Netflix: A Forecasting Case using Voluntary Disclosures1

Netflix: A Forecasting Case using
                                          Voluntary Disclosures1

Background:

Netflix, Inc. was founded in 1997 and is headquartered in Los Gatos, California. Netflix, Inc.
provides subscription based Internet services for TV shows and movies in the United States and
internationally. Netflix began as an alternative to the traditional “brick and mortar” DVD rental
stores which was dominated by the now bankrupt BlockBuster. The innovation that Netflix
provided was to offer a subscription service with DVDs being delivered by mail. This innovation
was initially very successful, appealing to consumers due to the convenience of receiving DVDs
by mail, the large selection of DVDs available, the useful interface that helped consumers select
movies they would like based on their ratings of prior DVDs viewed and a flat rate monthly
subscription fee meant that there were no penalties for returning a DVD late.

With broadband becoming increasingly affordable during the 2000’s the company was among
the first to provide online “streaming” of video material over the internet. Currently, the
company allows its subscribers to watch unlimited TV shows and movies streamed over the
Internet to their televisions, computers, and mobile devices. Its subscribers in the United States
can also receive standard definition DVDs and Blu-ray discs delivered to their homes. As of
December 31, 2010, the company had approximately 25 million subscribers, and was growing
rapidly.

Netflix becomes a “Darling of Wall Street”

By the middle of February, 2011 Netflix was trading around $240/share, giving it a market
capitalization of approximately $12.5 billion. One year earlier, Netflix was trading around
$60/share, giving it a market capitalization of approximately $3.1 billion. The fourfold increase
in the share price was not all “smooth sailing” but led to an impressive following of the company
from analysts and other market pundits. Many of these observers have made their claims as to
why Netflix has had significant growth and share price volatility. The careful financial analyst,
however, maps qualitative assessments and analysis into a quantitative accounting based
framework, thus allowing him/her to offer a more informed perspective on why Netflix’s value
has fluctuated significantly over the past two years, and a more precise forecast.

1
  This case was developed by Asher Curtis (Foster School of Business, University of Washington) in conjunction
with Robert Resutek (Tuck School of Business, Dartmouth College) as the basis for class discussion, rather than to
illustrate either effective or ineffective handling of a business situation. All financial data in this case is based on
publicly available information. The forecast model used in this case is based on work undertaken by Asher Curtis,
Russell Lundholm and Sarah McVay in their article “Forecasting Sales: A Model and Some Evidence from the
Retail Industry” which is forthcoming in Contemporary Accounting Research.

Sales Forecasting

Every financial statement forecast begins with a sales estimate. Typically the sales estimate is
then combined with margin forecasts to estimate future income, and combined with turnover
forecasts to estimate future assets, but the entire process is predicated on a precise sales forecast.
In this case, we will explicitly incorporate information from two distinct sources of future sales
growth – changes in the number of sales-generating units (e.g. new subscribers) and changes in
the rate of sales per unit (e.g. the subscription fee Netflix can charge).

Netflix is a subscription service and their revenues can be considered most simply as a function
of the number of subscribers they are able to retain times the subscription fee they are able to
charge, this can be written in terms of sales growth as follows:

        Sales growth = (1+growth in subscribers)
                                        *(1+growth in subscription revenue per subscriber).

By the middle of February, 2011 (when Netflix was trading around $240/share) Netflix released
their fiscal year 2010 results along with detailed voluntary disclosure on the number of
subscribers (the sales generating units). This information was downloadable from the Netflix IR
(Investor Relations) website in excel spreadsheet form. Their income statement is provided as
Exhibit 1. The information on the number of subscribers is provided as Exhibit 2.

This is an interesting period for Netflix, with an increase in competition in the streaming service,
an increased focus by Netflix to target streaming services over the traditional DVD-by-mail
service, and entering into foreign markets. For forecasting Netflix’s future profitability, our
primary question of interest is about sales growth – in particular the expected growth in
streaming customers – can Netflix maintain their first mover advantage and if so, how much
growth in subscribers does the $240 price per share imply?

Exhibit 1

Source: Netflix’s 10-K for fiscal year 2010.

Exhibit 2

Source: 2010 Supplemental Data, obtained from Netflix’s Investor Relations website.

Focus Questions:

   1. Historically, what was Netflix’s competitive advantage over BlockBuster? How has
      Netflix’s business model changed since then and what is Netflix’s main competitive
      advantage at the end of 2010? What are the key success and risk factors for Netflix’s at
      the end of 2010?

   2. These questions relate to implementing a sales forecast for Netflix:

          a. Using the information in Exhibits 1 and 2, calculate the subscription revenue per
             subscriber in 2009 and 2010, and then the growth rate from 2009 to 2010.
          b. Discuss your answer to part a – do you expect similar growth in the revenue per
             subscriber for Netflix in 2010 onwards?
          c. Using Exhibit 2, calculate the average growth rate in subscribers for 2009 and
             2010. Use this historical growth to growth the forecast number of subscribers
             over the next five years to end in 2016. How many subscribers would Netflix
             have at the end of 2016 based on this forecast?
          d. Re-do the analysis above assuming the following growth rates: 20% in 2011,
             15% in 2012, 10% in 2013, 7.5% in 2014, 5% in 2015 and 5% in 2016. How
             many subscribers would Netflix have at the end of 2016 based on this forecast?
          e. Discuss your answer to parts c and d – which growth rate do you expect for the
             number of subscribers for Netflix in 2010 onwards?

   3. Collect the “churn rate” disclosed by Netflix over the past 4 quarters. Is there a trend?
      What does this data suggest?
         a. Do you believe that this information is informative for forecasting?
         b. Suppose Netflix announced that they would discontinue disclosing the “churn
             rate” how might you estimate this indirectly?

   4. Calculate Netflix’s operating profit margin using the information in Exhibit 1 for the
      year ended December 31, 2010. Using this margin, calculate the profitability of a single
      Netflix customer for a year. Assume that all customers stay with Netflix for 5 years, and
      Netflix earns this same amount in each of those years. Based on these assumptions
      answer the following:
         a. What is the present value of the earnings received by Netflix, using a discount
              rate of 10%?
         b. Multiply this present value by all customers that Netflix has at the end of 2010 –
              divide this number by the number of shares outstanding and compare with the
              price of $240 per share. What does this analysis tell you about the share price of
              Netflix?