Netflix Inc. (NFLX) recently announced that the company is in the process of splitting its business into two separate entities. Netflix will be carving out the DVD-by-mail business into a wholly owned subsidiary, which will be called Qwikster, while the streaming-only business will retain the “Netflix” brand.
Qwikster will be headed by Mr. Andy Rendich, who has been leading the DVD service for the last four years. Qwikster will have separate user accounts, movie ratings and billing. Qwikster will also be renting video game DVDs for Nintendo Co.’s Wii, Sony Corp.’s (SNE) PlayStation 3 and Microsoft Corp.’s (MSFT) Xbox 360 consoles.
Netflix, which started off as a DVD-by-mail company, has achieved significant subscriber growth over the last few years. As of June 30, 2011, the company’s total subscribers (Domestic and International) were 24.6 million, an increase of 64.0% from the year-ago quarter. Netflix reported new subscriber growth of 1.80 million in the U.S.
This strong subscriber growth was primarily driven by Netflix’s growing streaming business, as approximately 75.0% of the subscribers chose the streaming only plan in the last quarter.
On the other hand, the DVD-business has been going through a lean phase, due to lower demand and increasing postage and sorting infrastructure costs. To recover these costs, Netflix raised subscription rates for its DVD-by-mail customers by $6.00. Although Netflix apologized for the rate hike, the move has already backfired as the company is estimated to lose 1.0 million subscribers in the third quarter, which ends on September 30, 2011.
However, Netflix remains upbeat about its decision to divide the two businesses. The company believes that the split will help both the companies to serve their respective customers better. We believe the split is a prudent decision, as managing both the services profitably was becoming cumbersome for the company. Although the DVD business was facing tough times, it would have been disastrous for Netflix to shut down the DVD-by-Mail service due to its massive popularity. The separation makes it easier for management of the two companies to focus on their respective units to drive growth going forward.
Moreover, the split will free up resources for Netflix going forward. Earlier, the company was facing a dilemma about whether to continue its investments on the low-margin DVD business or to make incremental investments on the higher-growth streaming services. Now, the separation will allow Netflix to continue to invest aggressively on global expansion going forward.
We believe the increasing focus on the digital video service will be the key growth driver for Netflix over the long term. Higher adoption of mobile and tablet devices coupled with increasing broadband penetration will be the primary reason for this, in our view.
Our Take
We believe the restructuring will drive Netflix’s profitability over the long term, due to its lean cost structure, dedicated management team, international expansion and vast and varied library, through partnerships with big production houses like Paramount Pictures, Twentieth Century Fox and Miramax films. Although rising license fees is a concern and could very well impact margins, we believe these partnerships will drive rapid growth in the subscriber base, which will offset any negative impact on margins.
We also believe that these content additions will enable Netflix to reduce its dependence on cable TV operators and provide the necessary competitive edge over its peers in the emerging market of online video streaming.
However, intensifying competition from large players such as Amazon.com Inc. (AMZN), Apple Inc. (AAPL) and Google Inc. (GOOG) in the online streaming market is a headwind because it will further push up license fees and also affect subscriber addition., Netflix’s decision to enter the video gaming rental segment is also risky, as the new market is fully unknown to the company.
We maintain our Neutral recommendation on Netflix over the long term (6-12 months). Currently, Netflix has a Zacks #3 Rank, which implies a Hold rating on a short-term basis.
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