For the first time in years, Netflix (NASDAQ:NFLX) raised prices last May on its streaming video service. Everything went exactly according to plan — at first.
Netflix added significantly more new members in the second quarter than it had in the prior year period. CEO Reed Hastings said that the extra cost didn't seem to be pushing down new sign-ups, either. "There was minimal impact on membership growth from this price change," management wrote in an investor letter in July. At the same time, profitability almost doubled to 19% from the prior year's 10%.
But the executive team changed their tune in the third quarter when membership growth in the U.S. dropped below the prior year's figure for the first time. They explained: "As best we can tell, the primary cause is the slightly higher prices we now have compared to a year ago." While Hastings said this wasn't as important as the fact that user engagement was at a record high, Wall Street judged that Netflix had no pricing power. Profit and subscriber growth in the U.S. was going to be weak, which could also threaten Netflix's global expansion plans.
Now we know just how misplaced all of that worry was.
This week Netflix announced fourth-quarter earnings results in which profit in the U.S. business surged higher by 40% to $260 million. Membership growth did slow down, but it remained strong. The company added 1.9 million new members at the higher prices as compared to 2.3 million to close out 2013. Management projected the same trend to start 2015: Membership growth of a solid 2 million subscribers.
At the same time average revenue per user rose and profitability spiked higher by five percentage points to 28%.
Far from declining profitability, Netflix is seeing strong earnings growth. In fact, management expects to hit a 30% profit margin next quarter and to boost that figure by about two percentage points each year until 2020 when it could reach 40%.
What it means for investors
So the price increase has shown that Netflix is providing real value to its subscriber base over and above the prices that members are paying. And the added profitability is helpful because it allows the company to buy more content and thereby power the happy cycle of a better service leading to more members which funds a better service.
Netflix is planning its biggest year yet on that score. It will triple the output of originals launching on the service in 2015 to over 300 hours of exclusive content. That should help keep member engagement marching higher while also attracting a steady stream of new subscribers.
And with the U.S. business comfortably profitable Netflix can spend freely on its international expansion. The company is now set to cover the globe in just the next two years, while staying profitable.
A flexible model
Another risky price increase on U.S. subscribers is possible in the next few years. But Netflix isn't counting on that to fund the projected profit expansion. Chief Financial Officer David Wells said in this week's conference call with investors that the business model has plenty of flexibility built into it that would allow margins to climb to 40% under a range of membership scenarios.
That flexibility includes content rolling on and off the service, along with members upgrading to higher pricing tiers like the company's $12 per-month Ultra HD plan. "What you should expect from us is a steady growth in average selling price, and we'll disconnect pricing ... using our tiers to provide value and choice for the consumers to steadily grow our average selling price over time," he said.