Netflix Sings The Summertime Blues

By Davis Freeberg

Editor's Note: Davis is both a shareholder and customer of Netflix. This post should not be construed as financial advice.

Netflix reported their 2nd quarter 2006 earnings today and while they experienced their best quarter ever in terms of gross profits, they disappointed Wall St's expectations on their revenue performance and warned that revenue for the rest of the year could be lower than previously forecasted. The lower revenue was driven primarily by an increase in customer churn, which the company attributed to seasonality. In explaining how seasonality related to churn, they noted that in the warmer Los Angeles and San Diego climates did not see a sequential increase in churn, but that in areas like Chicago, Detroit and Boston they saw a 10 – 15% increase in the cancellation rate and in Minnesota, they actually saw a 20% increase in their churn rate.

During their conference call discussing the results, they pointed out that when they looked back over the last few years, they saw a similar trend during their 2nd quarter, but it was obscured by Blockbuster’s lack of competition in the online space last year and a price increase the year before.

During the quarter, the company also officially began offering a new $5.99 limited rental plan as a way to attract subscribers who wouldn’t normally sign up with the unlimited $17.99 price plan. While the company pointed out that the unlimited plans remain the most popular choice for new subscribers, it’s clear from the lower revenue that the lower priced plans are attracting their fair share of adopters. This creates an interesting dilemma for the Netflix because the lower price customers are actually more profitably on a percentage basis for the company, but because of the lower revenue they bring in, there is not the same profit potential as with the traditional $17.99 plans.

During the quarter, Netflix’s subscriber acquisition costs (SAC) increased to $44 per new subscriber which represents about a 10% increase over last quarter. This higher SAC was driven in part by higher marketing expenses during the quarter, an increase of 50,000 additional cancellations beyond Netflix’s expectations and a reinvigorate Blockbuster aggressively selling their online program to in store customers.

Specifically, Netflix pointed to increased signage at Blockbuster stores, but did not mention an aggressive free one month trial offer that Blockbuster began offering to it's in-store customers beginning in June. Hastings did say that they expects Blockbuster to continue to aggressively promote their online service throughout the remainder of the year and it's clear that higher churn expectations were part of what drove their decision to decrease guidance on their overall revenue expectations for the remainder of the year.

Throughout the call, both Reed Hastings and Barry McCarthy continued to repeat their goal of hitting $30 - $35 million in net income for the year and 50% earnings growth for the next several years. With the company having now already hit $21 million in year to date net income, they said that their net income for the year has become “front end loaded” and that they are prepared to invest more aggressively in subscriber growth for the second half of the year.

While the company was able to add 303,000 net new subscribers, from the conference call it was clear that they weren’t satisfied with the results and suggest that they had thought that they could have reached 5.22 million subscribers, had it not been for the increase in churn. While churn was higher in May and June, they did say that the first two weeks of July has shown some improvement on this front.

Despite the lower revenue forecast, Netflix remained confident that the online DVD rental market was still in strong growth mode. During his prepared comments, Hastings said

“New markets, like online rentals, generally go through an S curve of adoption rising net adds is on the first half of the S curve, falling net adds is on the 2nd half. Net adds for Netflix in 2004 were 1 million, in 2005 they were 1.6 million, this year we are forecasting at least 2.1 million net additions.”

He later went on to add that the company continues to see an increase in subscriber growth within the Bay Area.

”In our Bellwether San Francisco, San Jose, Oakland metro area our household penetration continues to climb and reached 14%. More impressively in the Bay Area, our net adds in Q2 were higher then 1 year ago. This means that even at 14% penetration, the Bay Area is still in the 1st half of S curve growth.”

During the conference call, Hastings also took time out to address the HDTV DVD format wars and it’s impact that it’s having on the market and on consumers.

“Our view is that the current format war is unwinnable by either Sony or Microsoft in the next several years. They are both powerful enough to maintain the stalemate. Hopefully, early next year the single format studios will join Warner and Paramount in becoming format agnostic. The press will declare the format war over and the consumer adoption cycle for High Definition DVDs will begin in earnest.”

I think that Hastings is right about the format war being unwinnable, but I think that he’s dreaming if he really believes that the format dispute will be resolved by January. While I’m entirely in support of his approach to an agnostic content distribution platform, I also believe that the studios have no intention of blinking in this dangerous game of HDTV chicken. Ultimately, consumers may be able to force the studios to cross license their films on both formats, but I believe that there is far too much at stake for either side to back down from this dangerous stalemate. While dual licensing of content would clearly put consumers in charge of deciding the success or failure of the next generation DVD formats, I believe that it will be a cold day in hell by the time the studios actually give that type of control to consumers. While the format wars are clearly bad for consumers, I believe that the best solution to solving this crisis is for consumers to continue to boycott both formats until the studios feel the pressure to innovate or risk losing HDTV DVD renters to video on demand.

During the question and answer session of the conference call, I found the most interesting comments to be related to advertising. When Hastings was asked about advertising growth for the company, he mentioned that the advertising on the mailers have been a hit with marketers and that they have sold out of inventory on their mailers. He also discussed their approach to advertising via the web,

“Our #1 priority is to ensure that the Netflix subscriber has a great user experience and if we can find a way for advertising to co-exist on the site without disrupting that experience, then we’ll continue to pursue those opportunities but for the foreseeable future we’ll limit the kind of advertising we accept on the site to movie related content and in that way we’ll self limit the revenue opportunity”

While I’m encouraged to hear that Netflix is still evaluating their online advertising program, I believe that they made a serious blunder by including ads on the home page. I’ve always viewed Netflix as a premium service like HBO or Cinemax. My feeling is that if TV is going to be free, then it’s OK to have ads, but if they are going to charge me $22 per month for my 4 dvds at a time, then I deserve the right to not be bombarded with advertisements. By forcing subscribers to view ads, the company risks alienating customers who have fled the traditional broadcasting method of ad based television for a subscription based ad free program.

While I support Netflix’s experiments with advertising, they need to create a way for consumers to opt out of banner advertisements, if this does in fact bother them. One thing I really liked about when Netflix announced their deal with Wal-Mart was that they gave customers a chance to opt out of the banner ad on the top of the page. This hasn’t been the case with their deal with Sony and it represents a huge degradation of quality, in my opinion. By not giving me an opportunity to opt out of the program, Netflix has essentially decided that they plan on having their cake and eating it too.

While overall Netflix’s comments certainly didn’t impress Wall St., the company did continue to show strong subscriber growth. With the entire online DVD market continuing to grow, it was amazing to hear the company point out that over the last 18 months alone the company has doubled their subscriber base. As we see the issues with HDTV DVDs worked out and as we begin to see more and more video on demand offerings, it will be fascinating to watch how Netflix manages the transition from a DVD by mail program to an on demand subscription based service. The company plans on updating investors on their VOD plans next January, but in the meantime they continue to focus on aggressively expanding their subscriber base, in preperation for the eventually transition to an on-demand service.

Seeking Alpha has a transcript of the call here.