the future and thereby resulting in positive net income.
Netflix’s ability to amortize its massive content spending over several years gives the company time to use all the content to attract subscribers, and thereby increase subscription revenue. However, Netflix needs to keep adding subscribers at a rapid pace in order to cover future content costs.
4.3.0.1 Summary Cash Flow analysis
Based on this section we can conclude that the Profitability Analysis and Risk Analysis might not give the most accurate picture of the financial health of the company. The cash flow statement indicates much higher costs, where the costs are pushed into the future by amortizing the expenses, leading to significant negative cash flow. Additionally, the company also have substantial future content obligations which will profoundly affect the company in the future.
Table 4.9: Change in Gross Added Customer
Year 2012 2013 2014 2015 2016 2017 2018
Total subscribers 30.4 41.4 54.5 70.8 89.1 110.6 139.3
Net added customers 8.8 11.1 13.0 16.4 18.3 21.6 28.6
Gross added customers 9.1 11.5 14.3 18.0 20.1 23.9 30.8
% change in gross added customer - 26% 24% 25% 12% 19% 28%
Figure 4.6: Development in Subscribers for HBO, Netflix, Hulu, and Amazon Prime
Source: Data retained from Netflix annual reports
4.4.0.2 Value of subscribers
It is better for a company to lose money because it is spending money trying to acquire new users than it is to be losing money on service for existing users. For high-growth companies, like Netflix, it is best to have more fixed costs than variable costs, since it is the fixed cost portion that yields economies of scale, as the firm grows (A. Damodaran, 2018b).
A user-based model that grows cash flow from existing users is more valuable, other things remaining equal than a user-based model that is dependent on adding new users for growth. Since firms already have expended resources to achieve the existing users, any added revenue it derives from them is more likely to increase the bottom line directly. Adding new users is more expensive, partly because it costs money to acquire them but also because new users may not be as active or profitable as existing users. Consequently, user-based companies that are more cost-efficient in adding new users will be
worth more than user-based companies that spend a considerable amount on promotion on marketing (A. Damodaran, 2018b).
A comparison of Netflix and Spotify illustrate how this can be an essential value driver, as they are both subscriber-based companies, but with very different models for paying for content. Netflix pays for content as a fixed cost and derives economics of scale when it adds new subscribers, whereas Spotify pays for content based upon how much subscribers listen to songs, making it a variable and existing user-based cost (Viner, 2018). Spotify’s variable content costs, hinder the firm’s ability to increase profits because costs will always scale with revenue. As a result, Netflix derives a much higher value from both existing and new subscribers.
Netflix invests in customer retention. Their user interface and recommendation system are designed to encourage continued usage, especially when subscribers finish watching seasons of their favorite shows. Netflix’s content recommendation algorithms automatically queue a recommended show after a subscriber finished the season. Furthermore, the detail and depth of its personalization through the recommendation system is one of Netflix’s most excellent tools in retention. As long as users can find something to watch effortlessly, they will spend more time on Netflix and be less likely to switch to another service. By personalizing the interface to such a high degree, Netflix can maximize the engagement and minimize the time spent searching for something to watch.
As of 2018, Netflix has the highest renewal rate, at 93 %, compared to 75 % for Amazon Prime and 64 % for Hulu (Seitz, 2018). Since Netflix is the market leader in terms of subscription growth, the statistics indicate that Netflix is both good at maintaining their existing users as well as attracting new users, which is especially important since it is effortless to change between streaming providers.
According to Parks Associates, the average length of a subscription among all broadband households is just over 30 months, where the industry average for all services except Netflix is just above 21 months.
This fact indicates that Netflix is the best in the industry to retain its subscribers. Further, Park Associates states that a steady stream of original content is a powerful tool for retaining subscribers, which Netflix is heavily investing in (Pegoraro & Chamberlain, 2017).
4.4.0.3 Churn rate
The renewal rate is a significant factor for firms, as non-renewal will lead to a more significant loss of income compared to transaction-based companies, because of higher acquisition costs (A. Damodaran, 2018b). However, it is difficult to conduct the accurate number when calculating the renewal rate, because some of the subscribers cancel their subscription and renew them again multiple times during
a period. Additionally, the streaming services do not disclose any information about this in the annual report. Therefore, we have to rely on analysts predictions of the churn rate, making the calculations less accurate.
In 2015, Netflix had a churn rate (opposite of renewal rate) of 9% while Amazon, Hulu, and other OTT providers had a rate of 19%, 50%, and 60% (DTVE, 2015). In 2017, the churn rate for Netflix was as low as 1.9%, but a 10% increase in monthly fees immediately increased the churn rate to 9.7%
(Mulligan, 2018). In 2018, Netflix’s churn rate was estimated to be 7% of its subscribers, which is lower than all the other streaming services. That compares with Amazon’s churn rate of 25%, and HBO Now’s rate of 36%, which were the next highest (Patrick, 2018). Netflix’s low churn rate suggests that users are holding onto their Netflix account while experimenting with a wide variety of other video subscription options (DTVE, 2015). In the analysis below, we assume the same churn rate in both the domestic and the international segment, the historical churn rate is stated below:
Table 4.10: Churn rate 2012-2018
Year 2012 2013 2014 2015 2016 2017 2018
Churn rate 4% 4% 9% 9% 9% 10% 7%
Source: Associates (2018) & Patrick (2018)
4.4.0.4 Customer Acquisition Cost (CAC)
Customers do not come for free, and in addition to the content production costs, Netflix spends money on marketing in an attempt to achieve new subscribers. CAC is calculated based on how much they spend on marketing in a given period and how many gross customers they add in any given period, stated in the formula below (Jaipuria, 2018):
CAC=Marketing costs/(number of net new customers/(1- churn rate) (4.2)
One can argue that CAC may include some content costs or technology and development cost. However, we have chosen not to include any of these cost in our CAC. This matter is because it is stated later in the forecasting and valuation that technology and development costs are assumed not to be a direct cost for existing or new subscribers, and the later calculated lifetime value of subscribers include content costs. Further, by only including the content cost in the lifetime value of customer and marketing cost for acquiring a new customer it is easier to use this analysis further in the valuation.
Figure 4.7: Development in CAC for the Domestic and International market
Source: Data retained from Netflix annual reports
Netflix now has 58.5 million subscribers in the US, which is almost half of all households. The closer Netflix gets to saturation, the more difficult it is to grow the business (Green, 2018). A good indication of a higher market rivalry is the company’s marketing spending which has increased throughout the historical period. According to a report from Cartesian Consulting, the average cost of acquiring a new subscriber in the over-the-top video market is currently below $100. However, they expect the average to rise as the number of competitors increases (Bleylevens, 2018). Netflix’s CAC in the domestic segment has through the historical period had a considerable growth leading to a much higher CAC than the international segment. Where the CAC in the US has increased from $ 49.84 in 2012 to $ 168 in 2018, the international CAC has been more stable between $ 40 and $ 56. Both markets indicate that adding the same amount of users has become more expensive in the last years. There will be a continuing need for marketing spend to stimulate consumption to prevent people from canceling their subscription. Increased competition might likewise push Netflix to more expensive marketing in order to continue to grow, and this will likely increase the cost of acquiring new customers.
Dividing CAC by average revenue per user (ARPU), which Netflix discloses in their annual report, gives us the time in which Netflix recoup customer acquisition costs (Jaipuria, 2018). The calculation indicates how many months a user must subscribe for it to become profitable to the firm. In the domestic segment, the CAC/ARPU has increased from 5.12 to 14.74, meaning that in 2018 Netflix users need to subscribe for almost 15 months for Netflix to be able to earn back the CAC and for the users to become profitable. In the international segment, the CAC/ARPU has increased from 4.92 to 5.78, meaning that in 2018 an international subscriber will become profitable in less than six months, which is more than half of time of the domestic subscriber. Hence, even though the domestic ARPU is higher than the international ARPU, the international subscribers start creating profit for the firm much earlier than domestic subscribers. One of the reasons for the lower ARPU in the international segment is varying exchange rate as mentioned in the PESTEL that affects the monthly fees. The
calculations can be found in Appendix A5.3.
4.4.0.5 Lifetime value of the customer (LTV)
In order to evaluate the CAC, we need to know the lifetime value of customers, which is referred to as the average revenue a single customer is predicted to generate throughout their account, calculated as (Jaipuria, 2018):
LT V =Gross profit per user/churn rate (4.3) Figure 4.8: Development in LTV for the Domestic and International market
Source: Data retained from Netflix annual reports
Looking at the LTV for the domestic segment, it has increased from $ 329.51 to $ 881.35. For the international segment, the LTV has increased from $ -960.90 to $ 354.80, giving it a higher growth rate than the domestic but lower value throughout the historical period. A higher ARPU in the US has given the domestic segment a much higher revenue per subscriber which represents most of the difference between the segments’ LTV. Hence, Netflix is able to extract more value from the domestic subscribers compared to the international because of higher revenues per subscribers.
4.4.0.6 Ratio LTV/CAC
The ratio LTV/CAC answer if the return of the customer is worth the investment. A ratio above 5 is considered very good. However, this has to be interpreted carefully since the ratio will vary depending on which costs LTV and CAC includes(Jaipuria, 2018). Some also indicate that a ratio of 3 or higher is indicative of a healthy business (Premo et al., 2017).
For the domestic segment, the ratio has varied from 4.58 to 23.04 throughout the historical period, where the ratio has decreased in the last four years as a consequence of the higher cost of acquiring new customers. However, the ratio has been at a healthy level. For the international segment, the ratio
ranged from -17.13 to 6.51, where the ratio has increased in the last four years as a consequence of stable CAC and higher LTV. The international segment has as of 2018 become the most profitable market, and we expect this trend to continue in the future. The detailed calculations can be found in Appendix A5.2.
Table 4.11: Ratio LTV/CAC 2012-2018
Year 2012 2013 2014 2015 2016 2017 2018
Domestic 6.61 23.04 8.12 8.55 6.18 5.48 5.25 International -17.13 -3.95 2.52 1.62 1.78 2.80 6.51
Source: Data retained from Netflix annual reports
4.4.0.7 Gross profit comparison with HBO
Figure 4.9 shows that Netflix overall has the highest gross profit per subscriber with an average of $ 26.19 in the period 2012-2018, whereas HBO has an average of $ 21.26. Further, we see that Netflix has had a growth of 728.85 %, whereas HBO has had a growth of 23.78 %, resulting in higher profitability for Netflix as well as a much higher growth throughout the period indicating a possibility for better future results for Netflix.
Netflix has an average annual revenue per subscriber of 179.52 dollars compared to HBO’s average of 36.42 dollars resulting in 4.9 times as high revenue per subscriber. Further, Netflix has a much higher cost per subscriber average compared to HBO. Netflix’s average is 137.14 dollar which is an average of 78.3% of revenue per subscriber, whereas HBO has an average of 15.29 dollars which is an average of 42.1% of revenue per subscriber. This indicates that even though HBO is more cost efficient, Netflix is still able to be more profitable because of their higher revenues. The cost as a percentage of revenues has declined more for Netflix than for HBO, indicating a higher focus on cost efficiency for Netflix the latest years. HBO’s subscription calculations can be found in Appendix A5.4.
Figure 4.9: Gross profit per subscriber for HBO and Netflix
Source: Data retained from Netflix annual reports
For Netflix, most of the cost per subscriber is the production of original content which Netflix is focusing heavily on. The cost for original content is on average during the period 50.94 % of revenues for Netflix, whereas HBO has an average of 21.14 %, showing that Netflix uses more than double the amount on original content compared to HBO.
The content officer at Netflix, Ted Sarandos, stated that in 2018 more than 90 % of Netflix’s customers regularly watch original content (Spangler, 2018). This statement indicates the importance of Netflix’s focus on original content. Another reason for focusing on original content is to save licensing costs over the long term. The original content will allow the company to increase subscriber numbers and decrease the cost, therefore becoming more profitable. This transition will happen in the long term because original content costs more up front compared to licensed content. Netflix has stated that content comes at a 30-50 % markup when they use outside studios (Lovely, 2018). Hence, we find it reasonable that Netflix will continue to have high costs in the future and will not focus heavily on reducing costs.
4.4.0.8 Summary of Subscription Analysis
The subscription analysis shows that Netflix can be more profitable than HBO because of higher subscription growth, especially in the international market, as well as higher overall revenues. However, for Netflix to be able to be profitable in the future, the company has to continue to expand in the international market in order to cover the high cost the company will continue to have in the future, mainly because of original content spending. Further, the analysis shows that the ratio LTV/CAC had the highest growth in the international market, and as of 2018 it is the most profitable market based on the LTV/CAC ratio.