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Analyst: Netflix’s Business Model is ‘Broken’

30 Nov, 2011 By: Erik Gruenwedel

Netflix shares Nov. 30 dipped nearly 5% following an analyst’s concerns that the streaming pioneer is spending too much on content acquisitions in the face of declining subs and rising international expansion costs.

“In our view, the company’s business model was broken when it raised prices [in September] for its hybrid [disc and streaming] customers, and continued customer defections will require it to invest ever-increasing amounts on marketing,” Wedbush Securities analyst Michael Pachter wrote in a note.

The analyst, who downgraded Netflix’s shares to “underperform” from “neutral,” expects the streaming service to spend upwards of $800 million on content license deals this year — spending that will balloon to at least $1.7 billion in 2012. He added that continued emphasis on streaming also would save Netflix about $200 million in disc and related postage expense next year.

Los Gatos, Calif.-based Netflix recently acknowledged that it expects to post a fiscal loss through 2012, due to cost associated with international expansion and content acquisitions.

Specifically, Pachter is critical of Netflix’s overzealous growth plan underwritten in part through escalating content spending — a scenario CFO David Wells seemed to acknowledge Nov. 29 when he hinted about forthcoming license agreements in December at an investor event in Phoenix.

Pachter believes Netflix will lose 11 million hybrid subscribers by the end of the year, including 7 million who traded down to a less expensive plan and 4 million who quit the service.

In order to replace the lost revenue that resulted from its pricing missteps and Qwikster (its ill-fated disc-rental service name) debacle, Netflix must attract approximately 15 million streaming-only subscribers — which won’t happen in the short-term, according to Pachter.

“It is clear to us that the defections and trade-downs would have been less dramatic had the price increases been smaller,” Pachter wrote.

Indeed, the analyst said Netflix should have raised subscription prices $2 across the board instead of targeting its higher-margin $9.99 hybrid plan with a 60% rate hike to $15.98. A disc-only plan should have been priced at $9.99.

Pachter said such a pricing change would have resulted in about 2 million subs downgrading to a less expensive plan and about 2.5 million quitting the service. He said that would have left from 8 million to 9 million subs paying $9.99 monthly and 16 million paying $12 for the hybrid plan — a scenario Pachter said would have saved Netflix about $250 million annually.

Instead, with content costs once projected to reach $2.2 billion in 2012, rapid subscriber attrition has sapped Netflix of the requisite revenue to spend — not lose — unilaterally.

“There may be no bottom to the company’s 2012 losses,” Pachter wrote.

Indeed, Netflix shares closed down $3.04 to $64.53 per share. The stock has lost nearly 80% of its value since peaking at $304.79 per share in July.

About the Author: Erik Gruenwedel

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