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  • Brett Schafer

How High Can Netflix Raise Prices?

With news out this week that AT&T’s streaming service will cost $16-$17 a month, investors have to be asking themselves: how high could Netflix raise prices before they lose subscribers? Why should they be asking that? Because the answer will determine where the stock price will be in 3-5 years.

As they’ve transitioned to spending more and more on original content (now the biggest spender in the world), the video streaming pioneer has been able to raise prices around 5% per year. But earlier this year, Netflix announced its largest price increase ever. The standard HD plan now costs $13 a month, up from $11, and it looks like no one even batted an eye. That shows Netflix has extraordinary pricing power and has been drastically underselling its product by trying to grow users as fast as possible.

I am going to try and deduce how much Netflix could charge for its service and what impact it would have on the company’s earnings. But first, we need to see what the business looks like right now.

By the Numbers

The cool thing about Netflix is how simple their business model is. All you need is two variables (total subscribers and how much they pay) to figure out the company’s top-line. Here is a chart from their latest earnings report outlining the most important financial figures. Pay attention to the last column. Yes, it is only a forecast, but Netflix is historically precise on their financial guidance, so we can expect with high probability they will hit those numbers +/- 5%.

Source: Netflix

Two numbers popped-out to me. One is the expectation for operating margin to expand in the second quarter. This is occurring because of the recent price hikes in the United States, which offset lower prices paid by some international customers.

Another interesting tidbit is the YoY growth in memberships. As you might expect, as Netflix gets larger and more saturated, growth has started to slow. However, right now it is only slowing by 1-2 percentage points a year, which is helping them stay on pace for a record number of absolute subscriber adds in 2019.

Source: Netflix

If we are going to base our future expectations on this chart, it wouldn’t be unreasonable to see around 30 million “Net Adds” every year for the next few years. Based on an average-revenue-per-user (ARPU) of $10.50 a month, which is around what Netflix gets right now, that’s $3.75 billion in additional revenue annually.

But what if Netflix could get an ARPU of $11, $12, or even $12.50 a month? What would their sales and profits look like? Let’s take a look.

The Power of Price Hikes

Investors underestimate the effect of gradual price hikes because they also apply to the existing members, not just new sign-ups. For example, based on the guidance for 153.86 million subscribers at the end of Q2, a $1 price increase ($12 per year) would instantly add $1.846 billion in sales with little user downside. I mean, how many people are canceling Netflix because it costs $14 vs. $13 a month?

Now let’s do some back-of-the-napkin financial estimations. Here is a table of what Netflix’s core financials would look like, assuming 30 million subscriber adds, 5% growth in ARPU, and steady growth in content spend. YearSubscribersARPUAnnualized RevenueContent Spend +Operating ExpensesOperating Income2019154$10.50$19.4$19**$0.42020184$11.025$24.3$22$2.32021214$11.58$29.7$25$4.72022244$12.16$35.6$26$9.62023274$12.77$42.0$28$14

*ARPU is monthly. Dollar amounts besides ARPU are in the billions. Subscribers extrapolated from Q2 2019 guidance and are in millions.

**Content spend will be around $15 billion in 2019.

Please don’t get caught up in whether you think my estimates for content spend and operating income are way off from what you expect. Nobody, possibly even Netflix themselves, knows how much they will spend on content in 2023. All I wanted to do here was give a conservative estimate of what Netflix’s operating income could be in 2023 based on the current company trends.

Take a look at the far-right column above. If Netflix wanted to, it could grow its operating income to around $14 billion in 2023 with slowing user growth and only 5% annual price increases. But what does that mean for the stock price at its current valuation?

Stock Valuation

As of writing this, Netflix has a market cap of $158 billion, a trailing P/E of 129, and a forward P/E of 61.5. The stock has been “expensive” for the past 10 years, which has led it to be a popular (and terrible) short call and extremely divisive among analysts.

If we apply an 18% tax rate on our $14 billion operating income estimate for 2023, it looks like Netflix could have a net income of $11.48 billion. That would give them a P/E of 13.75 based on their current market cap. But there’s no way a stock growing the top line at 18% and bottom line at 45% (the 2023 estimates from the table) would have a P/E that low.

Netflix would likely enjoy a Microsoft-level earnings multiple of 25-30 since they both have highly stable, recurring revenue business models. That means if Netflix executes on its growth and profitability strategy, the stock could (emphasis on could) double over the next five years.

What has me worried about Netflix is the quality of content they are producing. I only watch 7-10 of their original shows/documentaries every year, which makes me hesitant to think I would be willing to pay $12-$15 a month for the service.

But if we look at the statistics, it on average users are still highly engaged with the service. Based on a 2018 report, members watch Netflix for 50 minutes a day, or around 25 hours a month. That means they are essentially only spending $0.42 per hour of watch time, based on a $10.50 ARPU. Talk about a value proposition!

Personally, I’m more of a fan of Disney stock and think they will offer an even better deal once Disney+ comes out for $6.99 a month. However, if Netflix’s stock price continues to hover in the mid-300’s range by the end of this year, the growth potential may be too high to pass up.

Disclosure: The author is not a financial adviser, and may have an interest in the companies discussed.

#Netflix #Pricehikes #Profitability #Streaming

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Listen On: Spotify Apple Podcasts Disclosure: The author and podcast guests are not your financial advisors. Ryan Henderson and Brett Schafer are general partners and portfolio managers at Arch Capita

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