Go Netflix Go! Part Two

Netflix is an interesting case study in the development of a direct-to-consumer business. In their most recent annual report, Netflix published five years of financial results. This allows us to follow the development of their business. Of interest is the growth of their customer file, coupled with their stated "churn rate" of about 4.3%.

What follows from this point forward is purely speculative on my behalf, and is not representative of actual facts or findings published by Netflix.

Netflix states that the churn rate is lower for existing subscribers, and initially greater for new subscribers. If we estimate an approximate 2.5% to 3.0% monthly churn rate for existing subscribers, this yields an approximate 70% annual retention rate. Furthermore, if new subscribers churn at a 7% rate, this yields an average six month retention rate of about 63%. Let's use these two assumptions to understand the dynamics of the Netflix customer file.

At the end of 2005, Netflix had 4,179,000 active subscribers. If, during 2006, Netflix is able to keep 70% of these subscribers, then 2,925,000 subscribers remain at the end of 2006. If Netflix wants to continue to grow, it has to replace the 1.2 million subscribers it lost, find more new subscribers, and then find even more new subscribers to overcome new subscribers that will be lost during 2006. Let's assume that Netflix finds 5,387,000 new subscribers, and keeps just 63% of these subscribers. This yields 3,394,000 new subscribers who are still subscribed at the end of the year.

The 2,925,000 existing subscribers, and 3,394,000 new subscribers yield 6,319,000 subscribers at the end of 2006, a fifty percent increase in subscribers, roughly equal to the growth in customers over the past two years.

This is important to call out for a couple of reasons. Even though Netflix does a great job of retaining an estimated 70% of its existing subscribers, it still has to find a staggering 5.4 million newbies to overcome attrition, allowing Netflix to grow quickly.

This is a fact that retention pundits frequently miss. The "it costs 'x' dollars more to acquire a new customer than it does to retain an existing customer" is entirely factual. However, pundits occasionally use this quote to create fear among business leaders, causing the leaders to buy retention-based "solutions". This example shows how critically important customer acquisition is. Netflix must focus its energy on acquiring new customers, or it simply won't grow at a rate acceptable to investors. Netflix could retain 100% of its customers, and it wouldn't grow.

By using a very simple customer file dynamics example, we can illustrate how easy it is to project the growth of a company. Customer file dynamics are critically important to understanding, and determining, the strategy of a company.

Of course, growth must be tempered by the cost of acquiring customers. In tomorrow's essay, I will explore how the increased customer acquisition costs influence the growth of a customer base, and ultimately dictate how fast and how profitably a company like Netflix can grow.

For those of you who want a preview of tomorrow's discussion, check out this spreadsheet, one that estimates future Netflix growth based on a series of assumptions that I made up, assumptions that are not reflective of any statements made by Netflix. Again, any information I am sharing here is only for illustrative and teaching purposes. It is not meant to actually forecast the estimated growth or profitability that Netflix can expect.