Friday, July 22, 2005

At what cost is NetFlix growing?

I'm in the mood for math. I want to illustrate some principles of how Netflix's current potential profitability is being spent to induce growth. I'm going to focus principally on the marketing component of cost.

Marketing for Q1 was 23% of revenue. For the year, it will be about 20%. 2005 Net earnings is estimated for -10M, producing a net profit margin of -1.5%.

Now, what if Netflix decided to convert all growth to profit?

This introduces what I call the 'replacement rate' which is the nominal number of new subs required each quarter to achieve a net growth rate of 0%.

At 3M subs and 5% churn this figure is 530K subs per quarter. This is a direct result of the Netflix churn calculation applied in reverse.

Now, what is marketing as a percentage of revenue if this were the number of gross adds per quarter?

Presuming a 40$ SAC (to be revisited):
Marketing Cost: 40$ * 530K = 21.2M$
Revenue: 3M * 18$ * 3 months = 162M$
Marketing as percent of revenue: 13.1%

We have now squeezed out 6.9% in net profit points. But it gets better for 2 reasons:
a) Slower growth implies a more rapid aging of subscriber base, which has been shown to reduce churn.
b) At a 40$ SAC Netflix actually achieves much more then the replacement rate, so it must reduce the SAC in order to reduce growth.

To address the first component, recall that a trial sub churns at 10%, 6-month-old subscriber churns at 5%, and a 12+-month sub churns at 2.5%. It should be fairly evident that the fewer new subs put in the pipe, the lower the average churn will be for the entire sub base given the above fact. Let us for simplicity presume something like a 4.5% churn just so we feel like we have considered this benefit.

Running the numbers on a churn of 4.5% we get a reduction of marketing from 13.1% to 11.6%.

To address the second component, Netflix does not pay 40$ per new member precisely. Some members are former customers that would return without advertising inducement, other members are free word of mouth subs, still others are enchanted by a banner or two but don't go through affiliates.

The expectation in Q2, which is the most difficult quarter for Netflix to add subs, is 750K gross adds at a SAC of 40$. If we presume that 200K subs would join at 0$ in marketing, the SAC of the remaining members is 55$. At replacement rate this is: (200K * 0$ + 330K * 55$) / 530 = 34$. If 200K is accurate, this is an upper bound to the SAC required.

Employing this fact reduces marketing expenditure further by (34/40) or 15%.

We now have a 'replacement rate' marketing expenditure of 10%. Revenue for the year would be 3 * 18 * 12 = ~650M, and net profit is then 8.5% (-1.5% + 10%), and the current profitability is 55M or a current P/E of roughly 21.5.

This would be considered pricey if you are looking at a company with 0 growth, however Netflix chooses to invest in growth because it leads to a higher total in profitability. If you run these figures at 4M subscribers, the P/E drops to 16.

Another perspective... in 9 months they will add 1M subs but will incur an opportunity cost to do so of about 40M$. However, at 4M subs they would be making 18M$ more per year and it is therefore like an investment with a 45% yield. A wise choice.

This analysis focuses only on marketing; there are many other reasons to adjust potential earnings including today's news. The second biggest adjustment to profitability expectations is a change at Blockbuster.


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