Netflix IPO Questions. 1. What is Netflix’s long-run objective? How does Netflix

Question

Netflix IPO Questions.

1. What is Netflix’s long-run objective? How does Netflix plan to achieve its long-run objective? How would you assess Netflix’s business model

2. Why does McCarthy use a subscriber model to forecast Netflix’s future cash flow requirements? What are the basic elements of a subscriber model?

3. Construct an annual subscriber model for Netflix that can be used to forecast the expected cash flows for a new subscriber over the next five years. What is the value of a new Netflix subscriber? Assume a discount rate of 20%. Should Netflix be acquiring new subscribers?

4. Assuming that Netflix does not change its current business model, what is the value of Netflix.com? What changes, if any, would you suggest be made to its existing business model? What are the value implications of these changes?

Explanation / Answer

1. 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-runobjectives by building and enhancing customers’ brand loyalty in NetFlix. It providessubscribers various features to encourage them to stay with the company. For example, it offersone 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 assoon as they return the DVDs in their possession to NetFlix. Along with NetFlix’s individualizedservices, its extensive DVD library, fast shipping, no return dates, and no late fees build andenhance customers’ brand loyalty.

Its performance to date can be assessed by looking at the conversion rate oubscribers have free-trialusers to paid users and the retention rate of paid users after 6 months. If these rates are high, itimplies that more free-trial users have converted to paid users, and more , high conversion and retention ratesultimately meet the company’s long-run objectives

continued to subscribe with the company. Therefore, high conversion and retention ratesultimately 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 thecompany’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 valueindicates 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. Bylooking at the total enterprise value, we can see how much revenues are generated and how muchcosts 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 anew subscriber and the total enterprise value are positive. If the NPV of a new subscriber and thetotal enterprise are positive and high, it means the company is performing well.

2. A subscriber business model is typically used by businesses that have revenues dependentupon the number of subscribers and the durations of subscribers’ contracts. Such businessesinclude rental companies, magazines, newspapers, telephone / cell phone companies, cabletelevision providers, Internet providers, and fitness centers. What all those companies have incommon is that they grant periodic access to products and services to their subscribers; period setunder the contract can vary, from monthly, yearly, to seasonal. NetFlix should use a subscriber model because of several reasons. First, NetFlix is a movierental 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 newlyacquired and already existing subscribers as long as possible. The reason why these objectivesare significant is that once a subscriber is bound to NetFlix’s contract, the company books cashinflow in advnace from that subscriber, eliminating risk or uncertainty. Also, the longer NetFlixretains its subscribers, the higher the probability that subscribers’ loyalty develops. Developmentof brand loyalty ultimately attracts more subscribers and increases switching costs. Thus, the useof 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 mode

The basic elements of a subscriber model in this case include: the subscription fees (paidmonthly), expected number of discs rented, shipping and disc acquisition costs, and other subscriber-related cash flows. Finally, the company must project the chance of retainingsubscribers over set time horizons, and how many new subscribers will join NetFlix in the future.

3. Assuming that NetFlix does not change its current business model, the value of  NetFlix.com 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 thehistorical data and future forecasts, we assume that the perpetuity growth rate, general andadministrative expense growth rate, and product development growth rate are all 3%, while theDVD 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 currentvalue 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 presentvalue 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.

4. 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, andG&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 morethan 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 thanthe present value of costs. The changes in growth rates will have a negative impact on the valueof 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.

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