If you're a Netflix follower (and these days, who in the industry isn't?) then this morning you're being greeted by many cheerful headlines regarding the company's Q4 '11 results, released late yesterday. A sampling includes: "Netflix shares surging after a blowout quarter," "Netflix wins over analysts by adding customers," "Netflix recovers subscribers" and "A turnaround at Netflix, as its mail sector shrinks." All of that is contributing to a run-up in Netflix's stock price, based on optimism that the company is back on track, and ready to surge again.
To be fair, given the negative sentiment shrouding Netflix for the last 6 months and dramatically reduced expectations, the results did show some glimmers of a turnaround. But, if you read past the headlines, look closely at the numbers and listen to management's discussion of the results, what emerges for me are the staggering ongoing consequences of last summer's Qwikster/price change fiasco, the continued pursuit of an unnecessary, hyper-aggressive phase-out of its core DVD-by-mail business, murkiness about its international prospects and near-certain intensifying competition in streaming. Given all that, I think it's still way too early to conclude Netflix is back on track, particularly in the U.S.
First, the Q4 numbers demonstrate that last summer's Qwikster/price increase decisions continued to impact the company's U.S. subscriber base, contrary to management's characterization, in its Q2 '11 earnings release, that subscribers would only be hurt in Q3 ("in Q4, we expect domestic net additions to return to a pattern of year-over-year growth…"). The damage is primarily among "hybrid" DVD/streaming subscribers. Recall this is the group that had its monthly rate hiked by as much as 60%. As shown in the Venn diagrams I've created below, Netflix shed approximately 3.2M hybrid subscribers in Q4, a whopping 28% of the 11.6M it ended Q3 with. That contributed to Q4 U.S. churn totaling 4.6M subscribers, up from 2.4M in Q4 '10. Combine Q4's 4.6M with Q3 '11's churn of 5.5M and Netflix has dropped over 10M subscribers in the last 6 months in the U.S. Talk about a remarkable reversal: Netflix added 12 million subscribers in the prior 6 quarters Q1 '10 to Q2 '11 but could only muster up another 600K in the U.S. in seasonally-strong Q4 '11.
But the damage to the hybrid group isn't close to over. The mid-point of Netflix's Q1 '12 forecast is to lose another 1.5M DVD subscribers (this includes both hybrids and DVD-onlys, but will mainly come from hybrids), and according to CEO Reed Hastings, this will continue "forever." Netflix's rationale for forcing this wrenching adjustment is so that it can focus entirely on streaming, and so that as the company expands internationally with streaming-only service, its brand will stand for "streaming-only."
This emphasis on brand purity is coming at an enormous, and in my opinion, completely unnecessary cost to the company. Rather than running away from hybrids as fast as it can, Netflix's strongest strategic positioning actually would be to emphasize the hybrid service, and use it as a graceful bridge to a long-term streaming-only world. As I've said repeatedly in the past, hybrid combines the best of both worlds: DVD's choice with streaming's convenience. As research bears out, for most real-world Netflix subscribers (i.e. those not living within an hour's drive of Netflix's Los Gatos offices) streaming provides a taste of an exciting future, but DVDs still account for a lot of viewing.
It's also worth noting that in Q4 DVD subscribers were much more profitable than streaming subscribers: the dwindling base of 11.1M DVD subscribers contributed $194M of profit in the quarter while the 21.7M streaming subscribers contributed just $52M. And notice something else peculiar in the Venn diagram above - DVD-only subscribers actually increased by 400K in Q4, representing two-thirds of its U.S. growth in the quarter. Despite Netflix doing virtually all it can to de-emphasize DVDs (management said "no specific DVD retention efforts or marketing are planned"), 400K subscribers proactively chose DVDs over streaming, providing still further evidence that DVDs have real value to a meaningful segment of the population.
The watchword these days among media executives trying to navigate their companies through the technology changes roiling the industry is "balance." As in, it's critical to pursue exciting new technology-driven opportunities but this must be balanced by the need to preserve existing business models to the greatest extent possible. That is what investors expect, and importantly, it's also what loyal customers expect. With everything that's going on these days, achieving balance is increasingly difficult. But it is possible. HBO is a good example; it is embracing multi-screen access with its HBO GO app, which its subscribers love, but is balancing that initiative by still requiring an underlying pay-TV subscription, which its business model requires. Importantly, HBO is also keeping its options open for a possible future move to direct-to-consumer.
Bizarrely, for Netflix, "balance" does not seem to be in its vocabulary. No question, streaming is the future, but DVDs are still very much the present. Yes, there are ever-greater variable costs in servicing the DVD business (postage, buying DVDs), but as Netflix management admits, most of its DVD distribution infrastructure is fully depreciated and represents little ongoing cost. All of this would argue for Netflix having balanced its pursuit of streaming with the preservation of DVD to the greatest extent possible - in other words, positioning the hybrid service front and center instead of kicking it to the curb as it has. Given the mind-numbing product extensions managed in the CPG industry, for example, I believe a dexterous marketing executive - who Netflix should have long-ago recruited from that industry or a similar one - could have easily handled this branding assignment and ongoing evolution of the Netflix value prop.
Netflix's Q4 results show the disruptive impact of the company's "streaming at all costs" strategy. Although Q4 streaming usage was strong, the domestic content catalog is improving and Q1 streaming subscribers additions are said to be in line with last year's quarter, Netflix's results will be haunted throughout 2012 by its purposeful evisceration of its once prized DVD business. Meanwhile, Amazon and others will be ramping up their competitive streaming offerings, posing new challenges. Maybe Netflix can resume its torrid subscriber growth as giddy investors this morning are banking on, but with Netflix forcing so many existing hybrid subscribers to the exit, the likelihood of strongly growing the overall domestic business seems quite daunting indeed.