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Walking a Pricing Tightrope

25 Jul, 2016 By: Erik Gruenwedel



Has the Netflix juggernaut hit a snag?

In an era of all-you-can-stream video services available at low prices, none does it better than SVOD pioneer Netflix. That air of supremacy, however, took a hit July 18 when Netflix reported disappointing subscriber growth — missing quarterly projections by 32%. The streaming video giant added 1.7 million members in the second quarter (ended June 30), much less than the 2.5 million projected. It added 3.28 million subs during the previous-year period.

It ended the period with 83.18 million members globally, including 79.9 million paid. Domestic subs grew by 160,000 to 47.1 million (46 million paid), down from 500,000 projected and 900,000 added in the previous-year period.

The impact was immediate, sending shares down as much as 15% with $4.7 billion in market capitalization wiped out.

The apparent culprit: Price hikes, or what Netflix calls “un-grandfathering” long-term domestic and select international subs over the course of the year, which saddles them with a new 20% monthly fee increase.

“People don’t like price increases; we know that,” co-founder/CEO Reed Hastings said on the company’s fiscal webcast.

Controversy surrounding price increases is nothing new to Netflix, which perhaps explains why Hastings chose to downplay the hikes. The executive marched down memory lane to the second quarter of 2007 when Netflix dropped from 6.8 million subs to 6.7 million — partially in response to Blockbuster entering the by-mail disc rental market.

“It’s didn’t feel great [then] going down [in subscribers], but here we are at over 80 million [subs],” Hastings recalled. “So, you just got to take a long-term perspective and Internet TV is going to be an enormous market.”

The executive suggested the price hikes were “a necessary phase for us to get through,” quickly adding that the increased revenue would translate into better content.

“That’s what makes us feel very strong and positive about the long-term and that this is a short-term phenomenon,” he said.

With more than 83 million subs, $1.5 billion in revenue and a global footprint in 190 countries, Netflix is hardly wanting. Yet the slowdown in sub growth has worried investors and analysts, as has its increasing competition from other players.

Indeed, Netflix’s share of the domestic SVOD market declined from 76% in 2015 to 72% in Q1 this year, according to Strategy Analytics.

"Netflix [market] share will continue to [drop] as the SVOD market becomes saturated with competition,” said Mike Goodman, director of digital media with Strategy Analytics. “There are over 20 services operating in North America and Western Europe.”

Pricing: A Netflix Horror Story

This isn’t the first time Netflix has faced a pricing backlash. It was five years ago, in the summer of 2011, when Netflix infamously announced a 60% price hike to a popular hybrid disc/streaming rental plan, from $9.99 to $16. Netflix offered separate by-mail and streaming plans for $7.99 each. When compounded with a hastily concocted spin-off of the disc rental business (Qwikster, anyone?), about 800,000 subs dropped Netflix, sending shares freefalling 75%.

The media whipped the missteps into a frenzy. Calls for Hastings to be dismissed surfaced, with the CEO joking on Twitter about testing his food for poison. The Huffington Post characterized Qwikster as a prime candidate in the “bad decision hall of fame,” along with New Coke.

“Better choices have been made at 24/7 Las Vegas chapels after too many Limoncello shots,” wrote the online publication.

Netflix promptly backtracked (not on the price hike), abandoning the Qwikster scheme, with Hastings — whose singular idea it had been to jettison the company’s legacy (and highly lucrative) disc business — issuing a mea culpa of sorts to the investment community.

“We got overconfident. We berate ourselves tremendously for that lack of insight because it didn’t need to be that way,” the CEO told the UBS Global Media and Communications Conference later that year.

With knowledge of that cautionary tale, Netflix carefully phased in its next price hike. In 2014 Netflix quietly raised the price for new subscribers from $7.99 to $9.99. Existing members weren’t impacted, yet projected subscriber growth fell 27%. Netflix could only kick that can indefinitely. Now, 37% of Netflix’s domestic subs will see their monthly fee upped to $9.99 — and most aren’t even aware of it.

A market survey earlier this year by UBS found that more than 40% of respondents who are Netflix subs said they would cancel the service following the price hike, while the research firm contends just 4% will actually follow through with it. A separate JP Morgan survey found 15% of Netflix subs would cancel service.

Jim Cramer, host of CNBC's “Mad Money,” found Netflix’s attempt to disguise price hikes with wordplay puzzling.

“I am truly baffled by the whole ‘un-grandfathered’ thing,” Cramer said July 20. “I’m always leery of words Spell Check won’t check off on. This is one of them. It dominated everything on the Netflix financial call.”

The TV personality noted consumer apprehension regarding price hikes increased churn and undermined sub growth. Worse, Netflix management didn’t appear to understand why churn increased.

“I’m clearly baffled by this,” he said. “It’s simply not that much money compared with how much your cable service is going up. I finished that conference call dazed and confused.”

That caution may be overblown, according to Piper Jaffray analyst Mike Olson, who thinks Netflix has more price elasticity. In another survey of 1,500 subscribers, Olson found that 55% of respondents said they would continue with Netflix priced at $15 monthly — 50% above the current upgraded $9.99 price. While Olson contends any future Netflix price hike is at least two years away, he also estimates no more than 4% of domestic subs would leave the service following another price hike — and from 2% to 3% internationally.

"Based on our survey, we believe ‘un-grandfathering’ of subscribers on a lower-priced subscription will have minimal impact on the overall sub base," Olson wrote before Netflix released financials. "Regarding future price increases … it appears Netflix has runway to push pricing higher."

BTIG Research analyst Richard Greenfield said Netflix missing subscriber growth projections is nothing new. He said the service has whiffled three out of the last four quarters. Instead, it is management’s explanation — or lack thereof — about the cause that Greenfield finds “hard to digest.”

“We often wonder if management should guide at all, given the inherent challenges of accurately forecasting subscriber growth in net additions,” the analyst wrote in a July 19 note. “What is clear after looking at the impact from the infamous price change in 2011 and the current step-up of two-year grandfathered subs, is that Netflix price increases impact sub growth.”

Strange Bedfellows

Lost in the pricing furor was erstwhile competitor Comcast Cable agreeing to offer Netflix on its broadband X1 set-top box. While Comcast didn’t offer a time frame regarding availability (likely after the Summer Olympics in Rio de Janeiro), cooperation between the two companies previously had seemed inconceivable.

Comcast, the nation’s No. 1 pay-TV operator, had previously steadfastly refused to enable subs easier access to third-party subscription streaming and over-the-top video services, citing conflict of interest with proprietary platforms and pay-TV ecosystem.

“We have much work to do before the service will be available to consumers later this year,” the two companies said in a joint statement. “We'll provide more details at that time.”

The decision is significant considering Comcast’s scope, which includes more than 20 million households. The two companies have repeatedly sparred over issues, including net neutrality and, more directly, streaming speed into consumer households.

After years of hesitation, Netflix in 2014 agreed to pay Comcast — one of the biggest ISPs — an undisclosed fee to ensure direct access (and smoother video streaming) on its broadband network into its subscriber homes.

On the company’s fiscal call, Hastings downplayed the impact, saying the deal would only modestly improve Netflix subs since most of the cabler’s subs already have an Internet-connected TV or streaming media device.

“It will certainly help from a user perspective to just live on the Comcast remote … as opposed to having the switch inputs,” Hastings said.

The Comcast deal isn’t the only recent change in Netflix’s business plan. For the first time, Netflix is considering allowing subscribers to download select (original) content for viewing offline. It’s a move rivals Starz, Epix and Amazon Prime Video have started — the latter last September offering select movies and TV shows to portable devices. Devices include Kindle Fire tablets, Fire mobile phone, Android and Apple iOS.

“We’re open minded about it as we've expanded it globally,” Hastings said on the call. “It’s something we’ve taken more of a look at given the strength of cellular networks not being strong in some of the new markets. So that’s gotten us to take a look at it, and there’s no material cost-implications.”

Content Not Only King, But Costly

Some analysts have expressed worry about the price Netflix is paying for content, both original and acquired.

Media reports suggest Netflix is about to re-up a 2011 license agreement with The CW for about $1 billion. The cable network co-owned by CBS and Time Warner would grant Netflix expanded rights, including faster access to new episodes of “The Flash,” “Supernatural,” “Supergirl” and “Jane the Virgin,” among others, in addition to greater catalog depth.

Netflix ended Q2 with more than $13 billion in content license obligations. A $6 billion annual price tag, Michael Pachter with Wedbush Securities in Los Angeles, says is manageable — even with slowing subscriber growth.

“Even if they don't grow, they generate enough revenue currently to pay [$6 billion] for content,” he said. “If they stop growing, they will have to manage the growth of their content obligations. I really don't see any risk of default, only a ‘risk’ that they stop increasing what they spend.”
 


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