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.

Business Review: Sharper Image

If a tree fell in a Sharper Image store, would any customers or employees hear it fall?

The story of Sharper Image, and their quick fall from grace, illustrates the razor-thin margin of error businesses have. Mis-steps in just one or two items can lead to the collapse of a 2,500 employee company that spent three decades building its reputation/brand.

This MSN article, from a little over a year ago, outlines problems Consumer Reports found with an air purifier sold by Sharper Image.

All of the facts listed in this discussion are from the Sharper Image 2006 10-K filing.

In 2003, Sharper Image operated 149 stores, a catalog division, and a website. Combined, these channels drove $648 million in net sales, and $39 million in pre-tax profit. At a six percent pre-tax profit, Sharper Image posted average, if not spectacular, results.

Just two years later, Sharper Image operated 190 stores, a catalog division, and a website. Combined, these channels drove $669 million in net sales, and an amazing pre-tax loss of $27 million.

Along the way, a perfect storm of problems confounded Sharper Image management. Negative press about the failure of air purifiers to purify the air caused a dramatic drop in sales of these items. In addition, a significant portion of sales came from massage chairs. The vendor responsible for producing the massage chairs elected to sell cheaper versions to Sharper Image competitors, undercutting Sharper Image. Air purifier and massage chair sales plummeted by an amazing $126 million.

Sales of other items increased by $35 million, providing hope for Sharper Image. However, sales increased in product lines like branded MP3 players, which carry low margins, reducing profitability. In fact, cost of goods sold were nearly identical in 2005, compared with 2004.

Given the dire conditions at Sharper Image, management undertook several cost-cutting measures. Between 2004 and 2006, advertising expense will be reduced from $150 million to about $80 million. Reductions are across the board, with the notable exception of online marketing, which will be increased in 2006. Catalog page counts are being reduced from 88-96 pages to 52-76 pages. The catalog business decreased, from $131 million in 2004 to $87 million in 2005, in part to lower demand, and advertising reductions. Even the online channel, growing by 20% to 40% at most companies, failed to grow in 2005, decreasing from $116 million in 2004 to $107 million in 2005.

At the corporate office, headcount was cut by twenty percent. In stores, staffing was reduced from 8-12 employees per store to 7-10 employees per store. In addition, employees lost their sales commissions. Instead, management instituted bonuses based on achieving sales goals and expense management. Executive pay was reduced by fifteen to fifty percent, though executives somehow got to keep their jobs.

The bad news continues for Sharper Image. May same store sales are down an amazing thirty-six percent. A first quarter investor conference call is scheduled for June 8. Disenchanted investors forced a change on the Board of Directors, hoping to increase future sales and profit.

This business review clearly illustrates the razor-thin line that separates success from failure. Two years ago, the sky appeared to be the limit for Sharper Image. Impressive sales per square foot of more than $600, and huge comp-store sales gains, resulted in an aggressive expansion plan.

Mis-steps on only two items paved the way to collapse. I would be curious to hear what branding experts have to say about Sharper Image. If this company had a 'strong brand', then why would customers leave in droves when just a few mistakes were made? If this company had a 'weak brand', then why was it driving sales per square foot figures that were industry-leading, at over $600? What would a branding expert recommend to save this business?

Ultimately, no amount of branding, CRM implementation, target marketing, word-of-mouth marketing, return-on-customer studies, leadership blogging or other window-dressing can save a business when the fundamentals are messed up. In this case, customers did not forgive Sharper Image for making one mistake. In addition, customers did not exhibit any customer loyalty when competitors offered similar massage chairs at lower prices. An apparently healthy and profitable businesses quickly descended into chaos.

I believe the lesson to be learned from Sharper Image is one of managing the fundamentals of your business. Dependence upon a breadth of quality products helps a company ride out storms like this. In retrospect, the company expanded so quickly that, when everything turned bad, the added expense and lower sales-per-square foot of new stores caused the profitability of the company to suffer. In the rush to grow sales, the company relied upon products with low margins, making profitability even more challenging.

Unfortunately, the employees, the very same employees who did the same level of work two years ago when the business was successful, bore the brunt of this downturn. The importance of quality merchandising cannot be under-stated.

Business Review: Dell

The blogosphere is full of discussion about customer service issues at Dell. Debbie Weil, of Blogwrite for CEOs, links some of the meaningful articles in the ongoing battle between bloggers and Dell.

With Dell stock trading at levels not seen in the past four years, and non-stop criticism from a small but vocal group of bloggers, I thought it made sense to dig into Dell's most recent 10-Q statement, and learn a little bit about the company's financial performance.

In the first quarter, Dell generated just over $14.2 billion dollars net sales, verses $13.4 billion dollars last year. That's the good news. Gross margin, as a percentage of net sales, decreased from 18.6% last year to 17.4% this year. Dell states that pricing declined faster than decreases in component costs.

Of interest are comments about how Dell plans to reduce costs. One comment states the following: "Cost savings initiatives include providing certain customer technical support and back-office functions from cost-effective locations..." In other words, Dell plans to continue outsourcing various jobs to locations where labor is cheaper, including back-office functions. A lot of us "back-office" folks watched technology jobs move overseas during the past decade. Now jobs in finance or human resources are considered fair game as well. Without a doubt, it is time for the back-office employee to have a career plan, given that leading companies like Dell are publicly stating that back-office jobs are heading elsewhere.

Last year's 10-K statement outlined other issues that Dell faces. The statement indicated that, at the end of fiscal 2005, an amazing 39,900 of 65,200 employees (61%) were located outside the United States, while just 41% of revenue is generated outside the United States.. Dell's third quarter is more dependent upon government contracts than other quarters. Consumer demand is greatest in fourth quarter.

Also of interest is the meteoric growth in top-line sales, since 2001. Sales increased from $32.2 billion in 2001 to $55.9 billion in 2006. This helps explain the hoopla surrounding sales that increased slowly in first quarter. Operating income was 7.8% of revenue in 2005, compared with 8.4% in 2004, illustrating that the profitability trend observed in Q1-2006 continues unabated.

Also interesting is that Dell no longer reports on sales to consumers. At the end of 2005, Dell generated 14% of sales from consumers, verses 15% in 2005, and 16% in 2003. Desktop revenue declined from 45% of sales in 2003 to 38% in 2005. This revenue was offset by small increases in mobility (laptops and mp3 players), software and enhanced services. In other words, Dell has basically maximized their desktop business. As customer behavior shifts to laptops, and as the mix of business further moves to businesses, Dell is highly dependent upon transitioning its desktop business clients to laptops to maintain successful and profitable growth. This transition will largely determine Dell's success over the next 2-3 years.

As I read through Dell's financial records, it becomes obvious that the company is significantly impacted by the transition from desktop machines to laptops, margin pressure, a shift in focus from consumers to businesses, and a shift in focus from a US-based business to a Global-based business. While the blogosphere focuses on customer service problems and a lack of authenticity exhibited by the company, it is clear that Dell has much bigger fish to fry. Dell has to successfully manage four transitions, all happening simultaneously, in order to be successful in the long term. It will be interesting to see how well Dell navigates these tricky waters.