Case Analysis: Netflix. com, Inc k JAVK Consulting Company 6/14/2011 600 Civic Center Dr Detroit, MI 48226 Dear Mr. Hastings, Our company JAVK Consulting has examined the Netflix customer model and looked into the company’s five year financial future. We have analyzed Netflix with a scope of entering a rocky internet based company marketplace and seeing success in the future. The company currently is pumping lots of money into marketing strategy in order to growth their customer base and is in turn facing financial troubles while they approach their initial public offering stage.
As you read through our analysis of Netflix you will find our company’s thought on your financial performance so far, look into a subscriber model and correlated cash flows, and develop an idea of financing solutions to manage growth. While more users are using mainstream technology such as DVD players, video game consoles, laptops, combined along with high-speed internet the creates a growing environment for a consumers wanting entertainment at their joysticks and fingertips. Our aspiration is for Netflix to have a successful run at an IPO if chosen and manage their customer growth along the way for long term success.
Thank you for the chance to help your business thrive. We hope you agree with our financial outlook of Netflix and make a decision that catapults your company into financial success. Sincerely, JAVK Consulting Group Problem Statement: Based on Initial discussion and evaluation, we understand that the launch of Initial Public Offering (IPO) is critical and needs to be evaluated if the company should go forward with the offering, as a result of number of internet companies have been forced to withdraw their IPOs due to market down turn.
Secondly the need to show positive cash flows within a twelve month horizon in order to have a successful offering. Third to suggest modifications that would improve the company’s projected cash flows given the fact that the revenues were doubling every six months. One of the most critical points of success for Netflix depended on the company’s ability to manage and sustain their triple-digit growth into the foreseeable future. Analysis: Technology is continuously facing rapid change which gives a company such as Netflix an exclusive opportunity for a first mover advantage in a new market.
The Netflix product is one that can ship easily and cost effectively or be received directly to internet connections worldwide. The definite increase in internet and console users is creating a consumer demand for entertainment that Netflix can fill. This versatile product paired with emerging technology has led to rapid growth for the Netflix Company. The basic elements of Netflix core products give them an advantage over brick and mortar stores such as Blockbuster as Netflix offers a more personalized movie experience, the same new titles, all along with no time restrictions or late fees.
As part of this long term objective Netflix’s goal is to grow its customer base and retain users of free trial software. The goal of the free software is to have a positive acquisition rate of free trial users after a month of free service and retain them into the long run future. After retention, the goal of Netflix is to withhold those customers into the long term future by tailoring the Netflix product in a unique way to each customer. Netflix does this by adapting their website interactions for each customer based off of their viewing history and preferences using a unique personal movie finder service.
By offering this personalized service video users can find movies they would enjoy and possibly use the Netflix mail service. Theoretically speaking, Netflix performance to date has been positive (although the company has been incurring loss year over year) considering the high operating expenses for the initial years of a new business is common as most businesses make it or break it in their first 2-3 years which seems to be a normal trend considering this industry where the fixed assets increase year over year and the revenue generated on the fixed assets could drastically diminish based on user preference.
Netflix has an extremely high growth rate for their revenues as they are doubling every six months. While revenues are doubling in the last year sales and marketing expenses have gone up more than three times. The main objective now is to make sure that after an initial public offering Netflix will continue to create positive cash flows. We believe that Netflix has chosen the subscriber model to forecast its cash flow requirements because it is the most precise representation of how the company receives cash on a monthly basis.
Netflix at its core is in the movie rental industry, the only cash inflows received are from subscribers that pay monthly subscription fees. The basic elements of the subscriber model are monthly subscribers, subscription fees, and movie usage including movies rented and shipping costs. Based on these elements costs and revenues can be narrowed down and correlated to individual aspects of the model and accurate cash flows can be formed in order to predict future profitability. The subscriber model is fitting for Netflix for these reasons as subscribers are essentially their only cash inflows.
Exhibit A, illustrates the subscribe model premise. In our analysis, we used the subscriber model to forecast future cash flows. This allows us to see potential revenues month to month based on the initial subscriber rate and percentage, while incorporating the cost to your company for each additional subscriber. We have forecasted potential cash flows as well as revenues for the next five years (Exhibit D & Exhibit E). This gives us an idea of where we are going and how we will get there. Currently it costs your company $106. 58(Exhibit B) for the first month of a free trial customer.
This cost is offset by paid subscribers and can be considered a marketing expense. Every month each paid subscriber earns you on average $5. 82 (Exhibit B) in revenue. Netflix should continue trying to obtain new subscribers since there is a positive cash inflow for those customers after a weighted average is formed. Based on the weighted average of customers who stay with Netflix and those that leave there is a positive NPV based on the retention percentages. There are three basic types of customers for Netflix, one month trail exiting users, six month exiting users, and over five year users.
Based off the retention ratios after one month 70% of customers from the free trail stay with Netflix, after that first month 42% of the original 70% stay for six months and 28% stay longer than six months (we have assumed it to be of at least 5 years and above). If a customer leaves after one month of free service your company would suffer a loss of $19. 26 (Exhibit B) given the fact that the initial purchase ($98. 28) of DVD(s) can be reused ($88. 45) for the other new subscribers by purchasing an incremental of 2 DVD(s) which move to the back catalogue as they become obsolete.
Netflix can convert and retain those customers for six months they generate $1. 21(Exhibit B) of cash inflow for each customer. If the cash flow from acquiring new subscribers was negative we would advise your company to take an alternate route for generating cash flows. If your company continues with current business, retaining 28% of initial customers at least 5 years and above, the net present value of your corporation will be $65,851,642 (Exhibit E) based on certain assumption listed in Exhibit E.
This NPV of your company after 5 years is based on the weighted average NPV percentages that we determined for each of the three customer categories; one month subscribers, six month subscribers and five year subscribers. Over sixty five million as a NPV is a glamorous number to project but it requires your company to retain the current customer retention ratios over the three timeline increments (Exhibit C). If these retention ratios are held strong then we have determined the weighted NPV per subscriber would be $34. 34 (Exhibit C).
While this number is far from over sixty five million dollars over the five year time retention span it grows to be exactly that. Conclusion/Recommendation: Based on our analysis we have come up with some solutions to improve your overall cash flows and strengthen the financial health of your company. These solutions are not far from the product that Netflix currently offers so making the changes would not place a large burden on costs. Also, the changes will offer a more customer focused and interactive experience with the Netflix product.
Initially your first goal should be to increase the retention rate of potential new trial subscribers. Given that internet users are increasing year over year, we recommend that your company consider online video streaming (video on demand) which will be an out of the box approach. Using the online media streaming can help your company to cut down on sales and advertising cost. Secondly with introduction of online streaming reduce the membership fees to 75% of the current rates which will help you increase customer retention rates.
Third, promote revenue sharing which can help increase you marketing base while cutting your expenses. Forth is to promote referral bonus (can vary based on number of referrals provided) which can help you boost your sales through you existing customer base and in return reduce your operational expenses. Lastly to reduce the trial period to 2 weeks (if done by Mail only) and this will result in increase of NPV of Netflix by $25. 8 million (increase of NPV/subscriber from 34. 34 to 44. 10). Netflix is becoming even more personalized and may cut undesired costs such as unnecessary shipping costs.
By doing this you will increase your profitability and decrease your cost to acquire a new customer. Another recommendation is to continue to encourage all online subscribers to rate films. This will encourage other subscribers to rent more movies and help with the automatic marquee queue available to online subscribers. By encouraging this interactive use with the Netflix website the company will have an idea of which DVD’s to spend money purchasing and will be able to keep an updated DVD library that meets the growing demand of new subscribers.
To conclude, your company should delay the IPO until the economic condition improves and use this additional time to evaluate some of our recommendation to attain positive cash flows which can play in your favor. Appendix: Exhibit A - Subscriber Model Premises| Cost/New DVD| $ 17. 55 | Shipping Cost/DVD| $ 1. 00 | Number of DVD Initial Marque Queue| $ 4. 00 | Number of DVD Shipped /Month| $ 4. 30 | New DVD 1st Month| $ 5. 60 | Number of new DVD(s) subsequent Month| $ 0. 56 | Revenue /Month| $ 19. 95 | Free trial| $ 1. 00 |
Discount Rate| 20%| Exhibit B -New Subscriber Model| | Free| Paid| Paid| Paid| Paid| Paid| Paid| Paid| Paid| Paid| Paid| Paid| | M1| M2| M3| M4| M5| M6| M7| M8| M9| M10| M11| M12| Revenue| | $19. 95 | $19. 95 | $19. 95 | $19. 95 | $19. 95 | $19. 95 | $19. 95 | $19. 95 | $19. 95 | $19. 95 | $19. 95 | Cost of DVD/ initial (one time)| $ (98. 28)| | | | | | | | | | | | Cost of DVD/ releases| | $ (9. 83)| $ (9. 83)| $ (9. 83)| $ (9. 83)| $ (9. 83)| $ (9. 83)| $ (9. 83)| $ (9. 83)| $ (9. 83)| $ (9. 83)| $ (9. 83)| Shipping initial DVD's| $ (4. 0)| | | | | | | | | | | | Shipping new DVD's| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| $ (4. 30)| Net Revenue| $(106. 58)| $ 5. 82 | $ 5. 82 | $ 5. 82 | $ 5. 82 | $ 5. 82 | $ 5. 82 | $ 5. 82 | $ 5. 82 | $ 5. 82 | $ 5. 82 | $ 5. 82 | Exhibit C - Calculation of Net Present Value per new subscriber| | *assumes that if a subscriber stays with Netflix longer than 6 months will stay 5 years| Subscribers | 1 Mon| 6 Mon| 5 Yrs. *| | Probability| 30%| 42%| 28%| |
Weighted NPV per Subscriber| ($19. 26)| $1. 21 | $141. 46 | $34. 34 | | | | | | C1| $ (106. 58)| $ (106. 58)| $ (106. 58)| | C2| $ 88. 45 | $ 5. 82 | $ 5. 82 | | C3| | $ 5. 82 | $ 5. 82 | | C4| | $ 5. 82 | $ 5. 82 | | C5| | $ 5. 82 | $ 5. 82 | | C6| | $ 5. 82 | $ 5. 82 | | C7| | $ 88. 45 | $ 5. 82 | | …| | | … | | C8| | | $ 5. 82 | | C60| | | $ 5. 82 | | C61| | | $ 88. 45 | | CF By Month| | | | |
Exhibit D - Projection of new subscribers 2000| | | Revenue Growth rate 1998 --> 1999 | 274%| Existing subscribers| 110,724 | New Subscribers paid status| 303,231 | 30% free| 90,969 | New Subscribers 2000| 394,201 | Exhibit E - Value of Netflix| | 2000| 2001| 2002| 2003| 2004| | | | | | | | NPV per Subscriber| $34. 34 | | | | | | Discounted Rate| 20%| | | | | | Growth rate per new subscriber| | | 49%| 49%| 49%| 49%| | | | | | | | Existing subscribers| | 110,724 | | | | | Value of existing subscribers| | 3,802,273 | | | | | | | | | | | |
New Subscribers| | 394,201 | 587,359 | 875,165 | 1,303,995 | 1,942,953 | Value of new subscribers| | 13,536,829 | 20,169,875 | 30,053,114 | 44,779,140 | 66,720,918 | | | | | | | | Total subscriber value| | 17,339,102 | 20,169,875 | 30,053,114 | 44,779,140 | 66,720,918 | | | | | | | | Product development| | 7,413,000 | 7,413,000 | 7,413,000 | 7,413,000 | 7,413,000 | General and administrative| | 2,085,000 | 2,085,000 | 2,085,000 | 2,085,000 | 2,085,000 | Total Cost| | 9,498,000 | 9,498,000 | 9,498,000 | 9,498,000 | 9,498,000 | | | | | | | |
Total Subscriber value minus cost| | 7,841,102 | 10,671,875 | 20,555,114 | 35,281,140 | 57,222,918 | NPV of Netflix| | 65,851,642 | | | | | Assumptions:| Existing customers pay 19. 95 per month (same as new customers)| Additional cost projected at the same level as 1999NPV of Netflix only includes cash inflow and outflows and have not considered any liquidation value|