The last time Netflix (NASDAQ:NFLX) attempted a broad price increase the company tried to disguise it. That move was a disaster that led to waves of bad press, angry customers, and a general distrust of the company.
This time CEO Reed Hastings was direct, telling shareholders in a letter that accompanied the company's first quarter 2014 financial release that a price increase is coming. The genius of the move is that the higher rate only applies to new subscribers. Existing customers continue with their current price for a period of time (likely to be two years).
Increasing prices this way not only keeps customers happy, it dissuades people from canceling a subscription once they have watched a hot new show then coming back the next time something grabs their attention.
Netflix tested the price increase
Netflix has learned from past mistakes. In 2011 Hastings decided to split the company's digital streaming service from its DVD delivery offering -- essentially a massive price increase for customers that took advantage of both. Customers were outraged, and Hastings did not solve the problem quickly -- first attempting to spin off the DVD business under the Qwiskter brand name. That caused a drop in subscribers and a substantial loss of goodwill for the company.
In the third quarter of 2011, the company lost 800,000 subscribers and went from rising star to giant question and Hastings was very much on the hot seat.
This time Hastings has been very direct about his plans to increase prices and the company is using a model it tested in Ireland where new members paid €7.99 a month while existing subscribers were grandfathered in at €6.99 for two years. Hastings plans a similar strategy for the U.S. and detailed the plan to shareholders.
"In the U.S. we have greatly improved our content selection since we introduced our streaming plan in 2010 at $7.99 per month. Our current view is to do a one or two dollar increase, depending on the country, later this quarter for new members only. Existing members would stay at current pricing (e.g. $7.99 in the U.S.) for a generous time period. These changes will enable us to acquire more content and deliver an even better streaming experience."
The price increase makes sense and if the company grows by the roughly 12 million members it did in 2013, it offers a significant bump to the bottom line. If you assume an average of 1 million new subscribers a month paying an additional $1 per month, the hike adds around $78 million in the 12 months after it gets enacted (someone starting in the first month of the new plan would pay the extra dollar 12 times, someone joining at the end of the first year would pay that increase once). If Netflix raises the rate by $2 for even half of the new subscribers the numbers get even more significant and not a single current customer is angered.
If after two years the company inches up prices for its existing users by a dollar that's roughly $48 million a month on top. It's hard to imagine that Netflix will see much pushback from its customers for raising prices with two years of warning. Realistically the company should be looking at an extra $576 million in revenue from existing subscribers in the 12 months following a price increase on the existing customer base in addition to the extra money paid by new users.
Netflix had a strong quarter
Netflix added 4 million new subscribers in the first quarter with 2.25 million people joining from the United States and another 1.75 million signing up internationally. The company also saw revenue grow from $781 million in Q1 2013 to $1.06 billion in Q1 2014.
"Across the Internet, we're seeing companies like Amazon (NASDAQ: AMZN), Pandora (NYSE: P), and Netflix ... raising prices one way or another," RBC's Mark Mahaney told USA Today. "I don't think too many consumers are going to be put off by spending a dollar or two a month for the quality, the quantity of content that Netflix has."
Netflix is firing on all cylinders
Hastings learned his lesson from the Qwikster debacle and his new policy of directly addressing his subscriber base is a sound one. Adding subscribers remains key but maximizing revenue from existing users adds revenue without increasing expenses. All the dollars added from price increases and charging new customers more directly hit the bottom line.
Netflix does face pressure to keep delivering new programming that engages customers and makes them want to stay subscribers. But the grandfathering plan makes it less likely that a subscriber will jump on and off the service to save a few bucks as they will pay a higher price when they rejoin. If a customer loves even a single Netflix program, it's worth it to keep a subscription, which is great for the company's bottom line.
And finances aside, this is a promising switch in perception for Netflix and Hastings, from when the CEO stumbled and nearly wrecked his company to today's artful way of announcing a price increase that angered nobody.
Daniel Kline has no position in any stocks mentioned. He is a Netflix subscriber who usually forgets to use the service. The Motley Fool recommends Amazon.com, Netflix, and Pandora Media. The Motley Fool owns shares of Amazon.com, Netflix, and Pandora Media. 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.