Investors in Netflix (NFLX 5.54%) have been going through considerable pain lately. Shares of the video-streaming leader are down roughly 20% over the past year, as the company is being hurt by slower-than-expected growth in its subscriber base. Warren Buffett is one of the smartest and most successful investors ever, and investors in Netflix could learn some valuable lessons from the Oracle of Omaha.
Pricing power is a key consideration
Netflix raised prices for new customers two years ago, but existing customers were "grandfathered" and kept at the old price for two years. The company started un-grandfathering those customers in early April, and this produced an unexpected increase in the customer churn rate during the second quarter of 2016. This is the main reason why net user growth substantially missed the company's own guidance in the second quarter, a major concern among investors in Netflix stock.
Pricing power says a lot about the fundamental health of a business. Over the long term, companies that can raise prices without suffering much of an impact in terms of revenue losses versus the competition have an advantage over competitors. Over the long term, pricing power allows a business to transfer rising costs to customers, protecting shareholder profitability.
Warren Buffett pays considerable attention to a company's pricing power. Speaking before the Financial Crisis Inquiry Commission in 2011, Buffett said:
The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10%, then you've got a terrible business.
What's happening to Netflix?
The main question for investors in Netflix is whether the company is facing a temporary bump on its path to long-term growth or if the business is losing customers to competitors such as Amazon (AMZN 4.44%), Hulu, and Time Warner's (TWX) HBO Now streaming service.
To begin with, Netflix doesn't look too expensive in comparison to other streaming services. After raising prices by $1, the Netflix standard HD plan currently costs $9.99 monthly. Amazon Prime, which includes a video service, costs $99 a year ($8.25 a month) or $10.99 per month if you pay by the month and Amazon offers access to just Prime Video for $8.99 a month. Hulu Plus charges $8 per month, and HBO Now has a substantially higher price of $14.99 monthly. Netflix is priced broadly in line with other players in the sector, especially considering that it has a powerful brand and a popular selection of content.
Importantly, management explained to investors that the company is not losing customers to the competition. Growing competition would mainly reduce new members -- gross additions -- as opposed to increasing churn (loss of current members), and gross additions were in line with expectations last quarter. Also, Netflix experienced a similar increase in its churn rate in Canada during the period, where the company is also un-grandfathering customers, but said there has been on recent increase in competition.
The problem is that many longtime customers were not willing to pay the higher price. This doesn't necessarily mean that Netflix is too expensive, or that the company lacks pricing power, but it most probably reflects the fact that consumers are averse to change, especially when that change means a price increase after several years of stable prices.
On the other hand, Netflix has added lots of valuable content to its library over time, and the company is planning to release 600 hours of original content in 2016. It doesn't sound too unreasonable to assume that ex-subscribers could eventually come to terms with the idea of paying more per month, since the value of the service is consistently increasing on the back of growing content offerings.
Should Netflix investors be worried?
As Buffett said, pricing power is of utmost importance when making investment decisions, and the fact that Netflix is being hurt by higher-than-expected churn as the company implements a price increase is an important red flag to watch.
Netflix should keep in mind the lesson that customers don't like a price increase even if content has been expanding when making pricing decisions in the future. The company could also improve its communication, so that customers better understand its value proposition.
On the other hand, even at the higher price levels, the service remains competitively priced against the competition. The company is still attracting new members at a healthy rate, so it doesn't seem like Netflix is losing ground versus other players in the streaming business. Investors would be wise to keep a close eye on Netflix's financial reports over the coming quarters in order to make sure that this is in fact the case, but it looks like the company's problems could be temporary.
When an attractive growth business is going through temporary difficulties, this can be a source of opportunity for long-term investors. To quote Buffett again: "The best thing that happens to us is when a great company gets into temporary trouble. ... We want to buy them when they're on the operating table."