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Case Study

Ron Golan

Andy Shin

Kevin You

March 25, 2008

BMGT 440 – Professor David Kass

Company Background & The Issue At Hand, 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, offering pay-per-
DVD 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. 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
new 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 to 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 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 $79,578.39. 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.

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.