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John Engle
John Engle
Articles (332) 

Does Netflix Have Pricing Power?

One analyst thinks the streaming-service is Buffett-worthy

Warren Buffett (Trades, Portfolio), the doyen of value investing and long-time boss of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), has spent years avoiding tech stocks. Yet his antipathy toward such businesses has faded in recent years, most notably with his highly publicized investments in Apple Inc. (NASDAQ:AAPL) and Amazon.com Inc. (NASDAQ:AMZN).

Now that Buffett has started making plays in the tech space, many have started to ask what his next target will be. If a report by Ensemble Capital’s Arif Karim, CFA, is to believed, the answer could be Netflix Inc (NASDAQ:NFLX).

According to Karim, Netflix possesses Buffett’s most important criterion of a great business: pricing power.

But does Netflix really have pricing power in the sense Buffett uses? A closer examination suggests that Karim may be stretching his thesis a bit far.

The importance of pricing power

Pricing power, or market power as it is usually referred to in economics, is the ability of a company to act as a price maker when engaging with customers, rather as a price taker:

“A firm with market power has the ability to individually affect either the total quantity or the prevailing price in the market.”

A price taker has little pricing power and must accept the price set by other economic actors (or by the market as a whole). A price maker, on the other hand, is able to set its own price and thus extract a greater profit. Only a monopoly can claim infinite market power, but there are many examples of firms maintaining significant power over time.

Buffett loves pricing power

Buffett loves companies that have economic agency with the ability to raise prices consistently and progressively grow profits. Indeed, he has described pricing power as the single most important feature of a great business:

The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”

Fundamentally, a company with pricing power has control of its own destiny and is not subject to the whims of market sentiment or the day-to-day actions of other industry players.

The case for Netflix

In his assessment of Netflix, Karim seems to believe Netflix fits the bill of a company with pricing power:

“Despite steadily increasing the quality of its service for customers, Netflix’s pricing has lagged the growth of that consumer value leading to the build up of a large consumer surplus ...The power of the model is to realize that the consumer surplus represents latent pricing power that can be reallocated via price increases or reinvestment changes towards future profits for shareholders. In Netflix’s case, we believe this is an important lever in managing the rate of its growth and returns.”

While this looks good so far, Karim’s later analysis suggests something amiss:

“Over time, we believe prices can be raised substantially to improve the economics of the business, potentially to the detriment of subscriber growth because it will be a less compelling offer. If the service has stickiness to it (we believe it does), then the vast majority of existing customers are unlikely to churn off as that surplus decreases. The result will be higher prices, higher profits, but slower growth.”

That’s not pricing power

Karim’s concession that Netflix’s putative price increases would come at the expense of subscribers ultimately undermines his thesis. If price increases come at the expense of customers, then it is not really pricing power at all. It might be economically advantageous for Netflix to increase its prices to a more efficient (presumably higher) level, thereby appropriating some of the perceived consumer surplus, but that is something quite different.

Put another way, Karim’s analysis supports the claim that Netflix engages in inefficient pricing, not that it necessarily has real economic pricing power per se. Indeed, he concedes from the very start that there is a clear limit to Netflix’s ability to engage in price-hiking behavior.

Verdict

With a host of competitors already coming to market and threatening to balkanize the world of streaming content, Netflix’s position looks even more tenuous. Netflix can probably charge more than it does now, but its pricing power will be fundamentally constrained by the presence of other high-quality streaming options that are investing aggressively to gain market share.

Whatever market power Netflix currently enjoys is likely to be transitory thanks to advent of competition and a broad shift to multi-platform streaming. While Karim’s argument is a solid effort, it is not likely to convince Buffett.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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