Why Netflix Isn't About to Raise Prices

Netflix is allegedly about to raise prices, "as content creation, distribution, and licensing costs increase." Here's what's wrong with that argument.

Mar 11, 2014 at 4:00PM

Nflx Relax

Relax. It's Netflix.

Fellow Fool David Eller recently penned an article on Netflix (NASDAQ:NFLX) and its rising costs, which will force the company to raise prices for its customers.

David's story was well-received and made it into USA Today . Unfortunately, it could also use some debunking.

Plan tiering
David rightly noted that Netflix is considering a change to its pricing plans. This much is incontrovertibly true. In the fourth-quarter letter to shareholders, Netflix talked about generous grandfathering of current pricing plans in case it decides to change anything.

But David may have missed a couple of details in that letter:

  • "We are in no rush to implement such new member plans and are still researching the best way to proceed."

  • "Eventually, we hope to be able to offer new members a selection of three simple options to fit everyone's taste."

In other words, Netflix isn't in a hurry to launch new pricing plans -- and even if it does, we won't get a bewildering array of choices. Moreover, it isn't clear at all that Netflix even thought about raising the price for today's basic all-you-can-stream plan.

The direct connection deal with Comcast (NASDAQ:CMCSA) kept coming up as a driver of price increases, because David believes that Comcast is fleecing the video service with incredibly high costs.

First, that idea doesn't pass the smell test. Netflix is cutting out middleman Cogent (NASDAQ:CCOI) from its content flow to Comcast subscribers. In doing so, it ensures a higher-quality connection that Cogent couldn't deliver.

The higher-quality link would be enough to justify higher costs here -- but slapping away Cogent's hand from collecting its profit margins is likely to keep Netflix's total service bill stable at worst. See a fuller discussion of this topic in an earlier story on this very topic.

Moreover, Netflix would be silly to accept a higher bill in the first place. Comcast doesn't hold all the cards here. Netflix could also choose to route its Comcast traffic via third-party content delivery services like Akamai Technologies (NASDAQ:AKAM), which already have high-quality connections to every major network out there.

Netflix is weaning itself off Akamai and friends in order to save some money and have more control over the data flow, but it's always a last-ditch option if some ISP plays hardball at the negotiating table.

And if you're still not convinced, Netflix CFO David Wells is on the record as saying that the Comcast deal doesn't change his margin guidance for 2014.

Long story short, Comcast is most certainly not charging Netflix an arm and a leg for this higher-quality connection.

Why so desperate?
Finally, David offered this chilling nugget: "What we do know is that Netflix has its back to the wall as half of its $3 billion in content liabilities are coming due in the next 12 months, so it will do anything it can to reduce or stabilize costs."

In other words, content costs are skyrocketing so Netflix must cut corners wherever possible just to stay afloat.

Except that scary $3 billion liability is simply an estimate of the upcoming year's operating costs.

At the end of 2012, Netflix had $2.2 billion in content costs coming due within 12 months. The company ended up spending $1.8 billion on domestic "cost of revenues," and another $800,000 in international costs. This metric lumps content costs together with video delivery expenses, payment processing fees, and customer service operations. I think it's fair to say that the $2.2 billion content cost estimate ended up in the right ballpark.

Nflx Chart

Data taken from three years of Netflix SEC filings.

So content costs are soaring 36% higher in 2014. The company doesn't offer full-year guidance this early, but forecasts for the first quarter came up with a 24% year-over-year sales boost domestically and an 88% international surge.

Think it's unreasonable to assume that these skyrocketing revenues will cover Netflix's increased content costs? I don't.

The battle of the big takeaways
David's big takeaway is that Netflix is sure to raise prices -- and soon.

That conclusion seems based on several problematic assumptions, as discussed above. On top of that, the alarm fades away when you consider that the $8 monthly bill hasn't increased since 2011. Has your cable company ever gone three years without a price hike?

And a recent price hike in Ireland came with a two-year grandfathering option. Two years. The extra euro per month may or may not affect Netflix's Irish growth, but I'd be shocked if Irish subscribers panicked over a price change 24 months away. Netflix is likely to adopt a similar approach to whatever changes might happen stateside.

Long story short, Netflix is not "about to raise prices." It may give subscribers some new plan choices, but even that isn't necessarily just around the corner. And there's no crushing liability load waiting to smash the balance sheet into smithereens.

My big takeaway? We Netflix investors (and customers) shouldn't worry. The company is doing just fine.

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Anders Bylund owns shares of Netflix. The Motley Fool recommends and owns shares of 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.

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