Netflix Case Analysis



  1. What is Netflix’s long-run objective? How does Netflix plan to achieve its long-run objective?  How would you assess Netflix’s business model
Netflix has long-run objectives such as growth and increases market share in a billion dollar market. The company is trying to go public with an initial public offering. 
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 an unlimited number of DVD rentals. Netflix’s performance has been good in the sense of continued revenue growth and increased market share. Even though Netflix has incurred net losses in their first couple years, their outlook is positive for future growth into profits. 

2. Why does McCarthy use a subscriber model to forecast Netflix’s future cash flow requirements? What are the basic elements of a subscriber model?

There are several reasons why Netflix should use a subscriber model.  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 advance 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.

The basic elements of a subscriber model, in this case, include the subscription fees (paid monthly), expected the 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.

3. Construct an annual subscriber model for Netflix that can be used to forecast the expected cash flows for a new subscriber over the next five years.  What is the value of a new Netflix subscriber?  Assume a discount rate of 20%.  Should Netflix be acquiring new subscribers?


Subscriber Model

Please refer to the Excel Spreadsheet (Value of a New Subscriber)

Acquiring New Subscribers
Although Netflix currently has a high acquisition cost per subscriber, it is necessary for the company to continue acquiring new subscribers in order to increase the company’s market share. Although Netflix is allocating a large number of 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.

4.Assuming that Netflix does not change its current business model, what is the value of Netflix.com?
If we suppose that Netflix's business model remains the same,  the value of  NetFlix.com can be calculated using the following steps. To begin, as Exhibit 2 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 $79,578.39. 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.

             5What changes, if any, would you suggest be made to its existing business model? 
                  What are the value implications of these changes?

We can assume that 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 the 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 the higher present value of corporate costs. Higher present value of corporate costs will lower the total enterprise value of the company.

In order to increase the cash flow and raise profit, we would suggest Netflix enter into revenue-sharing agreements with famous and profitable movie studios. We can provide an example of Universal Studios or The Walt Disney Company. Agreements with companies of this level would not only cut costs of the DVD acquisition but also help the promoting Netflix as a fresh and very little known company. Users who might be in doubt about Netflix might put faith in the company after learning about their partnership agreements with famous studios who have been in the industry for a long time.
             
Therefore, we suggest McCarthy offer revenue-sharing agreement with one of the above mentioned or other well-known studios for the time period of two years. The revenue will be shared 50/50 (Netflix receives $10 on monthly revenue instead of $20), which also decreases the acquisition of DVD to 50% which is   $49.45 for the first month and $4.95 subsequent months. We also changed the probability of subscriber outcome. Subscriber dropping after the first month is 20%,  Dropping after sixth month 32% and retaining a subscriber is 48% which is quite realistic. These modified probabilities and revenue-sharing agreement resulted in the NPV of a New Netflix Subscriber to increase from $35.43 to $43.01. These changes also affected the total Netflix cash flows. Company is still in loss of $14,991,000, $16,514,000 and 7,505,000 for the Year 1, Year 2 and Year 3       respectively. And the positive cash flows that Netflix made for the Year 5 and Year 6 are $12,219 and $23,235 respectively.  Pre-tax enterprise value of the company went from  $227,017,025.87
 to $271,583.59  as a result of the changes.
           
We can see clearly that arise 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 the 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 the higher present value of corporate costs. Higher present value of corporate costs will lower the total enterprise value of the company.

Conclusions and Recommendations

 As for free month trials, If we were McCarthy, we would definitely keep the free month trials. Because this is the way to attract potential customers to the company. If the free trials are eliminated, it will affect the market share negatively and Netflix might end up doing even worse than it started in 1999 and 2000.   Therefore, free monthly trials should be retained to get a bigger lump in the market.

 As for the IPO, it will not be possible until the negative cash flow is turned into positive. In our case, it will not be possible until Year 4 when a company starts with earning profit instead of incurring losses. Therefore, McCarthy should wait with  Initial Public Offering until Netflix gets into better shape. To improve its financial state, signing agreements with studios should also be considered as it was mentioned above. 
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