Netflix Risks Essay

Netflix was founded in 1997 and is headquartered in Los Gatos, California. Netflix is a company that provides online movie rental subscription services in the United States. The company offers its subscribers access to a library of movie, television, and other filmed entertainment titles on digital versatile disc (DVD) and Blu-Rays. Its members can get DVDs delivered to their homes and can instantly watch movies and TV episodes streamed to their TVs and PCs. It also partners with consumer electronics companies to offer a range of devices that can instantly stream movies and TV episodes to members’ TVs from Netflix. Netflix entered the rental entertainment industry at a time where Blockbuster was king and renting movies required the consumers to drive to the store. However, Netflix realized that through innovation there was a much more efficient and cheaper way to provide the same service than the typical brick-and-mortar companies of the time. Customers of Blockbuster and other store rental places were attracted to the new features (monthly subscription, no late fees) provided by Netflix. Through innovation Netflix basically â€Å"changed† the way movie rentals were done and eventually became the leader of movie rental industry while Blockbuster and many other companies eventually became bankrupt. Netflix’s story of success is also one of caution as Netflix realizes that they will continue to face many risks throughout their business cycle and if they don’t anticipate and/or respond correctly, they too could face the same result as Blockbuster. As of December 31, 2009, Netflix served approximately 12 million subscribers. Currently, Netflix claims on its website to have over 20 million members, making it the leader in rental movie industry. However, Netflix faces many competitors that provide similar services: Comcast, Redbox from Coinstar and even Amazon is planning on also offering streaming services to its prime members. Therefore, if Netflix is to remain as the industry leader and continue its earnings and membership growth it will have to continue to innovate with new ideas. Generally, innovation requires a huge investment from companies in their Research and Development departments. These investments can come out from the companies own cash flow or from issuing loans. In order for a Company to decide if an investment is worth the money it uses either Net Present Value or Internal Rate of Return techniques which basically state that if the return on the investment is greater than the cost, then the company should go ahead and invest. But what is the cost of the investment? If Netflix plans to borrow money, then the cost will be the prevailing interest rate at the time of Issuance of the loan plus a spread premium for specific characteristics pertaining to Netflix. This poses a financial risk on Netflix, more specifically this is called interest rate risk. Interest rates tend to be volatile and there are many different theories (expectations theory, liquidity theory, preferred habitat theory, market segmentation theory) yet nobody really knows 100% for sure if interest rates are going to go up or down and by how much. However, based on the expectations of Netflix’s analysts they have a few choices on dealing with this risk depending on their expectations. If they expect interest rates to go up, then they should issue a long term bond or note now, because if they wait and interests rates do go up then it will be more costly for them to borrow the money they need which might end up affecting the Net Present Value of their investment project. On the other hand, if Netflix expects rates to go down then it will not be a good idea for Netflix to issue out a long term bond or note because if rates eventually do drop then Netflix be essentially borrowing at a higher rate than the prevailing market rate. So what Netflix should do instead is to issue short term debt such as commercial paper and continue to roll it over until they expect that interest rates have reached the lowest and then issue a longer term bond or note depending on their investment project. Finally, the other option for Netflix is that, if they are not sure if interest rates are going to go up or down, they can still hedge against this risk by issuing a long term callable bond so that if interest rates do drop significantly Netflix can call its debt back and reissue at the lower rate. Another way that Netflix has been and plans to continue expanding its membership is by offering its services abroad. In fact, Netflix has already entered the Canadian market and is in the process of offering its services in the United Kingdom. Obviously this is great news for Netflix shareholders however going international also brings additional risks. One of the major risks that we foresee would be exchange rate risk. For example, when Netflix starts to offer its services in the United Kingdom, it will have to decide on what it will charge its British customers a month. However, it will have to do so in pounds, which is the local currency. If for example, we assume that Netflix charges its U. S. customers 10 dollars a month for its services and that it wants to charge the same real value to its U. K. customers, if the pound/dollar exchange rate is . 5 pounds for 1 dollar then Netflix would have to charge its U. K. customers 5 pounds a month. However, interest rates are constantly changing and if Netflix doesn’t do something about this risk then its cash flow would be constantly changing. For example if the pound depreciates against the dollar to . 75 pounds for 1 dollar then the dollar value from its U. K. customers’ 5 pound subscription will now be only worth $6. 67. Netflix could deal with this cash flow loss in two ways, a good way and a bad way. The bad way would be to constantly adjust the prices up and down to its U. K. customers so that the real dollar value remains about the same, however we feel that customers wouldn’t appreciate this price volatility and Netflix would potentially lose many U. K. customers. The good way for Netflix to hedge against exchange rate risk would be to enter the futures market on currencies and lock in on a pound/dollar exchange rate that way any future volatility on the exchange rate wouldn’t affect either negatively or positively on Netflix’s international cash flows. Netflix also faces several nonfinancial risks. Netflix began its ground-breaking entry into the movie rental industry with its mail order system, but the mail order system is not the sole source of its success today. In fact, Netflix’s CEO Reed Hastings has admitted that a lot of Netflix success has been due to do their online streaming content. As an actual Netflix customer myself, I admit that I spend a lot of time streaming movies and shows online, in fact if Netflix were to only offer its mail order system, I would stop being a customer. If other Netflix customers’ value their online service as much as I do then this signifies the important value that the movie streaming services has for Netflix. But what if, something happens (virus, human error, etc†¦) and Netflix’s servers go down and they are unable to operate its streaming function for a couple of days? A couple days may seem trivial however it could potentially mean an enormous amount of lost profit due to unhappy customers. In order to avoid this type of scenario of ever happening, Netflix should think of ways to confront this operational risk. One idea would be to spend money in acquiring backup servers so that if the main servers were to go down for whatever reason, Netflix would be able to switch to their backup servers and therefore customers could continue to stream their favorite movies and shows online while Netflix worked on fixing the problem with the main servers. Even though Netflix is headquartered in Los Gatos, California, it has many â€Å"warehouses† around the United States that deliver movies to customers near their locations. Because of this, Netflix faces many different types of â€Å"pure† risks depending on the location in which their warehouse is situated. Pure risk is a type of risk that involves either a chance of loss or no loss. An example for Netflix would be an earthquake in Los Gatos California, or a tornado in its warehouse in Omaha, Nebraska. Pure risks have tremendous abilities for loss because they cause both direct and indirect losses. If for example, a tornado destroys the Netflix warehouse in Omaha, Nebraska, the direct losses would be the costs of the destroyed warehouse, but at the same time there would be indirect costs such as the costs of perhaps losing customers around the Omaha area because now their movies have to ship from a different warehouse which could potentially take many more days to arrive. Unfortunately, there are no ways to prevent catastrophes such as fires, earthquakes, tornadoes, etc†¦ However, these high severity, low frequency situations are part of life and therefore a part of Netflix’s business risk. The best way for Netflix to deal with these types of risks are either to self insure by saving a certain amount of money each month or they can do an insurance transfer and pay insurance premiums but not have to worry about these pure risks. As shown in the movie â€Å"Mind Over Money†, human emotions play a major role in driving the market. Netflix should pay attention to such matters as the company could be affected by the irrational decisions people make. Investors have recently been talking about Netflix prices being over priced and it depicts a bull market. Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue. It’s difficult to predict consistently when the trends in the market will change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets. Therefore, similar to what is shown in the movie people will make irrational behavior and it could lead to the sudden collapse in the market for Netlix. This can be a major risk to the company. Netflix started as a mail order movie rental company in 1997 and through much innovation it was able to not only establish itself in the movie rental business but actually be a leader. Throughout its path from rags to riches, Netflix faced many types of financial and nonfinancial risks and was obviously able to overcome them to reach where it is at today. However, the risks don’t stop now and Netflix is facing strong competition from other movie rental companies and in order for Netflix to stay on top it will have to continue to be innovative and also continue to properly deal with any forthcoming risks.