On Netflix, Here’s the Metric Worth Watching

Last week’s New York Times had an article detailing Netflix’s recent brush with near-extinction thanks to a premature attempt to focus the company on the streaming video business and away from the DVD business. While the latter was key to winning the competitive battle with Blockbuster, Netflix CEO Reed Hastings saw tablets and other mobile devices as the future platforms for the consumption of entertainment—much like Walter Brooke’s Mr. McGuire in The Graduate, who believes that the future lies in plastics and tries to convince Dustin Hoffman’s Ben Braddock to consider it for his own future.

Not wanting to be caught flat-footed, like other companies with legacy technologies that did not move quickly enough to embrace the new (think Kodak and the move from traditional film to digital technology), Hastings announced in September 2011 the separation of the DVD and streaming businesses. The DVD part was to become a new company called Qwikster.

Unfortunately, there were two issues that stood in the way of a smooth transition: first, Netflix tried to raise the price for the service; second, the content available for streaming was inadequate. As a consequence, the company lost 800,000 subscribers and the stock price plunged. Customers, used to exceptional quality that Netflix typically provided, were disappointed with what they saw as an attempt to make more money. It has taken almost a year and half for the company’s stock price to get back to where it was. One can almost hear the “Deshi Basara!” chants from the The Dark Knight Rises (I understand it loosely translates to “Rise up!”) when Bruce Wayne attempts to escape the pit of his despair.

Largely, the comeback has been attributed to a reversal of the Qwikster decision along with a focus on the core promise of customer service—providing the content the customer desires (including exclusive content such as House of Cards and Hemlock Grove) via the channel the customer finds most convenient (DVD or streaming) at a price that the customer feels is reasonable. The company has also, it seems, discovered that there are two broad segments in the market: one loyal to the DVD format, which has been reducing in size, but slowly, and the other a streaming segment that has been growing at a good clip as more content becomes available, connection speeds improve, and devices get better.

With services such as Netflix, a metric to keep a close eye on is customer lifetime value. Literally, it refers to the discounted present value of the stream of income generated by a customer over her lifetime. While ideally this would also include referral and word-of-mouth income generated by the customer, for most practical purposes, the metric focuses on the individual customer’s interactions with the company.

In their Harvard Business Review article and book, Sunil Gupta and Donald R. Lehmann provide an elegant description of the concept and provide a number of readily applicable rules of thumb to compute CLV. A simple version of the formula is the product of income obtained from the customer in any given year (call this M) multiplied by an income multiplier, which in turn depends on how likely the customer is to stay a customer the next year (the retention rate, R) and the rate at which the company discounts future cash flows (the discount rate, I). From this, we subtract the cost of acquiring the customer (i.e., marketing costs, A). Putting these factors together leads to the CLV formula:

M/(1 – R + I) – A

Further, if one expects margins to grow at the rate G a year, the formula can be modified as:

M/(1 – R*(1+G) + I) – A

The formula can also accommodate a growing base of customers over time.

In its quarterly results released last week, Netflix announced a gross margin of $297 million from a customer base of 42 million subscribers. This suggests a quarterly gross of $7.06 per customer, or $28.25 for the year. The results also mention marketing costs of $129 million-plus, which spread over its customer base works out to a quarterly acquisition cost of $3.07, or $12.28 for the year. If one assumes a 95 percent retention rate and a discount rate of 10 percent, this leads to a CLV of $188.32, which multiplied by the size of the customer base leads to about $8 billion in customer value. Interestingly, if one assumes that margins will grow at a rate of 5 percent a year, the resulting CLV of the customer base is about $12 billion, close to the current valuation of the company. One can now look at various scenarios as to what would happen with changes in retention rates, margins and margin growth, and customer base, and evaluate the CLV impact. Ultimately, these movements will be reflected in how the company is valued by the financial markets.

For now, though, the company seems to have overcome its recent travails. By not splitting up the services, it has stanched the outflow of customers, bringing its retention rate back up. However, margin pressures do exist with the availability of rival services such as Amazon Prime (which charges an annual fee and provides the additional benefit of free two-day shipping on all Amazon purchases). Finally, customer acquisition costs also are likely to mount if one accounts for the costs of new programming that seems critical for attracting new customers. How Netflix manages these diverse set of pressures over time will reveal its ability to sustain its stock price.

Pradeep K. Chintagunta is the Joseph T. and Bernice S. Lewis Distinguished Professor of Marketing at Chicago Booth.