Netflix’s Calculated Bet on Streaming

Update:

A few days after this post, Netflix decided to abandon its recently announced streaming-only strategy and instead retain its original combined Streaming + DVD business. All I can say is that correlation is not causation.

The following analysis is my opinion only and contains a set of assumptions which may or may not be accurate. Do not use this for investments or financial decision-making. All the analysis is based on public information only, as stated in my Policy.

Netflix Cost Structure Analysis

• What is the impact of Netflix’s decision to focus on Streaming–Only on their cost structure?
• Will the decrease in the cost structure offset any loss in subscriptions of customers who wanted DVD as an option?

I have attempted to estimate the Netflix cost structure 2 scenarios: (1) If Netflix had continued the blended (combined streaming + DVD) options, and (2) Streaming-only Option. Netflix has provided guidance that they expect 24 million subscribers in Q3 2011 with 12 M subscribers for both DVD & streaming, 9.8M for streaming only and 2.2 M for DVD only.

Assuming the same ratio Blended, Streaming-Only and DVD -Only users, I have estimated the Cost/ Subscription/ Month at different r user subscription numbers for the Blended scenario. In addition, I have also made estimates for the cost structure for the Streaming-Only scenario.

Key Takeaways:

• Looking at the above graph, the blended business will have the same Cost/ Subscription/ Month at 24M users as the Streaming-Only business at 17M users  –  $11.8 per subscription per month). So of the 12 M users who are subscribing to both streaming and DVD, at least 7.2M will need to convert to Streaming-only in order to retain the same Cost/ Subscription/ Month.

• However, Netflix has mentioned that they will maintain the same operating margins. Therefore, for the pricing of the Streaming- Only business to be at $8, the number of subscribers has to be close to 30M, which means they have to acquire an additional 6 M customers over and above their current base. Alternatively, they will have to either increase prices or come up with premium pricing tiers.

Below is the cost breakdown estimates for the scenario with 24M subscribers as forecast by Netflix for Q3.

Assumptions

NOTE: I have made many assumptions since the 10-K does not break out costs very granularly. These assumptions may or may not be accurate enough. If readers can come up with better assumptions, do let me know in the Comments section and I will rework the numbers.

1. I have used the 2010 Netflix 10-K as the basis for many cost items, since the 2011 Netflix 10-K will only be available at year end.
2. It is expected that streaming content acquisition is going to cost a lot more going forward.  Assumption:Content acquisition costs = $1.6 B / year. Source: http://www.trefis.com/stock/nflx/articles/73421/the-failed-netflix-starz-deal-highlights-the-rising-costs-of-netflixs-growth/2011-09-06
3. I’ve assumed that DVD content acquisition cost in the blended scenario is one-tenth of the Streaming content acquisition costs. This is under the assumption that Netflix is not going to invest much in DVD content acquisition.
4. DVD operational costs: I used the 2010 Netflix 10-K as the basis, in which I assumed that DVD operational cost is 55% of total subscription costs. This comes to $ 634 million total or $ 3.58 per subscriber per month. Assumed the same cost per subscriber per month for DVD operations going forward as well. .
5. Streaming operational costs: Assumed 50 cents per user per month to cover credit card and cost of streaming.
6. Fulfillment cost: based on 2010 10-K, fulfillment cost = $1.15 per subscription per month. The same value is assumed.
7. Assumed 10% increase in Technology, Marketing,  G&A over 2010.

I’d appreciate reader feedback on the following:

• Has streaming hit the mainstream for family viewing or is it still the domain of singles watching movies/ shows on their laptops and iPads?
• Following Netflix’s announcement that it is abandoning the Streaming-Only strategy, I am guessing that they may have determined that they cannot retain the requisite number of subscribers to make Streaming-Only a viable option.What do you think?