Netflix (NASDAQ:NFLX) needs to raise its prices, but doing so in the wrong way may send millions of customers fleeing.
Currently, the company appears to be following the axiom that has brought down countless retail stores: the service is essentially selling $20 bills for $19 and attempting to make up the difference on volume.
In some ways, this is not a crazy strategy for Netflix as the company does not sell hard goods. A large part of its expenses are fixed. Licensing fees for content aren't based on how many subscribers Netflix has or how many people watch a show or movie. Similarly, original content may be expensive, but once you pay for "House of Cards" or "Arrested Development" you own it whether nobody watches it or millions of new subscribers sign up for the privilege of tuning in.
If the status quo remained, Netflix could grow its way to long-term profitability. However, rising costs mean that the company simply needs to take in more money than it can from just adding subscribers -- which likely means a price increase.
Being Netflix is really expensive
It takes a lot of money to produce original content, but it takes even more to license existing movies and TV shows in an increasingly competitive environment. When Netflix began, its streaming service it was unique. Now the company faces a major competitor in Amazon.com's (NASDAQ:AMZN) Prime Instant Video service.
Prime Instant Video is essentially a throw-in for Amazon customers who are paying the yearly $79 fee for free shipping. Still, the secondary importance of video to Prime subscribers does not mean that Amazon is not driving up acquisition costs (and maybe stealing customers) from Netflix.
As of Dec. 31, Netflix had nearly $3 billion in streaming content obligations due in the 2014, another $3 billion due in 2014 and 2015, and just under a billion committed for the two years after that. The company expects those numbers to go up.
It's getting more expensive to be Netflix
Content is not Netflix's only cost. The company just reached a deal with Comcast (NASDAQ:CMCSK) to pay for the right for the service's customers to get higher streaming speeds from the cable company. The price for that has not been released yet, but assume it's not cheap and assume that Netflix will have to make similar deals with other cable companies or risk having its customers throttled off.
"Running equal to, or slightly above, prior year net additions is a great outcome because it implies that at 33 million domestic members we're still in the middle section of the S curve of consumer adoption, with years of member growth ahead of us," CEO Reed Hastings wrote.
That expected growth, however, is clearly not enough as the letter went on to prepare customers for an eventual price increase.
"Last April we introduced a 4-concurrent stream $11.99 option to begin our evaluation of plan tiering. Since late last year, we have also been testing 1-stream and 3-stream variants, as well as SD/HD variations, at various price points. Eventually, we hope to be able to offer new members a selection of three simple options to fit everyone's taste," the letter said.
Those new tiers and prices would seem to only apply to new customers, but Netflix clearly wants its existing paying users to know that they are not exempt forever (while also being very careful not to set off any panic.)
"If we do make pricing changes for new members, existing members would get generous grandfathering of their existing plans and prices, so there would be no material near-term revenue increase from moving to this potential broader set of options. We are in no rush to implement such new member plans and are still researching the best way to proceed," the company continued.
A Netflix price increase is coming, but the company has learned its lesson
In 2011, Netflix effectively raised its prices by attempting to split its DVD delivery service from its streaming one. That move represented a nearly 60% price increase for customers who used both services and it caused major displeasure among the Netflix customer base.
Netlix lost 800,000 U.S. subscribers between July and September of 2011 despite Hastings apologizing for the back-door price increase, HuffingtonPost reported. Worse perhaps than the subscriber loss was the cost in goodwill. A single bad decision (and a lot of bad attempts to fix things) turned Netflix from a low-cost service that customers loved to a product that people might be willing to live without.
Netflix has learned a lot from that lesson. The company knows it needs to make more money and that to do that, it needs to charge its customers more. That price hike will come eventually, but before it does Netflix will shout about its arrival from every rooftop. New customers may pay more first and then -- very slowly -- higher prices will come for existing subscribers. Netflix may even offer a way to keep the current price (perhaps for reduced service), but what it won't do is surprise anyone.
No matter how well Netflix broadcasts its intentions, some customers simply won't pay a dime more or take a bit less of service. Those subscribers will be lost, but their number will be far less than the number had Netflix simply announced a price increase. By going slow, putting its cards on the table, and not trying to put anything over on anyone, Netflix should succeed in raising prices while minimizing subscriber loss.
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Daniel Kline has no position in any stocks mentioned. He has a Netflix and an Amazon Prime membership. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. 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. The Motley Fool has a disclosure policy.