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Netflix Earnings Shows Why It Can Raise Prices, but Also Why It Needs To

By Jeremy Bowman - Updated Apr 21, 2019 at 10:53PM

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The latest round of earnings makes clear why Netflix just tapped subscribers for more dough.

As Netflix's (NFLX 2.90%) price hike earlier this week seemed to signal, the streamer blew its quarterly guidance out of the water. The Internet TV champ added 8.84 million paid subscribers in the fourth quarter, a new company record, easily beating its own forecast of 7.6 million additions. On the bottom line, it posted earnings per share of $0.30, topping its own guidance at $0.23, and on nearly every other one of its categories, it beat expectations, with the notable exception of revenue. 

Its top line grew 27.4% to $4.19 billion, but that was just shy of its prior guidance at $4.2 billion, which seemed to be why the stock was down slightly in after-hours trading. However, when accounting for foreign currency exchange, revenue actually topped its forecast, though Netflix didn't provide an exact figure.

While the report showed Netflix executing as effectively as ever and picking up momentum heading into a crucial year, it also shed light on the company's price hike on U.S. subscribers, which sent the stock up 6.5% on Tuesday. Investors cheered the move as it will bring more than $1 billion in profits directly to Netflix's bottom line at a time when the company could use the extra cash flow.

This isn't the first time Netflix has showed off its pricing power, as subscribers have barely flinched at previous hikes ever since the streaming service split from the DVD-by-mail one, and the record subscriber growth shows why Netflix can pass along higher prices to its members. The service is more popular than ever, with more than 80 million viewers having watched the Sandra Bullock-thriller Bird Box, and Netflix, through the Alfonso Cuaron-drama Roma, is a legitimate contender for the Best Picture Oscar for the first time ever this year. As the company's content library grows, the service's popularity has risen with it, and Netflix said it now commands one out of every 10 TV viewing hours in the U.S. 

While investors clearly understand the company's pricing power, as Netflix's price hikes have repeatedly pushed the stock higher, what's been less discussed is why the service needed to raise prices on its subscribers.

The receptionist at Netflix HQ

Image source: Netflix.

A maturing business

Netflix's domestic subscriber growth has been remarkably consistent. Every year since the streaming service split from its DVD counterpart, from 2012 on, the company has added between 5 and 6.3 million subscribers. In 2018, 5.68 million new paid domestic subscribers joined the service. However, percentage growth domestically has slowed each year, as its domestic subscriber base has gotten bigger. Netflix has compensated for that with accelerating growth in its international segment, which is now bigger than the domestic side, but 10% U.S. subscriber growth is not enough on its own to keep up with growth in Netflix's content spending, which increased 33% on a cash basis to $13 billion last year. 

More importantly, Netflix's domestic business is maturing. In its Long-Term View document, Netflix targets a range of 60 million to 90 million subscribers in the U.S., and it will cross the bottom threshold of that range in the current quarter as it projects finishing the first quarter with 60.1 million paid domestic subscribers. That means Netflix's subscriber growth potential in the U.S. is fairly limited. Even if it reached the top end of that range, that would only represent an increase of 50% total (over several years), and domestic subscriber acquisition may get harder as Netflix approaches 90 million as a majority of eligible households have already signed up. While there are about 126 million households in the U.S., only an estimated 110 million have broadband access. 

Therefore, in order for Netflix to derive significant profit growth out of its U.S. subscriber base, which it needs to do in order to justify its high valuation, it needs to raise prices. That explains why it just issued its biggest streaming price hike ever, lifting prices 18% on most members, and why U.S. subscribers should expect more to come down the road.

Finally, Netflix's fast-rising content costs demand the increased funding. Three months ago, Netflix said its would lose $3 billion to $4 billion in free cash flow in 2019 after a similar loss in 2018. It's unclear if that forecast included the just-announced price hike, but the so-called cash burn shows why it needs to bring in more revenue. 

The company continues to believe its best path to success is to build the biggest, broadest, and best streaming service available. It would rather charge subscribers a little extra to fund more programming than hold back on content growth in order to keep pricing low. While that strategy continues to pay off, investors should be aware that at this point, Netflix has little choice but to raise prices -- at least on its domestic members.

Check out the latest Netflix earnings call transcript.

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