A Million Reasons to Watch Netflix

Some milestones get lost in the maelstrom.

Netflix (NAS: NFLX) revealed on Thursday -- as the market took a beating -- that it now had a million subscribers of its streaming service in Canada.

Amanda Bell James, from Flin Flon, Manitoba (you can't make that up) was the lucky milestone maker. She will get a lifetime subscription, which cynics will note is one way to keep churn in check.

I jest, though it's important to keep a close eye on Canada.

The "streaming only" model for $7.99 a month is the same one that Netflix plans to expand to 43 countries in Latin America and the Caribbean later this year. Given the dual plan pricing that is already in place for new customers and will kick in for existing subscribers next month, this is also the same plan that Netflix expects 22 million of its 25 million domestic subscribers to be paying to be on by the end of next month.

What's the problem?

Well, let's look at the number of net additions in Canada.

Net Additions

Total Canadian Subs

Q3 2010

0.13 million

0.13 million

Q4 2010

0.38 million

0.51 million

Q1 2011

0.29 million

0.80 million

Q2 2011

0.16 million

0.97 million

Source: Netflix.

The service launched toward the end of the company's third quarter, so disregard the 130,000 early adopters who joined up during the service's first month. After a strong holiday quarter, net additions have shrunk sequentially.

Slow crawl to the finish line
How encouraging will the current quarter be? Netflix had 970,000 subscribers at the end of June, and only noted that it was "nearly" at a million during its quarterly conference call in late July. Netflix points out that James joined in July, but the fact that press release didn't go out until the first week of August is further proof that it took most of July to grow by a mere 30,000 Canadians.

My biggest fear of the streaming product -- short of the selection that will always be incomplete and the threat of metered bandwidth that is already the norm in Canada -- is churn. It's hard to justify canceling the DVD service when you know you have discs at home or in transit. It's a lot easier to cancel a monthly streaming service.

Forget about the next quarter or two of subscriber displeasure over the pricing plan changes that will indubitably force cancellation rates higher. A year from now -- long after the rubble settles -- churn rates will be higher than they are right now.

It may seem like an easy prediction to make. Churn is inching higher for most services that publicize their monthly retention rates. TiVo (NAS: TIVO) , Sirius XM Radio (NAS: SIRI) , and Ancestry.com (NAS: ACOM) have all checked in with higher year-over year churn in their latest quarters.

We're a fickle lot, quite frankly. The saving grace is that subscriber acquisition costs are generally shrinking for these companies. In other words, we're not as loyal as we used to be, but we're getting cheaper to bait.

Churning the churn
Netflix doesn't have a choice in emphasizing its streaming program overseas. It's the only flavor available. However, trying to force stateside couch potatoes to choose streaming over optical discs -- or at the very least to pay as much as 60% more if they want both -- should bump an already pesky churn rate higher.

Netflix's churn rate has grown from 4% during last year's second quarter -- and 3.9% during this year's first quarter -- to 4.2% in this year's second quarter. Keep in mind that this is a monthly number, so we're talking about a lot of people requesting cancellations.

It will be all too easy for Netflix subscribers to cancel once they've exhausted their favorite streaming selections, just as Ancestry.com runs into heavy cancellations once subscribers get the genealogical information they crave.

They may not leave forever. They may just quit for a few months and come back. However, it's telling that Netflix's quarterly report breaks out domestic churn but doesn't really address the international metric.

Sure, Canada is still in its infancy for Netflix. It's not fair to hold a company to a retention metric for a service that wasn't even around a year ago. However, investors will need to keep a close eye on the streaming model's churn rate because it will ultimately decide the direction of the stock.

Streaming success will deliver chunky profit margins to the company that is the runaway leader in digital smorgasbords. Recent initiatives by Amazon.com (NAS: AMZN) and Time Warner's (NYS: TWX) HBO to enter this market with offerings that are available at no additional cost to existing plans will make things interesting. Initially they will likely lead to even higher churn for Netflix. However, Netflix thinks it has a winner here. We'll have to let subscriber retention rates decide that one.

Are you streaming video these days? What services are you using? Share your thoughts in the comment box below.

At the time thisarticle was published Motley Fool newsletter services have recommended buying shares of Netflix, Amazon.com, and Ancestry.com. Motley Fool newsletter services have recommended buying puts in 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.Longtime Fool contributor Rick Munarriz has been a Netflix shareholder -- and subscriber -- since 2002. Rick is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.

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