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LTV stands for customer lifetime value and represents the revenue a customer brings you throughout the entirety of your relationship. Consider Netflix where an average subscriber stays on board for 25 months. Netflix says the lifetime value of its customer averages $291.25 (see source).
A poor understanding of LTV:CAC can put companies in complicated situations or lead to missed opportunities. Because of this, CEOs need to understand how the LTV:CAC ratio influences the health of their business.
As I alluded to above, the customer lifetime value represents the revenue you can collect from each customer, while the acquisition costs determine how much it costs to acquire the customer. The relation between the two defines how profitable your business is.
Consider a monthly revenue of $100 and that your customers spend consistently throughout the year with you. This model is a simple and flexible one, and it tends to work well with online businesses and marketplaces.
The second method focuses on the frequency that you experience customers dropping from your product. This method works best with subscription models. Continuing the previous example, suppose your churn rate is 10 percent every month.
Acquiring customers is more of an art than a process. Great product managers understand what drives costs up or down and also can double down on the winners and cut the losers. Not all channels will lead to sustainable conversions.
When Netflix transitioned to streaming, gradually leaving the DVD business behind, it became one of the greatest revenue-growth success stories in history. Netflix completely dominated the streaming market until its current rivals entered the market.
This is an example of the law of diminishing returns (or its equivalent, the law of increasing costs). Each additional dollar invested in advertising will have a worse marginal return than the previous dollar because it is probably directed at a subscriber who is more difficult to persuade.
Up to here, everything is fine for Netflix. However, as competitors HBO (with HBO Max), Amazon Prime (with Prime Video), Disney (with Disney+), and others enter the market, demand elasticity increases. With more substitutes, customers become more sensitive to changes in prices or content offered.
One of the problems for Netflix was that it was at the mercy of the large content distributors like HBO. It seemed that all the surplus was going to go to the owners of series and movies and that Netflix was going to take a loss.
At that point, Netflix decided to change its business from brokering content to creating content (or at least getting exclusive rights to new content). However, it is not at all easy to create winning content for an audience that is terribly critical, temperamental, and susceptible to short-term fads.
We know how much Netflix spends on producing a series. For example, the series Marco Polo cost $10 million per episode, so, before it discontinued the series, Netflix spent a total of $200 million on it. How much was this $200 million investment really worth? And what is the lifespan of a series?
This fits with the idea of economic calculation, in which accounting serves as a tool. This spontaneous order always evolves, and the way we treat investment in series and movies for accounting purposes is a good example of that.
The problem is that there is no capacity for increasing production. The streaming platforms with the most purchasing power, including Netflix, Amazon, Disney, and HBO, will demand greater film capacity. This does not include small producers of films and series, as these compete for the same resources with less purchasing power.
Production studios are delighted with the boom in film investments (I imagine UFM Film School is too), but the question is how sustainable this race to create more and more film content will be in a context of unprecedented rivalry.
At the end of 2021, the interest rate Netflix was paying was the lowest in the last five years. The drop in interest paid by Netflix came even though its debt increased from $5.5 billion to more than $13 billion in that same period. The really uncomfortable thing for the streaming giant is that if it were incredibly profitable, this debt would not have been necessary.
It is very likely that these big investments in film content will not translate to greater revenue for the companies making the investments. The only thing that is happening, for the time being, is that production costs are increasing as companies seek to attract customers in an increasingly competitive market. It is very possible that the greater investments in content will not translate to more and better series and movies.
Legal notice: the analysis contained in this article is the exclusive work of its author, the assertions made are not necessarily shared nor are they the official position of the Francisco Marroqun University.
Olav Dirkmaat is professor in economics at the Business School of Universidad Francisco Marroqun. Before, he was VP at Nxchange and precious metals analyst at GoldRepublic. He has a PhD in Economics from the King Juan Carlos University in Madrid. He has a master in Austrian Economics from the same university, as well as a master in Marketing Strategy from the VU University in Amsterdam. He is also the translator of Human Action of Ludwig von Mises into Dutch. He has a passion for investing, and manages funds for relatives, looking for investment opportunities in markets that are extremely over- or undervalued.
Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation.
Video streamer Netflix (NFLX -0.56%) saw its profits plunge in the fourth quarter. Net income was just $134 million, down 67% from the third quarter and 28% year over year. The company blamed the timing of new shows. Netflix's original content gets depreciated on an accelerated basis, meaning more of the costs are booked up front.
But other costs rose as well, most notably marketing. Netflix poured $730.4 million into marketing during the fourth quarter, a 57% jump compared to the prior-year period. That's a much larger increase than the 27% revenue growth and the 26% paid subscriber growth reported by the company.
Netflix now has 58.5 million paid subscribers in the U.S., along with another 2 million users on a free trial. That's less than half the total number of households, but the company is clearly running out of runway in its home market. Netflix added 1.53 million paid U.S. subscribers in the fourth quarter, but its customer acquisition costs are through the roof.
Winning a new U.S. customer now costs Netflix more than four times what it cost a few years ago in terms of marketing spend. One factor is that the company is simply running out of households that don't have a subscription or don't use the account of a friend or family member. Another factor could be increased churn. Netflix doesn't disclose how many users drop the service, so there's no way to tell.
International marketing spending also jumped, but that increase was more in line with subscriber growth. Netflix spent $417.6 million on international marketing, up 63% year over year. But it paid less than $60 in marketing for each new paid subscriber.
This increased difficulty winning U.S. customers comes before a fresh batch of competitors arrive. Disney plans to launch a streaming service this year; AT&T will expand its streaming offerings by the end of the year; Apple is rumored to be close to rolling out a streaming service of its own. These new services will join other Netflix competitors like Hulu, Amazon.com's Prime Video, and a slew of skinny TV bundles like Philo and Hulu's Live TV offering. Winning customers is only going to get harder and more expensive for Netflix.
Not all of the increase in Netflix's marketing spending was due to escalating customer acquisition costs. Netflix reclassified certain personnel costs in the fourth quarter, moving that spending from general and administrative to cost of revenues and marketing. That change didn't affect the bottom line, since it's just shifting numbers around. But it was one factor behind the increase in marketing spend.
Under the new classification system, general and administrative expenses were reduced by $199 million in the fourth quarter compared to the old classification system. About $83 million of that was shifted to marketing, with $30 million added to U.S. marketing spending and $53 million going to international marketing spending.
These numbers aren't big enough to change the trends. U.S. customer acquisition costs are still rising rapidly, even under the old classification system. Excluding these accounting changes, U.S. marketing costs would have risen by 34% year over year, and the U.S. customer acquisition cost would have been $184.
Despite a price increase announced earlier this month, Netflix still expects to burn around $3 billion in cash this year. Content spending is the main driver of this cash burn, but high marketing spending will also play a role. Winning new customers requires not only escalating content spend, but escalating marketing spend as well.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Timothy Green owns shares of AT&T. The Motley Fool owns shares of and recommends Amazon, Apple, Netflix, and Walt Disney. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.
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