Why Netflix Should Raise Its Rates Now

Content costs are spiking faster than revenue -- a huge red flag

   
Why Netflix Should Raise Its Rates Now

If there was ever a time Netflix (NASDAQ:NFLX) could justify a rate hike for monthly access to its library of on-demand video, it’s now.

Netflix just scored what may be the most significant content deal in its history by winning exclusive rights to Disney (NYSE:DIS) movies — including the Star Wars franchise — after they’ve left theaters, but before they’re turned into DVDs. Yet, the company has been adamant about keeping its monthly access fee at the palatable $8 mark.

Is it an admirable commitment, or just a crazy decision that will ultimately drive the final nail into the struggling company’s heart?

Not All Is As It Seems

From a consumer’s point of view, the Netflix we know and love today is the same one we knew and loved three years ago. Sure, the focus has fully shifted from DVD-by-mail to online streaming, but the basic premise is still the same: A nominal monthly subscription price gets you access to a very large library of video entertainment.

When you look under the hood and dig into balance sheets and income statements, though, it becomes clear that the company’s slowly deteriorating from the inside. The cancer? Content costs, which are rising faster than revenue.

Some numbers put the idea in perspective. One of them is the $3.7 billion in long-term liabilities that showed up off the balance sheet in the middle of this year. The cost stems from commitments Netflix had made to secure digital content it provides to customers, but it doesn’t actually have to put those liabilities on the balance sheet until the quarter they come due.

And while it’s just a number, it’s also a pretty big one considering the company has only generated $3.5 billion in revenue over the past four quarters — and only turned $44.5 million of it into a profit. It’s tough to imagine that $3.7 billion in liabilities not being a major burden, no matter how long it has to pay it off.

Another set of numbers that wave a red flag: The cost of revenue (mostly licensing and content costs) is eating into a growing chunk of sales. As you can see from the table, between 2008 and 2011, the cost of revenue for Netflix averaged 64%.

netflixannualchart Why Netflix Should Raise Its Rates Now

Things changed shortly after Netflix was forced to renegotiate those content contracts at much higher prices, though. Over the past three quarters, the cost of revenue has averaged 72%.

netflixquarterlychart Why Netflix Should Raise Its Rates Now

The leap from 64% to 72% isn’t numerically a big one, but when net profit margins are only 7% on a good year — like 2011 — those last 800 basis points can mean the difference between an acceptable profit and a dip into the red ink.

And just to be clear, it’s not like Netflix is offsetting the rising cost of revenue in other places on the income statement. Though revenue has generally continued to rise (sequentially and year-over-year) over the past four quarters, net earnings have also been in the gutter for nearly a full year now.

They’re all symptoms of the bigger problem Netflix is facing.

Now What?  

So, what is Netflix thinking?

In some regards, taking on those big financial commitments isn’t too crazy. The company maintains that 60 million to 90 million U.S. subscribers is a plausible number, and the potential number of subscribers could be even greater if the company’s overseas expansion goes well. At a mere $8 per month per subscriber, Netflix would more than be able to pay those ever-growing bills for its content even with just 50 million subscribers.

To get those subscribers, however, Netflix has to have the content in-hand first, not the other way around. That’s why it’s willing to take on what seems like more than it can chew at this point — on faith that its headcount will indeed swell.

It’s a big “if,” though, for a handful of reasons.

One of them is that, for better or worse, digital content has become a commodity. Competition is starting to pop up everywhere and while some of that competition is inferior, some of it isn’t. Instead, most of it is reasonably well-armed with content and, generally speaking, all of it is similarly priced. Differentiation is only going to diminish as time goes on.

Although it might alienate some users, a slightly higher subscription price might not only make Netflix the premium name in the business (people don’t mind paying for clear quality), it would also give Netflix the funding it needs now to go out and acquire a bigger and better content library, as it did with Disney.

The second reason now’s the time for Netflix to raise prices if it’s going to at all? The Disney deal really was something of a public relations coup. Although it’s unlikely any subscribers particularly want to start paying a slightly higher month fee now for content they won’t actually be able to enjoy until 2016, it’s likely going to be even tougher to raise the fee then when the euphoria behind the agreement is worn off.

And last but not least, Netflix may find now’s the right time for a modest price hike simply because at it’s current revenue growth and cost increase pace, the company may not be liquid enough to keep acquiring compelling content. The Disney deal is rumored to have cost more than $350 million, which is a pretty good chunk of the $798 million in cash or cash-equivalents it was holding as of last quarter.

Just food for thought, Netflix. The clock is ticking.

As of this writing, James Brumley did not own a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2012/12/why-netflix-should-raise-its-rates-now/.

©2014 InvestorPlace Media, LLC

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