Too Bad Netflix Doesn't Charge by the Hour

Earlier this month, Netflix (NASDAQ: NFLX  ) CEO Reed Hastings announced on his Facebook (NASDAQ: FB  ) page that viewers had streamed more than 4 billion hours of video on Netflix in Q1. That averages out to at least 1.33 billion hours per month; in contrast, Netflix first surpassed 1 billion hours of streaming video in a month in June 2012. Investors cheered the new usage information, on the premise that higher usage means more subscribers. Indeed, Netflix announced last week that it added 2.03 million domestic streaming subscribers and 1.02 million international subscribers in Q1.

However, the "hours watched" metric doesn't actually have much bearing on what Netflix is worth. If Netflix charged by the hour, then higher usage would be a proxy for sales growth. Instead, under Netflix's "unlimited viewing" policy, while total usage is correlated with revenue, the relationship is not one-to-one. Indeed, the impact of higher usage on Netflix's profitability is not at all straightforward. Netflix investors should therefore be careful of relying too heavily on non-financial metrics like "hours watched."

Usage and revenue: a divergence
Based on the data Netflix has provided, it appears that most of the increase in usage since last June is due to subscriber growth, but 5% to 10% of the increase can be attributed to Netflix customers using the service more. Netflix management has stated that customers who watch more content are less likely to cancel. Bulls would therefore argue that higher usage will improve revenue growth because fewer people will cancel their service in the future.

On the other hand, increasing usage per account could be the result of account-sharing. One analyst recently estimated that 10 million people use Netflix without paying, by sharing a Netflix customer's password. While these individuals are getting a lot of value out of their shared accounts, their high usage actually represents a revenue loss for Netflix (compared with paid accounts for both people). Some analysts had speculated that Netflix would crack down on account-sharing. Instead, the company's new $11.99 plan allows four simultaneous streams and could actually encourage more account sharing.

Higher usage in each account could also theoretically benefit Netflix by creating pricing power. If users value Netflix very highly, then the company could raise prices without losing too many subscribers. However, management has been adamant that it isn't interested in raising prices for the foreseeable future -- excluding the new $11.99 plan that allows up to four people to use an account at once. Given the level of customer outrage that followed the last price increase, Netflix is likely to remain extremely cautious on pricing. Overall, it's unclear whether Netflix benefits significantly from subscribers using the service more often.

Can usage drive costs?
On the flip side, heavy usage may actually be a longtime driver of cost increases for Netflix. While Netflix's content costs are fixed in the short term -- Netflix pays content owners a flat fee rather than paying based on usage or the number of subscribers -- everything is negotiable in the long run. According to the company's 10-K, almost 90% of Netflix's streaming obligations are due within three years or less. If content providers see that Netflix users want to consume a lot of their content, they will raise their prices as the contracts come up for renewal.

Netflix may already be seeing this occur. On the company's recent earnings call, management noted that Amazon.com (NASDAQ: AMZN  ) and Hulu have been more active in bidding for content in the past year, and this competition has driven up prices. One result is that Netflix is allowing a broad licensing deal with Viacom (NASDAQ: VIAB  ) to expire in May. Netflix hopes to license a few shows separately, but the rest will be removed. While Netflix can try to manage costs in this manner for a little while, it risks turning the virtuous cycle -- more content draws more users, driving higher revenue, which pays for more content -- into a vicious cycle.

Foolish conclusion
Unlike some companies that are very tight-lipped, Netflix provides investors a vast amount of information in its quarterly investor letters, blog posts, and other announcements. Investors need to sift through this information and figure out what is actually relevant. "Hours watched" does not seem like a particularly good metric for investors to follow. In the long run, higher usage probably increases both revenue and costs, but there is simply not enough data yet to know which factor will outweigh the other.

Netflix's long-term value will ultimately be driven by its ability to generate pricing power, so that it can pass through price increases from content owners like Viacom, rather than losing content or sacrificing margins. If investors chase "canards" like usage statistics in evaluating Netflix's business model, they may end up overlooking the most important information about the company's health.

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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  • Report this Comment On April 27, 2013, at 2:17 PM, MLyons2005 wrote:

    This article is absurd. As a chronic Netflix user (its my primary source of "Television" I log a LOT of hours, but if they started charging by the hour, I'd never use it again. I'd just go find somewhere else to get my content, even if the quality wasn't as good.

  • Report this Comment On April 27, 2013, at 2:35 PM, TMFGemHunter wrote:

    @MLyons2005: That's the whole point of the article. You log a lot of hours, but that doesn't actually benefit Netflix in any way. Presumably it means that you would keep the service even if they raised prices, but they've been very clear about the fact that they don't want to raise prices or do tiered pricing or anything like that.

    It's obviously great for consumers that Netflix allows you to watch all you want for $8 a month. It's not clear that this is great for Netflix, though.

    Adam

  • Report this Comment On April 27, 2013, at 4:01 PM, lildivalorianne wrote:

    I have Netflix and let me tell you the content is not worth charging by the hour. What you can get on streaming is mostly reruns of old shows and old movies. None of the new releases or newer movies are on streaming. I sit and watch a ton of old BBC stuff and if they start charging by the hour I will cancel my total service because I also have the regular DVD service with them as well. They make enough money off their customers because they charge us for every little thing we get.

  • Report this Comment On April 27, 2013, at 5:07 PM, The1MAGE wrote:

    Viewing hours would be a related metric. Obviously there would be some variable, but when viewing goes up 33%, it sure ain't their current customers.

  • Report this Comment On April 27, 2013, at 8:07 PM, TMFGemHunter wrote:

    @The1MAGE: You are right. As I said in the article, the usage per subscriber seems to have gone up 5%-10%.

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