Image source: Netflix.
When Netflix (NASDAQ: NFLX) raised its prices a little more than two years ago, it temporarily grandfathered current subscribers at the rate they signed up for. Last quarter, a lot of those longtime subscribers finally saw their monthly rate increase. Still more will see the price increase to $9.99 per month between now and November.
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Netflix was optimistic in April that very few customers would cancel their subscription because of the price increase. But when it reported its second-quarter results this month, it said an increase in subscriber churn caused it to miss its original forecast for the second quarter. Netflix was expecting to add 500,000 U.S. subscribers and 2 million international subscribers. It ended the quarter with an additional 160,000 subscribers in the U.S. and 1.52 million internationally.
Should we have seen this coming?
In April, just before the first group of subscribers saw their Netflix subscription rate go up, UBS conducted a survey asking subscribers how they'd respond to a price increase. A whopping 41% of respondents said they would not accept any price increase, let alone a $2-per-month jump.
Of note, a similar survey from UBS found that 68% of customers would cancel their cable service if it increased prices. Cable companies have consistently increased prices year after year. So, it's one thing to say you'll cancel, and another one to actually follow through.
UBS estimated that just 3% to 4% of affected Netflix subscribers would follow through and cancel their subscriptions, lowering Netflix's domestic subscriber growth to 450,000. Even that, however, turned out to be too optimistic.
With 47 million subscribers in the U.S. after the first quarter, a churn rate just 1 percentage point higher than expected (i.e. an additional 470,000 subscribers canceling)would have almost completely wiped out Netflix's estimated net additions in the country. In management's letter to shareholders it noted: "Churn ticked up slightly and unexpectedly, coincident with the press coverage in early April of our plan to un-grandfather longer tenured members and remained elevated through the quarter. ... With our large subscriber base, slight variances in retention versus forecast can result in significant swings in net adds, particularly in a seasonally small net add quarter like Q2.".
Netflix made similar price increases in its more mature international markets like Canada. Netflix says those subscribers exhibited similar churning characteristics as their U.S. counterparts.
Netflix made two price increases within 18 months of one another, and subscribers that signed up in between those price increases for $8.99 per month will see their price increase in October or November. As a result, Netflix could see a higher churn rate through the fourth quarter.
The good news for investors
Netflix says its gross additions were in line with its expectations, which indicates that competition isn't having a big impact on subscriber growth. Instead, the increased churn rate is what caused the big miss in net additions. Moreover, the increased churn from price increases is the result of a special event, which suggests that the churn rate should return to normal after the fourth quarter.
Most important, however, is the impact the price increases are having on the company's total revenue and earnings. Netflix's revenue for the second quarter was $2.11 billion, in line with analyst expectations. The company beat the Street's estimate of $0.02 in EPS, posting $0.09 in earnings per share.
The strong financial results indicate that the price hike is working to improve the overall profitability of the company. That's particularly important as Netflix's content costs continue to climb. It plans to spend $5 billion on content this year, and $6 billion next year.
Although Netflix will face a challenging environment to grow its subscribers through the rest of the year, the company's long-term prospects remain unchanged. That makes the pullback in the stock price an attractive entry point for investors interested in Netflix.
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Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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.