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Price Play

30 Oct, 2017 By: Erik Gruenwedel



Subscription-video-on-demand players in the past month seem to have been playing that venerable game show “The Price Is Right.”

SVOD services were recently raising and lowering prices to find the sweet spot for SVOD consumers.

As SVOD pioneer and global TV disruptor, Netflix would appear to have few weaknesses. The streaming video service added a record 5.3 million subscribers in the most-recent fiscal period to end the third quarter with 104 million paid subs. But those tallies don’t reflect Netflix’s mounting debt or decision to quietly raise the price of its standard and premium subscription prices 10% and 17%, respectively, beginning in November. The standard plan, which enables HD streaming on two screens simultaneously, increases from $9.99 to $10.99 per month, while the premium plan including 4K UHD content and access to four screens simultaneously surges from $11.99 to $13.99 per month. The new pricing, which mirrors similar hikes in Canada, affects new and existing subs. The basic $7.99 plan, which excludes high-definition and is limited to one screen, remains the same.

Wall Street reacted well, sending shares up 7%, contending the hikes wouldn’t result in a significant drop in Netflix subs. Following the release of the Q3 fiscal results, Netflix shares reached record highs.

“They delivered good numbers and guided to acceptable numbers,” said Michael Pachter, media analyst at Wedbush Securities in Los Angeles.

Regardless, Netflix made no formal announcement of the new pricing.

Others took the opposite tack.

Hulu in the same month cut the price of its ad-supported plan 25% to $5.99 monthly from $7.99. The introductory price includes a free 30-day trial — and expires after one year. The SVOD service co-owned by Disney, Fox, Comcast and Time Warner, also partnered with Spotify to offer a $4.99 bundled plan to college students. Amazon slashed the Prime membership fee to $5.99 from $10.99 for people on government assistance. Prime includes Prime Video, Prime Music and Prime Photos, in addition to legacy free shipping. Amazon late last year briefly cut the annual $99 Prime fee to $79 for new members in advance of Prime Video’s global launch. And the e-commerce behemoth last year began offering Prime Video separately for $8.99 monthly.

Pricing is a historically sensitive issue to Netflix. It recalls a calamitous management decision in 2011 when adoption of a 60% price hike on a popular hybrid streaming/by-mail disc rental plan, in addition to an aborted spinoff of the disc business, resulted in a PR nightmare. The move produced an exodus of nearly 1 million subs, widespread media backlash and freefalling stock valuation. The episode, which The New York Times characterized as a “near death-spiral” for Netflix, undoubtedly still strikes fear all the way up the corporate ladder at the Los Gatos, Calif.-based SVOD service.

“It was a textbook case of getting out ahead of the consumer, and alienating them,” wrote Times columnist James Stewart.

Co-founder/CEO Reed Hastings, who became the face of the debacle after blogging the hike from his home — on a Sunday — later admitted missteps.

“I should have personally given you a full explanation of why we are splitting the services and thereby increasing prices,” he said. “It wouldn’t have changed the price increase, but it would have been the right thing to do.”

Fear Factor

Netflix last raised prices in 2016, when the standard plan went from $7.99 to $9.99. That decision prompted Anthony DiClemente, analyst with Nomura Securities, to speculate Netflix would lose nearly 500,000 subscribers — while growing revenue significantly.

In an age of free shipping, no sales tax and ad-supported content online, even $1 to $2 price increases can seem significant.

“We note that this has long been a tenet of our investment thesis on the domestic business, as slowing subscriber trends are more than offset by increased monetization,” the analyst wrote in a note June 20, 2016.

Indeed, Netflix added just 160,000 domestic subs in Q2 2016, down from 900,000 subs added in the previous-year period.

“We are growing, but not as fast as we would like or have been. Disrupting a big market can be bumpy,” Hastings and CFO David Wells wrote in the Q2 shareholder letter.

Despite management handwringing, Netflix continues to shrug off rollercoaster domestic sub growth by focusing on international expansion. The service has added more than 12 million subs globally in 2017 compared with less than 4 million on home soil.

“Netflix has a lot of headroom for price increases," Michael Greeson, principal analyst for The Diffusion Group, told USA Today. "The service offers tremendous value even at the higher, but still very low, monthly costs.”

Maybe, but Pachter believes Netflix is being cautious, issuing domestic Q4 subscriber guidance of 1.25 million, compared with 1.93 million a year ago.

“They clearly anticipate some impact from higher pricing,” he said.

Debt Load

Pachter, a long-time Netflix bear, said Netflix shares steadily receded following the initial Q3 euphoria — a reality he attributes to the SVOD’s burgeoning debt as much as pricing.

While Netflix benefits from ongoing cyclical changes in how people consume home entertainment (i.e. OTT video, cord-cutting, online TV), costs for funding original and licensing of third-party content escalate.

Recent moves by Disney to remove Marvel, Pixar and Lucasfilm (i.e. “Star Wars”) from Netflix in 2019; Comcast (NBC Universal) and Fox diverting content to Hulu; and Amazon getting more aggressive signing exclusive deals make Pachter question whether Netflix can keep its content quality high.

“Its originals have been good, with ‘Ozark’ (starring Jason Bateman and Laura Linney) and ‘Stranger Things’ (Winona Ryder) leading the new stuff, but some of the older originals (‘House of Cards,’ ‘Orange Is the New Black’) are getting long in the tooth, so it's not clear that Netflix is doing more than just running in place,” he said.

In the meantime, Hulu and Amazon continue to get more aggressive with originals and licensed deals, escalating costs across the board. In May, Hulu hired Joel Stillerman to the new position of chief content officer. Stillerman most recently held a similar position with AMC Networks, where he was responsible for launching pay-TV hits “The Walking Dead” and “Better Call Saul,” among others. Hulu announced Oscar-winning actor Sean Penn had been cast in the original series “The First,” from Beau Willimon, who caught lightning creating Netflix's award-winning series “House of Cards.” The premiere season of Hulu's “The Handmaid’s Tale” became the first SVOD-exclusive series to win a best drama series Emmy — a feat not accomplished by Netflix or Amazon. Hulu is spending $2.5 billion on original programming this year.

Meanwhile, Netflix issued another $1.6 billion in bonds to institutional investors to help fund, in large part, original content production and increased long-term debt to $6.4 billion. When coupled with $17 million in third-party streaming content obligations, Netflix’s debt tops $23 billion.

“Our future largely lies in exclusive original content that drives both excitement around Netflix and enormous viewing satisfaction for our global membership and its wide variety of tastes,” Hastings and Wells wrote in the Q3 shareholder letter.

Netflix’s Q3 free cash flow reached a negative $465 million, or nearly $1.5 billion through the end of September. The service is on track to generate upwards of $2.5 billion negative free cash flow this year. Free cash flow (or lack of) represents the cash a company is able to generate after the spending required to maintain or expand its asset base. Hastings and Wells shrugged off the issue as a cost of doing business, including spending on original content.

“We pay for the titles before consumers enjoy the content, and the asset is amortized by estimated viewing over time,” they wrote.

Indeed, negative free cash flow is not necessarily a bad metric. It could be a sign that a company is making large investments — which Netflix is doing in spades.

“Still, some investors wonder if they will ever actually generate positive cash,” Pachter said.

 

 


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