Netflix says new capital 'adds to safety buffer' as company atones for pricing debacle

By Paul Deckelman

New York, Nov. 29 - Netflix, Inc. raised funds last week through private placements of stock and convertible debt in order to add to its capital structure's "safety buffer," its chief financial officer said - this after the online movie-rental company was rocked by unexpectedly harsh customer reaction to controversial pricing changes it announced during the third quarter.

"We've always run a lean capital structure," CFO David Wells asserted during the Credit Suisse 2011 Technology Conference on Tuesday in Scottsdale, Ariz. In fact, Netflix's total long-term debt as of the end of the quarter on Sept. 30 stood at just $200 million, consisting solely of 8½% senior notes due 2017.

However, he acknowledged that "the events of Q3 mean we have less of a safety buffer than before. So we needed to rectify that, and we added to the safety buffer."

A pair of transactions

Los Gatos, Calf.-based Netflix announced on Nov. 21 that it was shoring up its balance sheet to the tune of $400 million in two separate transactions. It privately placed $200 million of zero-coupon senior convertible notes due 2018 with funds affiliated with Technology Crossover Ventures, a Palo Alto, Calif.-based private equity firm. It separately and concurrently sold $200 million of stock to mutual funds and accounts affiliated with Baltimore-based investment management firm T. Rowe Price Associates, Inc.

The zero-coupon convertibles priced Nov. 21 with a conversion ratio of 11.6553 shares per $1,000 principal amount, a conversion price of $85.80 and a conversion premium of 9.92%. They are callable after six months.

The company priced roughly 2.86 million common shares at $70.00 apiece on Nov. 22. The company's shares had closed at $74.47 (Nasdaq: NFLX) on Nov. 21.

When asked during his presentation whether any of the $400 million generated by the twin placements might be used to offset the substantial costs of further domestic or international content for the company's streaming service, Wells flatly declared that the funds are "a cushion for the balance sheet."

New kid on the block

Netflix, founded in 1997 in California's Silicon Valley, quickly took the movie-rental industry by storm with its business model of low-cost DVD movie rentals ordered online by monthly subscribers and delivered by mail. In 2007, it added a streaming-video service that allows subscribers to instantly order movies and other content online and have it delivered right to their computers, cutting out the postal middle man.

Netflix was so successful doing this that competing traditional brick-and-mortar video-rental stores operated by established rivals such as Blockbuster Inc. and the Movie Gallery Inc. soon became obsolete, and both companies were forced into bankruptcy.

Dothan, Ala.-based Movie Gallery actually was a "Chapter 22" company - one that went into Chapter 11 reorganization twice but was ultimately forced to liquidate, closing all of its eponymous stores and those of its Hollywood Video subsidiary by mid-2010

Dallas-based Blockbuster (now known as Blockbuster LLC) had to close down most of its more than 5,000 retail stores, was ultimately bought in a bankruptcy auction by satellite television operator DISH Network LLC and has largely re-invented itself as a smaller Netflix-style mail-order DVD and streaming-video provider while also operating movie-rental kiosks in retail stores in competition with another industry player, Coinstar Inc.'s Redbox operation.

But while Netflix became the new kingpin of the movie-rental business after deposing former industry leader Blockbuster, it - unlike its vanquished rivals - recognized that technology was continuing to change the industry and wanted to stay ahead of the curve.

Changing the business model

After its introduction in 2007, streaming online video took off and quickly overtook the company's traditional DVD-by-mail business, both in terms of numbers of subscribers and, increasingly, percentage of profits generated. By the end of the 2011 second quarter on June 30, the company had 24.6 million separate U.S. subscribers - almost all of them subscribers to the streaming service. Under the price structure in effect earlier this year, a Netflix subscriber paid $9.99 per month for unlimited streaming ability and, under that package, could also order one DVD rental at a time.

On July 12, Netflix shook up its subscribers by announcing plans for pricing the two services separately. A customer could have unlimited streaming for $7.99 per month and/or could order DVDs for a flat fee of $7.99 per month, if only one DVD were ordered at a time. Someone who wanted to be able to order two DVDs at a time would pay a monthly subscription of $11.99. But a customer who wanted to be able to both order instantly delivered streaming video AND rental DVDs (since not all content is available to the streaming service) would be paying at least $15.98 per month, or almost 60% more than before, and someone who wanted to have streaming plus two DVD rentals at a time would be charged $19.98 per month.

The new pricing structure would go into effect immediately for new subscribers and by Sept. 1 for the established customers.

Netflix also announced plans to completely separate the two systems, repackaging the DVD-rental operation as "Quickster" and giving it a separate website while keeping the "Netflix" designation for the streaming service.

A big backlash

Reaction was not long in coming. Angry subscribers organized protests on Facebook and via Twitter, when Netflix reported its third-quarter results on Oct. 24, the company - after having continuously posted quarter after quarter after quarter of increasing net subscriber additions (3.3 million in the first quarter and 1.8 million in the second quarter) - was forced to report that it lost a net 805,000 subscribers during the third quarter. Netflix backed away from the "Quickster" plan, though it kept the pricing changes.

In a letter to shareholders released along with the financial results, CFO Wells and the company's chief executive officer, Reed Hastings, acknowledged that "we greatly upset many domestic Netflix members with our significant DVD-related pricing changes and to a lesser degree, with the proposed-and-now-cancelled rebranding of our DVD service. In doing so, we've hurt our hard-earned reputation and stalled our domestic growth. But our long-term streaming opportunity is as compelling as ever and we are moving forward as quickly as we can to repair our reputation and return to growth."

The company predicted that subscription cancellations would likely continue in the fourth quarter, though at a reduced pace versus the wave of third-quarter cancellations.

During his Credit Suisse conference presentation, Wells admitted that Netflix had learned "some painful lessons, as you can imagine."

He said that "no one likes a price change - especially a 60% price change in a bad economy. And I think we were very guilty of underestimating that aspect of it."

He said that Netflix "would have been fine" with the idea that consumers who had been getting both the streaming service and DVD rentals for $9.99 per month might only choose one or the other at $7.99 per month, rather than ordering both for $15.98. Instead, "subscribers viewed [the change] negatively" and "left in anger, and that's sort of where we ended up."

A long road ahead

Wells continued to defend the $7.99 monthly plan for either service as an attractive price, but he admitted that repairing the damage to the company's brand will not be quick or easy. While about one-third of the company's recent new subscribers are returning old subscribers, he cautioned that "this is a long-term thing that we'll have to live with, and we'll have to prove out to folks that indeed this is a great service and they can trust us. It will take a little bit of time to come back."

He added that "there's no one big fix that's going to undo this. The best that we can do is to grow the brand back, brick by brick."

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