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Too Bad Netflix Doesn't Charge by the Hour

Saturday - 4/27/2013, 5:00pm  ET

Earlier this month, Netflix CEO Reed Hastings announced on his Facebook page that viewers had streamed more than 4 billion hours of video on Netflix in Q1. That averages out to at least 1.33 billion hours per month; in contrast, Netflix first surpassed 1 billion hours of streaming video in a month in June 2012. Investors cheered the new usage information, on the premise that higher usage means more subscribers. Indeed, Netflix announced last week that it added 2.03 million domestic streaming subscribers and 1.02 million international subscribers in Q1.

However, the "hours watched" metric doesn't actually have much bearing on what Netflix is worth. If Netflix charged by the hour, then higher usage would be a proxy for sales growth. Instead, under Netflix's "unlimited viewing" policy, while total usage is correlated with revenue, the relationship is not one-to-one. Indeed, the impact of higher usage on Netflix's profitability is not at all straightforward. Netflix investors should therefore be careful of relying too heavily on non-financial metrics like "hours watched."

Usage and revenue: a divergence
Based on the data Netflix has provided, it appears that most of the increase in usage since last June is due to subscriber growth, but 5% to 10% of the increase can be attributed to Netflix customers using the service more. Netflix management has stated that customers who watch more content are less likely to cancel. Bulls would therefore argue that higher usage will improve revenue growth because fewer people will cancel their service in the future.

On the other hand, increasing usage per account could be the result of account-sharing. One analyst recently estimated that 10 million people use Netflix without paying, by sharing a Netflix customer's password. While these individuals are getting a lot of value out of their shared accounts, their high usage actually represents a revenue loss for Netflix (compared with paid accounts for both people). Some analysts had speculated that Netflix would crack down on account-sharing. Instead, the company's new $11.99 plan allows four simultaneous streams and could actually encourage more account sharing.

Higher usage in each account could also theoretically benefit Netflix by creating pricing power. If users value Netflix very highly, then the company could raise prices without losing too many subscribers. However, management has been adamant that it isn't interested in raising prices for the foreseeable future -- excluding the new $11.99 plan that allows up to four people to use an account at once. Given the level of customer outrage that followed the last price increase, Netflix is likely to remain extremely cautious on pricing. Overall, it's unclear whether Netflix benefits significantly from subscribers using the service more often.

Can usage drive costs?
On the flip side, heavy usage may actually be a longtime driver of cost increases for Netflix. While Netflix's content costs are fixed in the short term -- Netflix pays content owners a flat fee rather than paying based on usage or the number of subscribers -- everything is negotiable in the long run. According to the company's 10-K, almost 90% of Netflix's streaming obligations are due within three years or less. If content providers see that Netflix users want to consume a lot of their content, they will raise their prices as the contracts come up for renewal.

Netflix may already be seeing this occur. On the company's recent earnings call, management noted that Amazon.com and Hulu have been more active in bidding for content in the past year, and this competition has driven up prices. One result is that Netflix is allowing a broad licensing deal with Viacom to expire in May. Netflix hopes to license a few shows separately, but the rest will be removed. While Netflix can try to manage costs in this manner for a little while, it risks turning the virtuous cycle -- more content draws more users, driving higher revenue, which pays for more content -- into a vicious cycle.

Foolish conclusion
Unlike some companies that are very tight-lipped, Netflix provides investors a vast amount of information in its quarterly investor letters, blog posts, and other announcements. Investors need to sift through this information and figure out what is actually relevant. "Hours watched" does not seem like a particularly good metric for investors to follow. In the long run, higher usage probably increases both revenue and costs, but there is simply not enough data yet to know which factor will outweigh the other.

Netflix's long-term value will ultimately be driven by its ability to generate pricing power, so that it can pass through price increases from content owners like Viacom, rather than losing content or sacrificing margins. If investors chase "canards" like usage statistics in evaluating Netflix's business model, they may end up overlooking the most important information about the company's health.

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