S7-1 Evaluating Netflix\'s Decision to Separate Its Lines of Business and Raise

Question

S7-1 Evaluating Netflix's Decision to Separate Its Lines of Business and Raise Prices In July 2011, Netflix decided to separate its DVD-by-mail service from its streaming video service. In addition to the hassle of receiving two bills instead of one, Netflix subscribers now had to pay about $16 for both services, when they previously only paid about S10. Many Netflix customers were outraged by this decision, and the company reportedly lost about 1 million of its 25 million subscribers due to this decision. In response to the uproar from customers and investors, Netflix co-founder and CEO, Reed Hastings, posted a letter of explanation on the company website. He did not apologize for the decision to split the services and raise prices, which he maintained was the right strategic decision given the importance of streaming video to Netflix's future. However, he acknowledged that he should have done a better job of communicating the rationale for the change to customers in advance of making the change. Consider the following additional information and estimates: Prior to the split, Netflix had about 25 million subscribers who were paying an average subscription fee of S10 per month. After the split, Netflix estimated the following: o 21 million subscribers would continue with the streaming video service, o 12 million of those subscribers would also continue with the DVD-by-mail service. o 3 million users would subscribe to DVD-by-mail only. The new subscription fee for each service is dollar 8 per month. Assume that variable costs of the DVD-by-mail serv ice (for shipping, handling, and DVD replacement) are S0.40 per movie exchange and that the average user exchanges 5 movies per month. The variable costs of the streaming video service are negligible. Required: Determine how much Netflix's monthly profit would increase or decrease with the new pricing and subscription structure. If you were a Netflix shareholder, how would you react to this change? Optional: This is an opportunity for you to research what actually happened to Netflix's stock price in the days and months after the price change. Do you think Netflix made the change to boost short-term or long-term profit? In your opinion, was Netflix's decision to separate the streaming video from DVD-by- mail a good one? SHOW ALL THE WORK LEGIBLY TO SUPPORT YOUR ANSWERS

Explanation / Answer

Part 1)

The increase/decrease in profit is calculated as below:

Current Revenue = 25,000,000*10 = $250,000,000

Net Revenue with Revised Price Structure = 12,000,000*16 [Subscribers for Both Services] + (21,000,000 - 12,000,000)*8 [Subscribers for Video Service Only] + 3,000,000*(8 - 5*.40) [Subscribers for DVD-by-mail] = $282,000,000

The profits would increase by $3,200,000 [282,000,000 - 250,000,000].

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Part B)

The objective behind changing the price structure would definitely be based on the company's expectations for increase in revenue and better profitability in the future. As a shareholder, I would expect the price of the stock to go up as improved revenues will result in higher profits indicating capital appreciation of my investment in the company. I will, therefore, continue to hold the stock irrespective of the initial resistance that may be faced by the company's management from its existing user base.

____________

Part C)

Netflix obviously made the change to boost long-term profit. It is so because, Netflix's management must have taken into consideration the fact that many of its existing users may not find the change favorable and may react negatively which in turn might result in a reduction in the sales value in the near future or for a few quarters/years. The benefit of change in pricing structure will be realized only after the users overcome the initial resistance and understand the importance of the company's business strategy.

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Part D)

The company has made a strategic decision keeping in view the future of online video streaming. The company must have done all the calculations before implementing the change. With the growth of internet, the demand for streaming video service is expected to increase manyfold while the company may face a decline in demand for DVD-by-mail service. Also, customers willing to subscribe only the streaming service will have to pay lesser money ($8 against $10) to avail the service. All these factors must have been taken into consideration before seperating the divisions.

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