Netflix Solution

NetFlix. com, Inc. Case Study Ron Golan Andy Shin Kevin You March 25, 2008 BMGT 440 – Professor David Kass Company Background & The Issue At Hand NetFlix. com, the world’s largest online DVD rental company, was founded by Reed Hastings and Marc Randolph in 1997, and is headquartered in Los Gatos, California. The company started its online DVD rental business by launching Netflix. com, offering pay-perDVD rental services by delivering DVDs via mail.

As the company prospered during late 1999, NetFlix replaced its pay-per-DVD revenue model with a fixed monthly fee system that allowed customers to rent up to 4 DVDs per month with no due dates or late fees. In February 2000, it launched a new plan, where, with a monthly fee of $19. 95 instead of its previous $15. 95, subscribers were able to have up to 4 DVDs in their possession at one time. The website allowed subscribers to make their own lists or “queues” of movies that they browsed and selected to watch. Then, it shipped movies that were at the top of the queues of subscribers via mail.

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It also provided subscribers with individualized ratings on all movies that customers had previously rated after viewing. As the company enjoyed tremendous success, it decided to submit its S-1 filing for an initial public offering. However, soon after it was submitted, the NASDAQ stock market fell 25% to 3,794, making it more difficult for a company’s IPO to succeed with uncertainty in the financial markets. In July 2000, Reed Hastings, CEO of NetFlix, needed to decide whether the compnay should proceed with the IPO or withdraw it.

Investment banks predicted that the IPO of NetFlix would succeed if it showed positive cash flows within a twelve-month horizon, but the executives at NetFlix were unsure whether they could achieve that goal. Long-Run Objectives & Performance To Date NetFlix’s long-run objectives are to convert as many free trial users to paid users as possible and to retain paid users over the long run. NetFlix plans to achieve its long-run objectives by building and enhancing customers’ brand loyalty in NetFlix. It provides subscribers various features to encourage them to stay with the company.

For example, it offers one month free trials to potential subscribers with unlimited number of DVD rentals. As new customers experience free trials, NetFlix keeps track of movies they rented and provides individualized ratings on all movies in its inventory using its marquee queue system. New subscribers benefit from this feature by easily choosing movies that match with their preferences. It also automatically sends out movies that are on the top of subscribers’ queues as soon as they return the DVDs in their possession to NetFlix.

Along with NetFlix’s individualized services, its extensive DVD library, fast shipping, no return dates, and no late fees build and enhance customers’ brand loyalty. Its performance to date can be assessed by looking at the conversion rate of free-trial users to paid users and the retention rate of paid users after 6 months. If these rates are high, it implies that more free-trial users have converted to paid users, and more subscribers have continued to subscribe with the company. Therefore, high conversion and retention rates ultimately meet the company’s long-run objectives.

Its performance can also be measured by assessing the net present value of a new NetFlix subscriber and the total enterprise value. Net present value (NPV) shows whether the company’s cash inflows per new subscriber exceed its cash outflows per new subscriber. A positive NPV means that cash inflows exceed cash outflows, and it results in NetFlix making profit from each new subscriber. However, if it is negative, cash outflows exceed cash inflows, and thus results in NetFlix losing money for each new subscriber.

The total enterprise value indicates the net present value of the company as a whole by subtracting the present value of corporate costs from the present value of all projected subscribers and existing subscribers. By looking at the total enterprise value, we can see how much revenues are generated and how much costs are incurred by the company. Since NetFlix’s long term objectives are to attract and retain as many paid-subscribers as possible, it should ensure that the conversion and retention rates are high while the NPVs of a ew subscriber and the total enterprise value are positive. If the NPV of a new subscriber and the total enterprise are positive and high, it means the company is performing well. Forecasting Future Cash Flow Requirements with Netflix’s Subscriber Model A subscriber business model is typically used by businesses that have revenues dependent upon the number of subscribers and the durations of subscribers’ contracts. Such businesses include rental companies, magazines, newspapers, telephone / cell phone companies, cable television providers, Internet providers, and fitness centers.

What all those companies have in common is that they grant periodic access to products and services to their subscribers; period set under the contract can vary, from monthly, yearly, to seasonal. NetFlix should use a subscriber model because of several reasons. First, NetFlix is a movie rental company that allows its customers to rent DVDs for a monthly fee. Next, NetFlix’s primary objectives are to acquire as many subscribers as possible, and to retain both newly acquired and already existing subscribers as long as possible.

The reason why these objectives are significant is that once a subscriber is bound to NetFlix’s contract, the company books cash inflow in advnace from that subscriber, eliminating risk or uncertainty. Also, the longer NetFlix retains its subscribers, the higher the probability that subscribers’ loyalty develops. Development of brand loyalty ultimately attracts more subscribers and increases switching costs. Thus, the use of a subscriber business model to forecast NetFlix’s future cash flow requirements makes sense because its business and revenue models fit logically in to a subscriber model.

The basic elements of a subscriber model in this case include: the subscription fees (paid monthly), expected number of discs rented, shipping and disc acquisition costs, and other subscriber-related cash flows. Finally, the company must project the chance of retaining subscribers over set time horizons, and how many new subscribers will join NetFlix in the future. Subscriber Value & Acquiring New Subscribers The value of a new NetFlix subscriber is $41. 84 (see attached calculations). Even though NetFlix currently has a high acquisition cost per subscriber, it is necessary for the company to continue acquiring new subscribers in order o increase the company’s market share. Although NetFlix is allocating a large amount toward sales and marketing ($16. 4 million in 1999), this cost outlay is necessary because the company is still in its early stage of growth. The company will benefit from its subscriber base if they can turn their customers into loyal ones, as potential competitors enter the online video rental market. After a trial user is converted to a paid subscriber, the total monthly cost incurred by NetFlix drops from $107. 19 to $14. 15. As more competitors enter the marketplace, NetFlix will have the upper hand in terms of pricing power.

Even though the company may be inclined to drop their subscription rates as competition intensifies, it may not be forced to compete solely on costs. If NetFlix were to lower its subscription rate it charges its customers, cash inflow will narrow unless the company can either decrease operating costs and/or marketing and sales costs. Sensitivity of Valuation & Cash Flow Forecasts The value of a new subscriber and cash flow forecasts are sensitive to the total monthly costs associated with both a trial user and a paid subscriber.

During the trial month, the average number of discs that are viewed per month is 4. 26. Disc acquisition costs account for the largest component of the total monthly cost for servicing trial users. If the average number of discs increases by an average of one per month, the total monthly costs for a trial would rise to $116. 53, an increase of over 17%. The annual subscriber model and valuation of a new subscriber is also sensitive to the total monthly costs once a trial user is converted to a subscriber. NetFlix charges a set $20 per month fee for its video rentals.

With a total monthly cost of $14. 15 per paid user, the total cash flow NetFlix generates is $5. 85 per subscriber. If users view an average of one additional movie per month, total monthly cash flow generated per subscriber drops to $4. 85. If this were to occur, the value of a new subscriber would decrease by $11. 67 to $30. 17. Finally, if the probability of trial users that drop after the trial month ends increases by 10% to 40%, the value of a new subscriber would decrease to $28. 17. The annual subscriber model is unaffected by the change in probabilities after the first year.

Company Value & Business Model Assuming that NetFlix does not change its current business model, the value of NetFlix. com can be calculated using the following steps. To begin, as Exhibit 2 and the answer to question 3 suggest, the net present value of a new subscriber is $41. 84. In addition, using the historical data and future forecasts, we assume that the perpetuity growth rate, general and administrative expense growth rate, and product development growth rate are all 3%, while the DVD player growth rate is 50%. The value of a firm is the net of revenue and cost.

Revenue is equal to the number of subscribers multiplied by the value per subscriber ($41. 84). Therefore, we multiply the number of potential new subscribers with $41. 84 between 2000 and 2004, and add them to the current value of the company. Using a 20% discount rate and 50% new subscriber growth rate, the present value is $305,283. 24. The cost can be calculated by compounding the rate of growth of 3% to the base cost, which is $14,240 in the year 1999. Again, using the 20% discount rate, the present value of NetFlix’s costs is $79,578. 9. Subtracting the present value of corporate costs from the present value of revenues, the pre-tax enterprise value becomes $225,704. 75. After applying a tax rate of 40%, the after-tax enterprise value of NetFlix becomes $135,422. 85. Thus far, the existing business model seems like it does not need any modifications. However, if future expectations change, so should the discount rate, perpetuity growth rate, and G&A expense growth rate. A rise in the discount rate will decrease both the present values of revenues and costs.

It should be noted that the present value of revenues would decrease more than the present value of costs. A fall in the discount rate will increase the present values of revenues and costs, and once again, the effect on present value of revenues is much greater than the present value of costs. The changes in growth rates will have a negative impact on the value of NetFlix because a higher rate of growth means higher present value of corporate costs. Higher present value of corporate costs will lower the total enterprise value of the company. Our Recommendation The timing of NetFlix’s IPO is unfavorable for the company.

We believe NetFlix should delay its IPO until the financial markets have had a chance to begin recovery. We believe that going forth with the planned IPO in the midst of the high-tech bubble burst will be unfavorable for NetFlix, especially due to the fact that the company has not yet earned a profit on its operations and the fact that it is an Internet company. NetFlix should proceed with its IPO at a more appropriate time because its net present value of new subscribers is positive, in addition to the explosive growth in new subscribers due to the fast adoption rates in DVD players at 50% per annum.

The capital NetFlix will be able to raise from its IPO will enable the company to reach profitability faster than by foregoing it. Thus, in order to reach profitability, expand its customer base, and ensure a dominant market share already being realized by its early-mover advantage, NetFlix should proceed with its IPO once the technology sector begins to show signs of a turnaround. Convincing investors that an Internet company will be able to succeed after so many have failed, even with strong cash flow, a solid business model, and real assets will be no easy task during the near future.