Can Netflix Find Its Future by Abandoning the Past?

The video company is splitting its streaming business from its DVD mail-delivery service

For most of its decade as a public company, Netflix got a lot of things right. Consumers flocked to its original mail-order DVD service, a bold, disruptive move that helped push Blockbuster into bankruptcy. When Netflix added online movie-watching in January 2007, the strategy offered consumers flexibility and won a loyal following. Key to making it all work was Chief Executive Officer Reed Hastings’ outmaneuvering of the Hollywood studios, first undercutting their home-video sales with an all-you-can-eat monthly rental price for DVDs, then buying up digital rights to movies and TV shows from the weakest players. The result: Netflix shares almost doubled in 2009, more than tripled in 2010, and by mid-July had risen an additional 70 percent, to $304 per share at its peak.

Now Hastings faces what may be his most difficult task yet: reigniting growth after a series of pricing and other missteps that has angered and confused consumers and spooked shareholders. It started with the July 12 introduction of a pricing plan that translated into a 60 percent increase for 24 million subscribers who wanted discs and streaming. Then the cable channel Starz broke off talks to renew a key online deal to supply movies and TV shows—leaving customers with the prospect of paying more for less. Finally, Hastings apologized in a blog post, only to drop a bombshell that the DVD service would be separated from streaming and renamed Qwikster, with its own website and billing. By Sept. 20, Netflix shares had plunged 57 percent from their peak.

Despite the erratic way the transition has played out so far, media experts say Hastings’ risky changes make sense strategically. “You’ve got to give Reed credit,” says Paul Saffo, a managing director at Discern Analytics. “He knows Netflix absolutely has to flee into the future with digital delivery. The problem is, not all customers have come to that yet.”

Hastings has to manage a business model shift that has tripped up other former technology highfliers such as Netscape, AOL, and Myspace. To pay the rising sums Hollywood is demanding for online rights to movies and TV shows, Netflix needs to keep revenue flowing from the DVD rental business even as it expects industry revenue to decline as much as 10 percent a year—Hastings’ own guesstimate based on the music industry’s contraction. The cost of its new deals to acquire content for streaming has so far this year increased nearly eightfold from 2010, to $804.9 million. The company has $1.3 billion in content fees payable over the next five years, up from $68.7 million three years earlier. It will generate $344 million in cash flow this year, estimates Barclay Capital’s Anthony DiClemente, a big part of it from the 14 million subscribers who get DVDs.

So over the next few months, Hastings will step up marketing of that legacy business, “something we haven’t done for many quarters,” he said in a July letter to shareholders. “Our goal is to keep DVD as healthy as possible for as many years as possible.” Streaming movies online, unburdened by DVD warehouses and costly postal fees, is the real prize. That business generates a hefty 65 percent gross profit margin, according to Michael Pachter, an analyst with Wedbush Securities, compared with the 37 percent he estimates for DVDs. Netflix doesn’t provide detailed financial information for the two businesses.

Until now, Netflix had done an elegant job of avoiding the mistakes of Blockbuster, the video rental chain that went bankrupt last year because it failed to let go of its legacy retail business and move online, Saffo says. Netflix’s mistake was failing to manage subscribers’ expectations, he says: “The only surprises you should give your customers are good surprises. Loyalty is a two-edged sword.”

Piper Jaffray analyst Michael Olson says Hastings may be moving too fast because his library of online videos and movies isn’t enough to satisfy consumers: “I understand why they’re making this move toward streaming from a long-term perspective, but the only way they will now be able to make investors believe in them, and subscribers continue to be attracted, is to have a waterfall of new content in the next few months.”

Hollywood knows that Netflix needs product more than ever, and the price for its next deal with a studio or video service will likely dwarf previous ones, says Frank Biondi, former president of Universal Studios and one of HBO’s founders. “It was easy to get a good deal when the studios didn’t know just how big Netflix was going to be,” he says.

CBS just signed a two-year agreement that provides Netflix only about 7 percent of its TV library, including episodes of Star Trek and Cheers, CEO Leslie Moonves said at a Sept. 20 investor conference. At the same conference, Chase Carey, president of Fox parent News Corp., suggested future deals could be increasingly lucrative for studios. “There are real opportunities for us to take advantage [of],” he said.

Netflix’s bigger problem may be other deep-pocketed players crowding into streaming. Amazon has signed 5 million users to its $79 Prime shipping service, which also offers thousands of films and TV shows online at no additional cost. Google is prowling Hollywood for content and is said to be among those interested in buying Hulu, the online video service owned by Disney’s ABC, NBCUniversal’s NBC, and Fox.

Still, the competitors Hastings says he fears most are big media, cable, and satellite operators who already have relationships with consumers. Time Warner’s HBO currently delivers movies and TV shows for free online to its pay-TV subscribers, and satellite operator Dish launched a service of its own after acquiring Blockbuster, which gave it contracts with most of Hollywood. “Our task is to consistently improve the quality of our service and stay two steps ahead,” Hastings said in his July letter. Easier said than done.

— With assistance by Andy Fixmer


    The bottom line: Netflix faces increasingly high content costs as it shifts its business further toward online video delivery.

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