Business Review: Netflix

See this article for a recent update of Netflix performance, and increasing customer acquisition rates.

Paul forwards this article about Netflix. The article discusses how Netflix took advantage of a gaping marketing hole, by providing a catalog of 60,000+ movies via mail to customers with interests that go beyond the most popular, most recent 1,000 movies.

A quick review of financial documents (10-K and 10-Q) provides great insight into the customer and expense dynamics that make Netflix successful.

Netflix dramatically grew its subscriber base over the past three years. At the end of fiscal 2003, Netflix had 1,487,000 subscribers. This number grew to 2,610,000 at the end of fiscal 2004, and an amazing 4,179,000 subscribers at the end of fiscal 2005.

Rapid growth of this nature requires an enormous investment in Customer Acquisition. Customer Retention is also important. Let's explore these two dynamics.

Netflix states that their churn rate, the percentage of customers who end their subscriptions, is 4.1 percent per month. Netflix also states that the churn rate is greater for new customers than for existing customers. I infer that Netflix keeps, at best, fifty percent of its subscribers on an annual basis, keeping 1.3 million of the 2.6 million subscribers from the start of fiscal 2005.

Netflix must add 2.8 million subscribers to get to the stated total of 4,179,000 at the end of fiscal 2005. Netflix states they added 3,729,000 new subscriptions, so several (1/3) of the new subscribers also ended their relationship with Netflix.

Netflix allocates marketing expense to new customer acquisition. Given this allocation, we can make an educated guess as to the lifetime value of Netflix customers, and compare lifetime value against the cost per acquisition.

In 2005, Netflix paid $38.08 for each new subscriber. By looking at the profit and loss statements provided by Netflix, we can see that most of their expenses appear to be "variable". This means that most expenses increase at a rate similar to net sales. Expenses that are "fixed", like salaries of management, corporate office expense, and the like, are often not counted in lifetime value calculations.

Ok, Netflix states the following expenses, as a percentage of net sales:

• Subscription Fees (shipping disks) = 57.7% of Net Sales.

• Fulfillment Expense (Netflix buys movies) = 10.4% of Net Sales.

• Technology Development = 4.5% of Net Sales.

• General / Administrative Expenses = 4.3% of Net Sales.

• Resale of Old DVDs = -0.3% of Net Sales.

• Total = 57.7 + 10.4 + 4.5 + 4.3 - 0.3 = 76.6% of Net Sales.

Let's assume that half of Technology Development and General / Administrative Expenses are fixed. This yields 72.2% of Net Sales that are variable.

We're making progress, now. Netflix states that they receive $17.06 of revenue per subscriber per month.

We also know that about four percent of these subscribers leave the company each month. Therefore, on an annual basis, the average customer is expected to spend ($17.06*0.96*0.083 + $17.06*0.92*0.083 + $17.06*0.88*0.083 + ... + $17.06*0.52*0.083) = $154 of revenue per year.

Multiplying this number by 72.2% expense yields $42.11 profit. Subtract $38.08 of marketing expense, and we finally get to our magic number. $4.03 is the approximate amount of twelve-month profit generated by a new customer.

In other words, within twelve months, Netflix recoups its customer acquisition expenses. As long as Netflix keeps its churn rate below 4%, keeps its revenue per subscriber at $17.06 or higher, and manages expenses properly, it has the potential to be a very profitable business. Remember, many of these customers will continue to maintain their subscription into future years, driving lifetime value even greater, driving even more future profit.

Challenges will occur once Netflix exhausts the potential number of customers who are willing to receive rentals via the mail. At that point, customer acquisition costs will become very expensive, and Netflix faces the potential of becoming unprofitable, should it continue to spend so much on marketing. The data indicate that Netflix isn't close to that ceiling of customers, yet.

Challenges can also occur if Netflix continues to acquire customers at lower subscription fees ($9.99). I'm sure Netflix staff have "run-the-numbers" on these subscribers, and have measured short-term costs verses long-term profit. Management will need to identify the churn rate of these subscribers, and will need to evaluate lifetime value against a much lower revenue base.

Netflix receives a "thumbs-up" from MineThatData for good financial management of the business model, in today's business climate. At some point in the future, Netflix will have to deal with the inevitable shift in movies from DVDs to digital downloads. With luck, they will get through this and all other challenges in a profitable manner.