Shouldn't Netflix, Inc. Be Talking About This Risk?

Image source: Netflix.

Pricing power (or the lack thereof) seems to be one of the biggest risks facing Netflix today. But the company's leaders don't appear overly worried about it.

Why not?

Let's set the stage, shall we?Netflix delivered strong earnings in the third quarter, but fell about 700,000 new subscribers short of its own customer addition targets. Share prices plunged more than 17% lower overnight, and have only trended even further down since then.

At the time, Netflix leaders pinned the miss on a price increase of $1 per month for new customers. The change actually happened two quarters earlier, but effects may have been masked by the eyeball-magnet powers of Netflix original series Orange Is the New Black releasing a new season.

The third quarter just might have been the first time we saw the true growth-dampening effects of higher prices. "Slightly higher prices result in slightly less growth," Netflix admitted in its own press materials.

So far, so good. Netflix has seen the potential downside of price increases, and acknowledged its existence. But that's where things turn weird.

Every public company is required to list its most important business risks in quarterly SEC filings. The third-quarter 10-Q filing from Netflix keeps it simple, throwing us back to an earlier document:

"There have been no material changes from the risk factors as previously disclosed under the heading 'Risk Factors' in the Company's Annual Report on Form 10-K for the year ended December 31, 2013."

Fair enough -- nothing much has changed, and the company still faces the same set of risks that were identified at the end of the last fiscal year. Surely, Netflix had already pinpointed the price sensitivity of its customers as a significant risk back then, right?

Actually, nope (and stop calling me Shirley).

That 10-K report mentions "pricing" four times in the Risk Factors section, but never in relation to the company's own service costs. It's always about how the competition could damage Netflix's business by trying out aggressively low pricing strategies, except the one time Netflix worries about Internet service providers introducing bandwidth caps and pay-per-megabyte pricing plans.

"The relative service levels, content offerings, pricing and related features of competitors to our service may adversely impact our ability to attract and retain members," one passage reads. That's the closest you'll get to an admission that Netflix can lose customers or slow down subscriber growth by raising prices. The important concept of "price elasticity" -- which considers how demand changes when price changes -- simply doesn't come up.

OK, so maybe the copywriters and lawyers that produce these SEC filings for Netflix just made a mistake. Maybe investors are supposed to remember their price elasticity risks from Economics 101, since they apply to everyone.

But then, Netflix takes the time to spell out other blatantly obvious risks like the fact that share prices might not rise above your purchase price, or the risks of credit card fraud. These, too, apply equally to every company and stock, so there's no reason not to get explicit with pricing-power risks as well.

But wait -- there's more!I'm actually quite sure that it's more than a silly oversight. Netflix simply doesn't worry much about price elasticity.

Following the third-quarter plunge, Netflix executives hit the conference circuit. On stage, in front of analysts and investors, Netflix's management continued to brush off the price elasticity issue.

In November, at the RBC Capital Markets technology conference, Netflix CFO David Wells tried to refocus the discussion on a bigger picture.

David Wells, Netflix CFO. Source: Netflix earnings videos.

"I don't think we're hyper-focused on the quarter," Wells said. "We'll need several quarters to sort of process whether we're seeing long term price elasticity, short term price elasticity, or if something else was going on in the quarter in terms of affecting our growth versus expectations."

Conference moderator Mark Mahaney said that he believes in Netflix having pricing power, but with lower conviction after this intermezzo. Wells got back on his soapbox:

"I don't know about less conviction. We haven't confirmed that it's a long-term price elasticity issue. I think there's definitely something to short-term price elasticity, because of the coincidence of lower acquisition sort of being tied from a time perspective to the price increase, which means that there is some effect there.

"And if you go back to your Econ 101 days, there's no free lunch. You would expect there has to be some effect from a higher price. We have healthy retention. We're still growing, it's just slightly lower year-on-year.

"So I think we still have pricing power and if you look at just the results from the quarter and if you look in our guidance for Q4, our average subscription price is going to grow, right? So we're still net better from a revenue perspective. It just may be that we over-forecasted some growth."

Not to belabor the point, but Chief Content Officer Ted Sarandos followed the same party line at a UBS media conference in early December. The moderator asked whether Netflix still believed that the price increase caused slower growth in the third quarter, and here's what Sarandos said:

"We said there are lot of moving parts, the timing of original series, the price changes. There are lot of moving parts there, and it's still the case."

To summarize, then:

Yes, Netflix might be having issues with price elasticity, since price increases indeed appear to slow down the company's subscriber growth.
No, we don't know whether it's a long-term or temporary effect -- it's too early to tell.
In general, Wells believes that Netflix can raise prices and still walk away with an overall positive effect on total revenues. If anything was wrong here, it would be an overly optimistic official growth projection.

I don't know about you, but to me this sounds like Netflix really should break out price elasticity and/or pricing power as a significant business risk. If it's too early to tell exactly what the effects might be, isn't that sort of the very definition of "risk?"

On the other hand...It's possible that Netflix doesn't list price elasticity as a risk simply because Wells and company see it as more of an opportunity.

An independent market study by price optimization researchers Atenga points in this direction. Atenga surveyed 1,479 Americans on how much they would be willing to pay for streaming video services. The survey population was a cross section of American consumers, skewed just a little bit young, and carries a statistical accuracy of 99% with a low margin of error.

Here's how that analysis worked out for Netflix:

Source: Atenga.

"You can see that they can increase prices all the way up to $14.99 with no material loss in subscribers," said Atenga CEO Per Sjofors, who noted an attendant revenue increase shown in the analysis. " ... You can also see that it is increased competition, not price, that is the reason for the lower subscriber growth. This means that for next earnings call, it will be a repeat of the prior call.

"So, Netflix should increase their price to $14.99 and use the added revenue to license more content and develop more of their own content. This is the only way they can sustain growth and increase shareholder value."

If Atenga's analysis holds water, that would indeed be the best conclusion. The price sensitivity in this survey held steady from $7 per month, all the way up to $15. Leaving service prices in the middle of that range, where they are today, seems almost irresponsible -- Netflix might be leaving a lot of money on the table.

The same survey also showed very similar pricing curves for Netflix rivals HBO Go from Time Warner and Amazon Instant Video, with table-shaped sweet spots between $7 and $16 per month. Hulu Plus, on the other hand, dropped off dramatically at the $10 mark.

In this view, competition from the streaming services at Amazon and HBO pose much larger risks than a piddly pricing change. And against that backdrop, maybe price elasticity isn't such a huge risk after all. The service may be more immune to price-boost damage than the third-quarter results imply.

Still, I would prefer to see Netflix including its own pricing decisions in the SEC-mandated list of significant risks. If nothing else, that risk belongs there until David Wells has enough data to be sure that it doesn't.

The article Shouldn't Netflix, Inc. Be Talking About This Risk? originally appeared on Fool.com.

Anders Bylund owns shares of Netflix. Anders Bylund has the following options: short January 2016 $320 puts on Amazon.com and long January 2016 $320 calls on Amazon.com. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.