Netflix (NASDAQ:NFLX) has a burgeoning subscriber base, both in the U.S. and abroad. However, it also has rapidly rising content costs as it invests in new original and exclusive content. As a result, to grow into its roughly $50 billion valuation, Netflix will need to exert pricing power over time to expand its profit margin.
Netflix is starting to test just how far that pricing power goes. Last week, it raised the monthly price of its main plan -- which offers up to two simultaneous HD streams -- from $8.99 to $9.99 for new subscribers in the U.S., Canada, and several other countries.
"Probation" time has ended
In 2011, Netflix was ravaged by the "Qwikster" debacle. It faced a huge backlash after attempting to separate the DVD-by-mail and streaming parts of its business, effectively raising its price by 60% for many customers. After that incident, Netflix declared that it was on "probation" with its customers and couldn't consider raising prices for at least three years.
However, after being the butt of jokes on late-night TV for a few months, Netflix regained its customers' trust relatively quickly. The fast rebound gave the company the confidence to raise the price of its popular two-stream plan from $7.99 a month to $8.99 last May.
Netflix clearly learned a lot from its bungled 2011 price increase. That's why last year's increase applied only to new customers. Existing Netflix customers were permitted to keep their $7.99-per-month rate for two more years. This approach was a great way for Netflix to show loyal customers that it appreciated them, while encouraging them to stay long-term.
Netflix grows bolder
This past week's price increase represents a bolder move, coming less than a year and a half after the previous increase. That said, longtime customers are still grandfathered into the original streaming price of $7.99 a month until May. Even those who have been paying $8.99 a month will be able to keep that price for at least a year.
When tens of millions of Netflix customers get hit with a $2-per-month increase next spring, it could lead to a modest uptick in the churn rate (that is, the percentage of customers canceling each month).
Yet Netflix will still be extremely cheap compared to cable. Customers who have subscribed to Netflix for years probably like the service enough that they are willing to pay a little more. Customers also have the option of dropping down to the basic $7.99-per-month single-stream, standard definition plan.
In short, the gains in average revenue per user, or ARPU, from this price increase will almost certainly outweigh any reduction in Netflix's subscriber growth rate. Thus, the net impact will be more revenue and profit for Netflix in 2016.
Just how far can Netflix go?
Nevertheless, there's a big difference between achieving large enough gains in ARPU to offset a slowdown in subscriber growth on the one hand, and boosting ARPU with no meaningful impact on subscriber growth on the other.
In the first case, Netflix would have to be very cautious about raising prices again in the future for fear of causing an even greater slowdown in subscriber growth. As the U.S. and Canadian markets become increasingly saturated in the next few years, it will become more important than ever not to do anything that hurts subscriber growth.
However, if Netflix is able to add 5 million to 6 million domestic subscribers -- or more -- next year despite the price increase, that would be a testament to its pricing power. The more pricing power Netflix has, the more investors can be confident that it will expand its profit margin over time, despite the impact of rising content costs and growing competition.