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The quality of quantity at Netflix

OCTOBER 19 2018 1:41 PM

By: Jamie Powell

Only one metric seems to matter to Netflix investors: subscriber numbers.

On Tuesday, the junk bond financed content factory announced (https://s22.q4cdn.co

m/959853165/files/doc_financials/quarterly_reports/2018/q3/FINAL-Q3-18-Shareho
lder-Letter.pdf) 7m new subscribers in the third quarter, a third more than the 5.3m
predicted (https://www.ft.com/content/6b54abe6-d205-11e8-a9f2-7574db66bcd5) by
analysts. Netflix also said it expects to add another 9.4m in the final months of the year,
after which it's share price shot up 8 per cent:

It was a mirror image of the second-quarter results, when Netflix missed subscriber
expectations, and the price dropped 5.2 per cent:
Subscriber growth is obviously a crucial indication of prospects for the business. More
subscribers means higher revenues, more cash to spend on content, which attracts new
subscribers, and the wheels roll round and round.

But Alphaville isn't convinced the subs number is the only figure that matters for the
streaming leviathan founded by Reed Hastings. The cost of finding subscribers, and the
money that will be eventually squeezed from them, provides another way to assess the
prospects of one of the most hyped companies on the stock market.

The size of the fish versus the cost of the net

Silicon Valley loves subscriber businesses because customers, once signed up, provide
dependable monthly cash flows. For internet businesses, there is little additional cost in
providing the product to a new subscriber. And crucially, if the product works, prices
can be pushed up without customers unsubscribing. Business software groups
SalesForce and Slack, for instance, fit the bill.

Looking for the next big thing, venture capitalists, will often compare the estimated
lifetime value of a customer to the cost of persuading them to sign up (or in the jargon,
the customer acquisition cost).

Let's take a look at how Netflix's customer lifetime value to acquisition cost ratio (LTV
to CAC ratio, as it is known in the trade), and what it says about the quality of its
astonishing expansion.

Calculating the customer acquisition cost for Netflix is easy — take the segmented
marketing costs (handily provided (https://s22.q4cdn.com/959853165/files/doc_finan
cials/quarterly_reports/2018/q3/Q318-Website-Financials.xlsx) by the company), and
divide by the number of paid subscribers added. Here it is for the past 11 quarters, split
for the domestic (US) and international figures:

A few things to tease out. First is the high cost of acquiring US customers, an issue
Netflix seemed to have under control in 2017, but the expense has spiked back to 2016's
levels in the past two quarters. US growth has slowed — Netflix added 998k paid
subscribers this quarter versus 1.02m the same period in 2017 — and it is spending
more to achieve it, with marketing costs 42 per cent higher than last year, at $184m

Analysts at both Moffett Nathanson and Goldman Sachs list competition as a key risk,
and ballooning marketing costs do suggest growing competition from Amazon's Prime
service, as well as that soon to come from Disney (https://variety.com/2018/digital/ne
ws/disney-reorganizes-direct-to-consumer-streaming-unit-1202726528/) and, as of last
week (https://variety.com/2018/biz/news/warnermedia-direct-to-consumer-streaming
-service-john-stankey-1202975598/), Warner Media. It seems retaining, rather than
growing domestic subscribers, may soon be the name of the game.

Of course, with higher monthly revenue per paid subscriber in the US, $11.30 versus
$8.95 elsewhere, Netflix may think the spend is worth it.

Which brings us to the second part of our calculation — the lifetime value of a Netflix
subscriber. To work this out:

1. take the average revenue of a user in the quarter

2. multiply it by the gross margin (to figure out how profitable a subscriber is), then
 3. divide this figure by the churn rate — the proportion of customers which leave each
quarter.

Here's the average revenue per user figures, again for the US and International arms,
and for the whole business:

Last quarter was the first time in nearly three years that average revenue per paid
subscriber fell from one quarter to the next, dropping from $30.67 to $29.98. The
reason is overseas expansion, as Netflix brings in subscribers with less spending power.

On to stage 2 of our calculation: the profitability per user. So that's the numbers above,
multiplied by the gross margin (revenues, minus the cost of providing the service):
Gross profitability per subscriber has begun to fall, both in the US and abroad. A similar
blip occurred in 2017, so it would be unwise to read too much into this, yet. But perhaps
it does speak to the escalating cost of creating original hit shows, particularly in the
States. Last year a study by Tim Mulligan at MIDiA Research found that the 22 largest
TV networks in the US spent $53bn on content, a 45 per cent increase from 2012. In
short, there's a lot of money chasing an elite pool of TV talent.

Increased costs for high-quality television may be a concern for investors, but Netflix
shows no sign of cutting budgets. According to this quarter's cash flow statement, so far
this year they've spent $9.3bn on streaming content assets, $2bn more than at the same
point in 2017. While we're often sceptical of finance theory, there is something to be
said for the popular idea that paying more for an asset reduces its future returns.

Lower gross margins in the future due to higher content costs might effect the lifetime
value assessment, but lets stick with existing numbers for now. So we've got the first two
parts of our customer lifetime value calculation, leaving just the churn rate.

Churn on, tune in, drop out

Imagine our sadness when we found out Netflix have not disclosed its churn rate since
2010. In fact, according to an article (https://www.bizjournals.com/sanfrancisco/news/
2011/09/16/netflix-tells-sec-churn-rate-doesnt.html) from the San Francisco Business
Times, Netflix swotted away the Securities and Exchange Commission's requests for it
to do so. Apparently “the churn metric is a less reliable measure of business
performance, specifically consumer acceptance of the service.” Right.

The likelihood of a subscriber cancelling is a pretty important part of estimating their

value, so the proportion who do opt-out each quarter is a key part of our calculation.

There are a range of churn estimates available. For instance, MIDiA Research estimated
(https://www.midiaresearch.com/blog/netflix-q1-2018-results-hiking-prices-or-fightin
g-churn/) Netflix's churn in 2017 to average 9.6 per cent per quarter, thanks in part to
the October price hike. In the first half of 208, they estimate (https://www.midiaresearc
h.com/blog/netflix-2018-q2-earnings-wall-street-wakes-up-to-the-savvy-switcher/) the
rate dropped to 7 per cent each quarter, which equates to 28 per cent of the customer
base tuning out every year.

Other estimates come in lower. As one example, research-shop Ampere indicate (http
s://www.v-net.tv/2018/07/12/it-takes-11-months-for-netflix-to-achieve-payback-on-ea
ch-new-u-s-subscriber/) an annual churn rate of 20 per cent, or 5 per cent per quarter.
Yet, one media analyst we spoke to seemed to think this was low, given US cable churn
rates come in at close to 7 per cent per quarter, and that's with minimum contract
lengths. A Netflix subscriber is free to leave at any time, and Recurly Research (https://i
nfo.recurly.com/research/churn-rate-benchmarks) estimate video-on-demand churn
rates to run at 11 per cent monthly, a third of subscribers per quarter, as customers
switch between services.

So, given the range of estimates above, 9 per cent a quarter feels about right, if we want
to be reasonably conservative. (Feel free to put us right in the comments).

Input this churn number into our Excel sheet, and voila: we now have the lifetime value
of a paid subscriber to Netflix:
But that isn't really what we're after, what we want to know is the ratio between how
much money a paid subscriber is worth — the lifetime value — and how much it costs
Netflix to pull one in to its platform — the customer acquisition cost.

Dim the lights.

Drum roll please . . .

And raise the curtain:

First, to point out the obvious, both international and domestic subscribers are still just
about worth the marketing dollars to Netflix.

In the US, for instance, the ratio stood at exactly 1 this quarter, after dipping into
negative territory last. Suggesting that Netflix would do well to rein back its marketing
spend domestically, as each customer is worth $184, almost exactly what they cost to
acquire (assuming our estimate of the churn rate is accurate). The company could also
choose to raise prices, as it did last October, and keep its marketing spend flat. Whether
this is possible in the face of competition from rival streaming services is another
matter.

Internationally, Netflix's LTV to CAC ratio is far higher — 1.80 last quarter — suggesting
its marketing dollars are still worth the outlay. Yet international markets do hold some
worries in the future, according to the wonks at Buckingham Research Group. They note
"77 per cent of anticipated global streaming member growth through 2025 is from more
challenging markets outside the US and Western Europe . . .[and] . . . we still feel the
Indian market will remain competitively intense and difficult to monetise”. Yet given its
significant head start, and a good return on its marketing spend, it hard to see Netflix
slowing down overseas in the coming years.

So, the fundamentals of the business aren't broken. Netflix appears to maintain healthy
and rapid growth outside of the US, which could fuel expansion of the business — and
that virtuous circle we described above — for years ahead.
How investors choose to value a business growing like that, well, that's another question
entirely (https://www.ft.com/content/3f2382fa-b4db-3bc1-825a-c9d893a6516e).

Related Links:
The Netflix dilemma (https://www.ft.com/content/e76910eb-a786-3437-850d-c492cca
44aa5) — FT Alphaville
This is nuts, when does Netflix crash? (https://www.ft.com/content/3f2382fa-b4db-3bc
1-825a-c9d893a6516e) — FT Alphaville

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