Netflix: In Depth Financial Analysis Post Strategy Shift

Netflix (NASDAQ:NFLX) raised the prices of its combination plans (unlimited streaming and DVDs by mail), and reintroduced unlimited DVDs by mail-only plans. The separation of the unlimited streaming plan (still $7.99/month) from the unlimited DVDs by mail plans (previously viewed as an add on to the streaming plan) has raised prices significantly for each of the combination plans: 1 DVD out at-a-time now costs $15.98/month (up from $9.99/month), 2 DVDs out at-a-time costs $19.98/month (up from $14.99/month), and 3 DVDs out at-a-time costs $23.98/month (up from $19.99). Unlimited DVDs by mail-only plans, previously available until the introduction of streaming in 2007, will cost $7.99/month for 1 DVD out at-a-time, $11.99/month for 2 DVDs out at-a-time, and $15.99/month for 3 DVDs out at-a-time. The plan changes will be effective immediately for new subscribers, and the new prices for existing members will start for charges on or after September 1. We note that this is the second time Netflix has raised prices in the past 8 months.

The long-term impact of these changes remains unclear. Although ARPU would normally be expected to rise due to higher prices for the combination plans, we expect many subscribers to change to a lower-priced plan that includes only the options they use regularly (streaming-only or DVD-only). We expect limited impact on postage expense, which is included in cost of revenues, as any savings from subscribers seeking a cheaper combination plan with a lower DVD amount may be offset by subscribers that adopt DVD-only plans (potentially at higher DVD usage rates).

We can only speculate about why Netflix (NASDAQ:NFLX) made these changes. In our view, the company is facing increasing pressure from content providers to base streaming content costs on the number of overall subscribers. By bifurcating its subscriber base into streaming and non-streaming plans, the company may be able to successfully argue that a lesser number of subscribers access streaming content, and may be able to control growth in streaming content costs. Our central thesis has been that the company’s streaming content costs are rising faster than its revenues; today’s move reinforces our conviction that this thesis is correct. In our last note, we estimated that streaming costs could rise to between $1.6 – 2.2 billion in 2012; we now believe that content costs are tracking closer to $2.2 – 2.5 billion, perhaps providing the catalyst for today’s action.

Should Netflix (NASDAQ:NFLX) successfully manage streaming content cost increases through the bifurcation of its plan, we are prepared to revisit our thesis. While we believe it is highly unlikely that Netflix can generate sufficient earnings to justify its current share price, we would be prepared to reconsider our price target in the event that it demonstrates it can contain growth in streaming content costs.

One ancillary beneficiary of yesterday’s action should be Coinstar (NASDAQ:CSTR). The company’s Redbox unit provides an inexpensive alternative for new release DVD rental, and we expect 1 million or more Netflix customers to migrate to the streaming-only option, fulfilling their new release appetite by visiting their local Redbox.

Last week, Netflix (NASDAQ:NFLX) announced that it would launch a streaming service to 43 countries in Latin America and the Caribbean later this year. It will offer unlimited American, local, and global TV shows and movies playable on CE devices, computers, mobile devices, and TVs for a monthly subscription fee. While we expected this move, the scope of the expansion is greater than we had previously anticipated. However, given that the Latin American (NYSE:ILF) subscriber ramp up is likely to progress very slowly, we expect the cost of content minimum guarantees to vastly exceed the revenues derived from the rollout for the next several quarters, and we expect earnings to suffer as a result.

We are maintaining our FY:11 estimates for revenue of $3.22 billion and EPS of $4.00 as we believe that, on balance, any increase in revenues from higher-priced combination plans and the re-introduction of DVD-only plans will be offset by subscriber migration to lower-priced alternatives as well as Latin American start-up costs. Also, any postage savings from migration to cheaper combination plans with lower DVD amounts is likely to be offset by the reintroduction of DVD-only plans. We are also maintaining our FY:12 estimates for revenue of $3.96 billion and EPS of $5.00.

Michael Pachter is an entertainment analyst at Wedbush Morgan.