It’s Not Too Late to Sell Netflix

by Will Ashworth | September 27, 2011 6:00 am

NetflixAll those interested in a career in public relations need not look any further than the current maelstrom[1] that surrounds Netflix (NASDAQ:NFLX[2]) and its decision to split its video streaming and DVD rentals into two separate services. The backlash has been severe, with its stock falling 50% in just two months. Speculation is rampant that this provides an opening for Google (NASDAQ:GOOG[3]) or Amazon (NASDAQ:AMZN[4]) to acquire Netflix, and the chatter so far has kept its stock price from plummeting further.

With intense competition on the horizon, expect the downward spiral to accelerate below the $100 mark. The Wall Street darling’s reign is over, and it’s not coming back. Here’s why.

Good/Bad Decision

On the surface, I can understand Netflix’s decision to split the two services. The DVD business — while the girl that brought you to the dance — is low-margin and painstakingly boring; the streaming business is oh-so-now and high-margin.

Also, Hollywood content providers are putting the screws to digital streamers like Netflix by requiring a fee per user per month. When you have 24.6 million subscribers, it gets expensive fast. Netflix didn’t want to pay for all its subscribers when only a percentage of them were actually streaming. It had two choices: either continue negotiating on a flat yearly fee for the right to distribute content, or split them up. It chose the latter.

From a business perspective, that makes a lot of sense. What doesn’t make sense is its decision to up the monthly fee of $9.99 for both to $15.98. That’s a 60% increase. At a time when America is reeling, the arrogance of such a move is palpable, and trying to brush the increase under the rug with a sin of omission is even worse. Reed Hastings might have been a good CEO at one time, but no longer. Netflix’s move has both angered its loyal customer base and re-energized its competition in both businesses. According to research firm Frank N. Magid Associates, up to 7.4 million of its users still are seriously considering canceling their subscriptions. Talk about jeopardizing the goose that laid the golden egg.

It’s Not Too Late

Netflix earned $11.49 in monthly revenue per subscriber in the second quarter ended June 30. In its 10-Q, Netflix said it expects the lower-priced plans to grow (streaming only) as a percentage of its total subscriber base, so you can expect that number to continue to drop.

In a letter to shareholders[5] Sept. 15, Netflix detailed the subscriber base broken down by use. The company estimates that 2.2 million are DVD-only users, 12 million use both DVD and streaming and 9.8 million are streaming only. This means Netflix generated $234 million in revenue from its streaming-only customers. Given it had no DVD-only plan until now, those 2.2 million users likely were at the $9.99 price point, which allowed for one DVD rental at a time. That’s another $65 million in revenue. The remaining 12 million users are between $9.99 and $14.99 per month depending on whether they have one or two DVDs out at a time. I’ll guess that 75% of those users chose the lower-priced plan. Together, they represent another $405 million in revenue for a total of $704 million. The remaining $80 million would be monthly surcharges for high-definition Blu-ray discs. Under the new plans, I estimate that revenue would be $950 million for the same quarter, a 22% increase. That’s in a perfect world.

If 30% or 7.4 million subscribers were to bolt, most of that would come from the $15.98 pie, meaning a $360 million reduction in revenue. If so, its second-quarter number would be more like $590 million, or a 24% drop in revenues. That’s a considerable swing, and while its content costs would drop, I’m not sure they would fall enough to avoid a loss.

The risk taken by the company to force subscribers to make a choice between one and the other seems premature at best. Part of its charm is the combination service. Splitting the two gives Dish Network (NASDAQ:DISH[6]) with its new Blockbuster streaming service and Coinstar (NASDAQ:CSTR[7]) with its Redbox kiosks the perfect opportunity to build market share at Netflix’s expense. It’s not too late to call the whole thing off.

Better Option

For those of you that do own Netflix, there’s a better option. If you feel the stock’s decline puts it in play and therefore want to hang on until the acquisition takes place, why not buy the SPDR S&P 500 (NYSE:SPY[8]) instead? If the acquisition does happen, you benefit indirectly through your ownership of the index ETF — and you’ve bought yourself some diversification. If it doesn’t, you avoid further deterioration in its stock price. Even better, you can buy both Coinstar and Dish Network for about half the cost of your Netflix shares, owning the two companies most likely to benefit from its bonehead move. It’s your call.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.

Endnotes:

  1. the current maelstrom: https://investorplace.com/2011/09/netflix-nflx-qwikster-dvd-video-games/
  2. NFLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=NFLX
  3. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG
  4. AMZN: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMZN
  5. letter to shareholders: http://www.sec.gov/Archives/edgar/data/1065280/000119312511248698/d231910dex991.htm
  6. DISH: http://studio-5.financialcontent.com/investplace/quote?Symbol=DISH
  7. CSTR: http://studio-5.financialcontent.com/investplace/quote?Symbol=CSTR
  8. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY

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