What's Behind Netflix's Massive Subscriber Additions

By Adam Levy Markets Fool.com


Image Source: Netflix

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It's been 10 years since Netflix (NASDAQ: NFLX) launched its video-streaming service, and it just added the most new subscribers ever in a quarter. The streaming-video leader added 7.05 million total new subscribers -- 1.93 million in the U.S., 5.12 million internationally -- bringing its total to almost 94 million.

Not only did those numbers exceed Netflix's and analysts' expectations, they represented a significant recovery from poor net addition numbers in the second and third quarters. In fact, Netflix added more subscribers in the fourth quarter than the second and third quarters combined. So, what factors led to Netflix's massive subscriber additions?

The end of the great un-grandfathering

During the second and third quarters, longtime Netflix subscribers saw their monthly rates increase from $8 or $9 per month to $10 per month. Netflix had un-grandfathered 75% of subscribers by the end of the third quarter. Importantly, those un-grandfathered in the fourth quarter saw just a $1 increase, while most of the earlier price increases were $2.

Netflix noted that subscriber churn increased more than expected in the second quarter, and it clearly remained elevated in the third quarter. However, management also told investors that gross additions remained in line with expectations. In the fourth quarter, it seems churn rates returned to normal levels.

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What's most telling is the amount Netflix spent on marketing, particularly in the U.S. Marketing expenses actually declined compared to the third quarter, but Netflix managed to add five times as many subscribers. Unless Netflix made some drastic changes in marketing last quarter (it didn't), its gross adds have likely remained relatively stable (with adjustments for seasonality).

It's also worth noting that some customers who left over the Summer may have rejoined last quarter. Netflix's constant stream of new releases makes it difficult to stay away from it once you've gotten used to it.

Pulling forward some subscribers

Netflix's outlook for the first quarter is about in line with analysts' expectations, but it expects a little less from the U.S. and a little more from the rest of the world. In its letter to shareholders, management wrote, "We believe our strong Q4 results likely pulled forward some net adds from Q1'17 to Q4'16."

To be clear, that's not a bad thing. The sooner people sign up, the sooner Netflix starts making money off of them.But it does mean investors should temper their expectations for the first quarter, especially with the new season of House of Cards being pushed back into the second quarter.

A new high-revenue subscriber base

Now that Netflix customers are all paying higher rates, the company should continue to add subscribers at a more steady pace. Netflix said its average sales price per U.S. subscriber was up 15% last quarter thanks to its price increase. As a result, domestic revenue increased 27%, while the subscriber base increased just 10%.

Netflix will face more pressure on international growth this year now that Amazon (NASDAQ: AMZN) launched Prime Instant Video globally. What's more, Amazon is undercutting Netflix's pricing in most countries, which could constrain Netflix's ability to keep increasing its prices.

Netflix may respond by shifting some of its marketing budget from the U.S. to its International division. Of course, it will also continue investing in new originals and licensed content for its international audience. But Amazon has the marketing and content budget to keep up with Netflix.

Whether that impacts Netflix's ability to continue growing its subscriber base or raise prices remains to be seen. It certainly hasn't had a huge impact in the United States, where Amazon also undercuts Netflix's pricing.

Last quarter's results show that Netflix might experience a few hiccups as it raises prices, but it's capable of getting back on track quickly.

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Adam Levy owns shares of Amazon.com. The Motley Fool owns shares of and recommends Amazon.com and Netflix. The Motley Fool has a disclosure policy.