Last year, Netflix(NASDAQ:NFLX) faced criticism for raising prices for new members. At the time, the decision to increase the price of subscriptions by $1 to $8.99 a month was met with skepticism. Critics of the strategy argued that customers are not fond of paying more, and a price increase would incentivize potential members to opt for a different service. After all, Netflix tried to pass through an ill-fated price increase just three years prior and then recanted and made an awkward public apology.
However, it is now clear that this strategy was the right one. Price increases are often criticized, but what the skeptics missed is that customers are actually willing to pay a slightly higher price for a high-quality product or service. Investors should recall the similar criticism that Starbucks initially received when it increased its own prices last year.
But in both cases, the takeaway remains the same: Companies that hold premium brands and leadership positions in their industries have pricing power, and it is foolish to not exercise this power when the conditions warrant doing so.
The recent criticism was due in large part to the disastrous prior attempt to raise prices. In 2011, Netflix intended to split its streaming and DVD offerings into two separate services. But this plan was doomed from the start. Creating two offerings, one called Netflix and the other called Qwikster, created massive headaches for members. Customers had to create memberships with two different websites, pay two different companies each month, and maintain two separate profiles.
Netflix scrapped the idea soon after its announcement, but it learned a valuable lesson. The price increase itself was not so much a problem as the extremely disorganized and confusing process. This time around, Netflix passed through a clean, $1 per month increase without the headaches.
A stellar quarter
The result: Netflix unveiled a fantastic fourth-quarter. In the United States, member additions slowed, but profit margin rose more than a full percentage point year-over-year to 13%. At the same time, revenue grew 35% year-over-year, signaling no slowdown from the new pricing.
We can see above that stock price performance closely tracks the revenue growth rate. For most of the past three years, revenue growth has run less than 30%. Now, Netflix is once again approaching that pace, and not surprisingly, its share price is also climbing. Note that revenue growth is still accelerating after the price increase took effect as well.
Comments from the management team back this up. It turns out that the price increase had almost no impact on membership. Back when Netflix reported third-quarter results, it blamed its slowing U.S. additions on the price increase, which made sense. Now, the company believes that slowing U.S. member growth in the third quarter would have occurred regardless of the change.
Subscriber growth in the fourth quarter was actually strongest in low-income areas of the country. Moreover, the company implemented a similar price increase in Mexico last quarter, and it had little effect on membership growth. In other words, the U.S. is a mature market, and slowing growth is inevitable. For that reason, the task now is to improve profitability, and the price increase did just that.
Netflix strategy is right on the money
Even at $8.99 a month, Netflix remains an attractive option for those who are tired of paying for an expensive cable package. As the streaming service expands its library of content and continues to win viewers with original programming, there should be more room for future increases and improved profitability.