhere close.

    In any case, it's worth noting that Netflix's subscriber count is already roughly equal to HBO's. Netflix might eventually be able to maintain subscriber count at the current level while boosting prices to $12 and thus improving profitability. But I don't see how Netflix can reach its goal of 60-90 million subs at $8/month, let alone $12 or more.

    Adam

  • Report this Comment On April 10, 2013, at 10:36 PM, AceInMySleeve wrote:

    I'm aware of contracts being per region. It's not true if Netflix owns the content, which was my comment.

    " I don't think it can become the next HBO just by throwing money at the problem"

    I explained why they could throw money at the problem vs. HBO. If you have the above opinion, you need arguments to make it persuasive. House of Cards is Netflix throwing money at the problem and succeeding (according to the high rating it got on the website, and high pundit plaudits). It did not take them years to get the formula right. But of course it takes years to get to the 29 original series that HBO has accumulated. Although I think they are close to 10 already. Just looking through the reviews for HoC it's eye-opening how many people are congratulating and appreciating Netflix explicitly.

    "But I don't see how Netflix can reach its goal of 60-90 million subs at $8/month, let alone $12 or more."

    You can certainly make that assertion, but it's not an argument. Netflix is indeed about the size of HBO, and are on a 25% Y/Y growth trajectory while HBO is flat. Again, I listed the competitive arguments against any traditional competitor (HBO included) rather clearly. The most dominant of which is the price paid:content spend. HBO Go reduces the relative benefit of some of the others, but HBO is not the only competitor. Personally I model 50M subs in 5 years with a slow price ramp. 60M-90M does stretch credibility, but those numbers are clearly the addressable market given enough time for internet TV in general (which should really be very close to every broadband home).

  • Report this Comment On April 11, 2013, at 10:08 AM, TMFGemHunter wrote:

    @AceInMySleeve: Netflix doesn't own any content, as far as I'm aware. Even House of Cards is under an exclusive license for the first TV window, but not owned by Netflix. I don't know if it has one contract for the whole world, or separate contracts for U.S. and other countries, but in any case it has allocated costs between different regions (since it reports profit for domestic streaming separately from int'l streaming).

    As for the comment on 60-90 million subscribers, the argument is goes back to the issue of churn. Even if churn goes down to 4%, at 60 million subscribers you have to replace nearly 30 million cancellations a year. There are about 115 million households in the U.S., so that means NFLX would need to sign up half of the remaining households every year just to maintain the 60 million level.

    Looking at it another way, while NFLX grew 25% last year, the pace of growth is on a downward trajectory (due to the churn factor and beginning to saturate the market). NFLX was growing at more than 60% annually prior to the Qwikster debacle. It's possible that the new originals could provide a little extra momentum this year, but I am still estimating sub growth of just 15%-20% this year and 10%-15% next year. After that, it depends on whether Netflix raises prices. At $8/month, I think the sub base would stabilize in the 40-50 million range, but that's just an estimate based on the churn rate and size of the total market.

    I like looking at questions from different angles, so I'll add one more: why does HBO go through cable network anyway? Nothing prevents it from axing the cable/satellite channel and making the whole service HBO GO. This suggests that Time Warner gets valuable benefits from partnering with cable networks: presumably marketing support. Netflix has to do its own marketing, which is why it has lower margins. (It also spends a lot more on technology.) This is the real reason why HBO makes a lot more money even though its domestic revenue is probably comparable to Netflix's.

  • Report this Comment On April 11, 2013, at 6:20 PM, AceInMySleeve wrote:

    40-50M isn't far from my 50M. And I look at price increases as not occurring in a vacuum, I anticipate Netflix continuing to spend over 50% of that on additional content so it's more pricey, but a better service as well.

    Churning is clicking a button to quit, and joining the service is clicking a button to start again. It's just a little more difficult than turning your tv on and off. It's simply not clear what to do with this information.

    Netflix may be spending 15-20% on marketing and tech but that's deceptive because it's closer to a fixed cost than a variable one. 50% of the price of HBO goes to cable. That does track with revenue.

    "why does HBO go through cable network anyway?"

    It can be as simple as the transition being difficult and not guaranteed. Large organisms make changes organically, or they face Qwikster style debacles and CEOs get fired. HBO has to plot things out a step at a time from where they happen to be. I expect them to leave cable eventually anyway, and I don't worry excessively about HBO where Netflix is concerned. I suspect a very high overlap in that if you have HBO you likely have or will have Netflix. Although vice-versa is not as true since Netflix has broader reach (mostly in terms of the price (HBO is 15$ + the whole cable package nonsense under it)).

  • Report this Comment On April 11, 2013, at 9:52 PM, TMFGemHunter wrote:

    Thanks for your comments. It will be interesting to see how things develop over the next few years. I'm sure much of my bearishness can be attributed to my own low opinion of the service; content that I want to watch is much more likely to be available for free on the internet than on Netflix. Since I have a limited amount of time to watch stuff, there's no need for Netflix. (I've used Netflix on a free trial basis twice in the last two years, but canceled each time after the free month.)

    Maybe I'm in a very small minority. But I don't think so. In fact, I've had more than one person say that they have/had Netflix but couldn't find much content worth watching. Content is just really expensive, and I don't think Netflix can get enough to really expand its addressable market at an acceptable cost.

  • Report this Comment On April 11, 2013, at 10:34 PM, AceInMySleeve wrote:

    Yeah the way I see it is that for the price of 8$, no one can beat the overall content offering (for the reasons discussed above, and glossing over advertising). Yet, 8$ won't get you everything.

    If Netflix charged 15$, then for that price, no one could beat the overall content offering. Yet, 15$ won't get you everything.

    etc.

    I find it interesting and a bit perplexing that Netflix doesn't even entertain higher price points, but there is no fundamental reason they can't except that they don't like the pros/cons as they see it. I spend more on Redbox than at Netflix and would gladly divert that money to Netflix if plausible, although Redbox has the peculiar economics\legalities of DVD working in their favor. That is, the enormous profit of DVD for studios, and the legal allowance to rent them for cheap for Redbox.

    Thanks for the discussion.

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