NETFLIX

Case Study Analysis Click to edit Master subtitle style By: Brittany Price 3/9/12

Background informationfor digital disc Netflix operated an Internet based unlimited rental subscription service
(DVD) formatted movies. By paying a single monthly subscription fee ranging from $15.95 to $19.95, a Netflix subscriber could rent an unlimited number of DVDs each month and could keep them as long as desired because there was no specific return date or late fees. In order to attract new subscribers, Netflix offered a free trial month of service as well as new DVD players in hope to convert the customer to paid status. Netflix purchased its DVDs on a wholesale basis from distributors, maintaining an extensive DVD library containing approximately 5,800 titles and over 620,000 individual discs (as of 1999), 20% of which were allocated to new releases. Also offered individual movie recommendations as part of its Personal Movie Finder Service. By providing this information, Netflix sought to develop sufficient brand loyalty to compete effectively against potential future entrants as well as existing video rental retailers. Viewed as a combination of a traditional video store and a subscription cable TV service.

3/9/12

issues to address
In July 2000, Reed Hastings, chairman and chief executive officer of Netflix.com, Inc. faced a critical decision. Netflix had submitted its S-1 filing for its initial public offering but because of the market downturn, many Internet companies had been forced to withdraw their IPOs. Investment bankers indicated to Hastings that Netflix would need to show positive cash flows within a 12 month horizon in order to have a successful offering.
1.

Will Netflix be able to sustain the type of future growth necessary to achieve its long run objective, have a successful public IPO? Can Netflix afford to continue offering a free month of service to attract potential new subscribers? Does Netflix create value with each new subscriber? Will revenue sharing and offering video on demand have a positive effect on Netflixs projected cash flows?

1.

1.

1.

3/9/12

New Subscriber Model

Assumptions Netflix Purchase Cost/DVD $15.54 Shipping Cost/DVD $1.00 Paid Monthly Subscription $19.95 Free Trial Months 1 DVDs watched/Month 5.16 Netflix DVD stock/Subscriber 5.79 New Release Percentage 20%

Month Subscription Revenue Shipping (movies watched) Purchase DVDs (acquisition cost) Purchase DVDs (new releases) Net Revenue
Percentage Retained

1
Trial -0$5.16 $89.98 -0($95.14)

2
Paid $19.95 $5.16 -0$9.00 $5.79 70%

3
Paid $19.95 $5.16 -0$9.00 $5.79

4
Paid $19.95 $5.16 -0$9.00 $5.79

5
Paid $19.95 $5.16 -0$9.00 $5.79

6
Paid $19.95 $5.16 -0$9.00 $5.79

7
Paid $19.95 $5.16 -0$9.00 $5.79 40%

8
Paid $19.95 $5.16 -0$9.00 $5.79

9
Paid $19.95 $5.16 -0$9.00 $5.79

10
Paid $19.95 $5.16 -0$9.00 $5.79

11
Paid $19.95 $5.16 -0$9.00 $5.79

12
Paid $19.95 $5.16 -0$9.00 $5.79

3/9/12

New Subscriber value

Assumptions Discount Rate 21% Subscriber Drops After: 1 months 30% 6 months 42% 5 years 28% 100%
Probability

1 month 1 2 ($95.14) $80.98 -0-0-0-0-0-0-0-

6 months ($95.14) $5.79 $5.79 $80.98 -0-0-0-0-0-

5 years ($95.14) $5.79 $5.79 $5.79 $5.79 $5.79 $5.79 $5.79 $5.79

Expected Value ($93.23) $28.23 $3.94 $34.01 $1.62 $1.62 $1.62

Annual Value ($12.84)

Month s

3-6 7 8-12 13 14-48

The annual value remains the same for years 2, 3, & 4 $17.42

3/9/12
50-60

49

Discount Expected Value =

$1.62

$1.62

$35.51

$37.56

Expected Cash Flow per Subscriber Year 1 ($12.84) Existing Subscribers (From 1999) 107,000 Year 2 $17.42 Value of a New Subscriber $37.56 Year 3 $17.42 New Subscriber Growth Rate/Year 55% Year 4 $17.42 Corporate Expense Growth Rate 3% Year 5 $35.51 Assumptions
2000 Year 1 New Subscribers Year 2 Year 3 Year 4 Year 5 Year 1 Year 2 Year 3 Year 4 Year 5 ($3,852,724.06) ($5,971,722.29) $5,225,398.35 ($9,256,169.55) $8,099,367.45 $5,225,398.35 ($14,437,062.81) $12,554,019.54 $8,099,367.45 $5,225,398.35 300,000 2001 465,000 300,000 2002 720,750 465,000 300,000 2003 2004 1,731,602 1,117,163 720,750 465,000 300,000 ($22,237,947.35) $19,458,730.29 $12,554,019.54 $8,009,367.45 $10,654,199.59 ($3,852,754.06) ($746,323.94) $4,068,596.25 $11,531,722.53 $28,528,369.51

Netflix Cash flow stream

1,117,163
720,750 465,000 300,000

New Subscribers Expected Net Revenues

Existing Subscribers

3/9/12

Total Revenue

New Subscriber model

New Subscriber value

The discount rate of 21% I used was from Netflixs annual 10-K report. Then I set up a probability map to determine the chances of subscriber drops and the amount it would cost the company. After first month, 70% retained: 1 - .70 = 30% drop off, after six months, 40% retained: . 70*(1-.40) = 42% drop off , at the conclusion of my five year analysis, the remaining: .70(.40) = 28% drops off

As of 1999, Netflix had 620,000 individual discs with 110,000 subscribers, meaning 5.79 DVDs per subscriber. According to Netflixs 10-K report, subscriber acquisition cost in 1999 was $110.79 therefore I estimated the amount for 2000 would decrease to $89.98. Using those two figures, I calculated the purchase cost per DVD would be $15.54. I used the estimate of 5.16 DVDs watched per month being that in a given month, Netflix shipped 800,000 DVDs to about 155,000 total subscribers.

Cash flow stream

According to Netflixs 10-K report, there were 107,000 subscribers in the year 1999. I then estimated a projected new subscriber growth of 55% per year and an annual corporate expense rate per year at 3%

3/9/12

calculations

Financial recommendation
As evident through my financial analysis, Netflix doesnt produce positive cash flows until 2003, therefore they should not go forth with its IPO at this time. The ideal opportunity presents itself in 2004 being that years cash flow stream is projected to more than double because of the increasing number of subscribers as well as having a better chance of a favorable financial market situation. Netflix can afford, and should continue, offering new customers a free trial month of service. Even though there is a negative net revenue after the first month, users are more likely to subscribe if theyve had the opportunity to experience all that Netflix has to offer at no cost. With a 70% retention rate after the trial period, followed by 40% after 6 months, it is clear that Netflix eventually profits from the initial subscriber acquisition costs. Once customers convert to paid status, Netflix generates a present value of $37.56 per subscriber. Revenue sharing is an alternative to distributor wholesale purchasing that has the potential to positively effect Netflixs cash flows in the immediate future. In a typical agreement, Netflix could purchase a newly released movie for fewer than $10 in exchange for returning less than half of the revenue generated during the first six months to the movie studio. This arrangement could not only reduce the required inventory investment but also allow Netflix to stock more movie titles per subscriber. Video on demand is a future alternative Netflix could benefit from. Being that it is already an established internet company, offering movies via the web could help acquire new subscribers because of the convenience as well as satisfy the ones they already have.

3/9/12