NetflixSometimes taking a big step forward can be perceived as taking a step in the wrong direction. That seems to be the case with Netflix's deal to add movies from Paramount, Lionsgate and MGM to its Watch Instantly service's inventory.

Last week, Netflix (NFLX) said it signed a deal, valued close to $1 billion, with Epix, a pay-TV channel on cable and satellite systems that distributes movies from the three studios. Netflix already has similar deals with the Starz channel (Walt Disney Studios and Sony Pictures) and smaller niche distributors like classic-film collector Criterion.

The move is one that Netflix will need to make if it wants to wean itself off the DVD-by-mail model that involves costly postal fees and is being threatened by the rise of online video. Yet it drew two bearish notes from Wall Street analysts and triggered a stock-rating downgrade, which has weighed on Netflix's stock price this week.

This is strange because Netflix at first rallied on the news. Before the announcement early on Aug. 10, the stock was at $116.90, then it surged 17% to $137.22 a week later. But once analysts started looking at the number -- Morgan Keegan estimated the $1 billion, five-year deal will cost $1.11 per subscriber, enough to erode profit margins -- the stock fell to as low as $123.61, marking a 10% drop from its recent high.

Taking the Long-Term View

The stock market seems very unsure whether to applaud or jeer this move. In the end, though, the bullish case is likely to prevail over the concerns. The concerns center around three factors, which are likely to trouble Netflix in the short term but can be overcome in the long run. And Netflix's online movie strategy has always been built for the long run.

The first concern is margins. The Epix deal will weigh them down until the company can bring in more subscribers -- it will need at least 2 million signing up for its cheapest plan to break even on the deal. If Starz comes back and demands more from Netflix later on, or if Netflix needs to sweeten the pot to lure HBO and others to the table, margins could decline further.

The second concern is that Netflix may already be saturating its market. Yes, it's signing up 4 million subscribers a year, but many of them are scaling down to the cheapest option of $8.99 a month for one DVD by mail at a time and all you can eat on the Watch Instantly option. In that respect, the Epix deal was a terrible idea, since it's pushing up costs when revenue per subscriber is declining.

Another concern facing Netflix is competition, not just in the form of cable and satellite television but increasingly from other online movie formats like iTV from Apple and industry-backed initiatives like Hulu. As The New York Times pointed out recently, the number of pay TV customers ready to cut the cord and move to online viewing is less than you might think.

Luring the Holdouts

Let's take these problems one by one. Netflix knows it will never be a key player in online video unless it builds a critical mass of inventory to make it a must-have service, the way people see cable TV today. The Epix deal was one Netflix needed to make, and by making it on more generous terms for Epix than many analysts expected, it has a better shot at luring holdouts. Those holdouts, like HBO, know they will need to embrace online streaming one day. They just want to wait for the best business model.

And while revenue-per-subscriber is declining, this was something Netflix surely expected all along. DVD-by-mail fees are high because of the friction and costs of the postal delivery system. While postal fees go up every year, streaming costs are falling. As Bloomberg reported, digital distribution of TV is getting ridiculously cheap -- 3 cents to stream a standard movie and 5 cents for high-definition movies. Netflix passes much of these savings on to the studios, yet another incentive for the holdouts to stop holding out.

Netflix will not only be able to stomach the cheaper subscriptions, but the $8.99 for limitless movie watching is going to be very attractive to customers, even those with cable or satellite TV. What's another $9 a month for movies when you're already paying $130 a month for all those crappy TV shows?

A Great Experience for Watching Movies Online

Finally, Netflix has been readying for competition for a long time. And it's done so in one of the most devious and effective ways: By offering the best experience for watching movies online. When the iPad debuted, it was Netflix's app that was called the tablet's killer app. Watching a Netflix film on the iPad is a happier experience than anything even Apple has come up with. Or Amazon, for that matter, and Amazon has been trying to rent and sell movies for some time.

So whether or not people ever work up the courage to cut their cable cords, they will sign up for Netflix as the experience of watching an Internet-streamed movie improves. How many times do you hear people complain about cable and satellite TV -- the anti-consumer policies, the high monthly fees, the dearth of quality programming? The most frequent complaint about Netflix's Watch Instantly is its inventory isn't big enough. As we've seen, the company is working on changing that.

Is Netflix facing some turbulent times in the next year or so? Probably: Margins will drop, investors will complain and the short sellers who have long circled the stock will try to push it down. But Netflix's user-friendly interface and its $8.99 all-you-can-eat plan will bring in subscribers. That will draw in more deals with stubborn studios. And eventually Netflix will become what it has wanted to be all along -- the place we go to watch movies on the Internet.

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clutzy

Lisa you must have money , most of us like to save money stretch as far as we can. Goimg to Block-buster with kids your your going to spend at least $30.00 or more and the gas and were and tear on your car Netflix under $10.00 a month all the movies and shows you wont and tons of kid shows.

August 27 2010 at 12:18 PM Report abuse rate up rate down Reply
clutzy

Hollaifyouneedtoo what does cash-teacher and penny stocks hav to do with Netflix ecept for your phishing for clicks shame on you goaway I can here anthony morrison calling for.

August 27 2010 at 11:48 AM Report abuse rate up rate down Reply
Doc -ter -luv

BUY BUY BUY NETFLIX STOCK. PEOPLE MIGHT NOT SEE IT NOW BUT I SEE NETFLIX PUTTING EVEN SOME OF THE BEST CABLE COMPANIES OUT OF BI. I HAVE NOT HAD CABLE IN TWO YEARS AND MY COMPANY FINDS MORE ON MY TV THEN AT THERE HOME

August 27 2010 at 10:43 AM Report abuse +1 rate up rate down Reply
Alissa

Our cable bill was high, and the service wasn't that great (often stoped for a few seconds) and so we made the tough decision to get rid of cable and save $40 a month and get Netflix. I was worried I would get bored with it, but it has been great! There are so many TV shows on there, and we can always find some sort of movie to stream. I'm excited that more choices are coming!

August 27 2010 at 10:32 AM Report abuse rate up rate down Reply
g7nevada1

netflix is a great source for movies except for new ones. Most of the time they put the new movies on a short wait. Been with netflix a few years and never had any problems except with the postal service putting my movies in someones elses box. I find that for the new movies your better off to use the red box. Between using the two you can get the movies you want with out having to wait.

August 27 2010 at 10:05 AM Report abuse rate up rate down Reply
Sheila Marie

I cancelled my cable pay TV channels and signed up for Netflix. That was the best move I could have ever made. Just cancelling those worthless channels saved me $40/month. And as Netflix adds more programming more of the expensive cable will go away too.

August 27 2010 at 9:52 AM Report abuse +1 rate up rate down Reply
Michael

I am a devoted subscriber to Netflix. True their selection of downloaded movies are limited, but with this new deal that should improve. Right now I download mostly British TV shows. But I refused to pay for ON Demand movies at $4.99 to $6.99 each. At $8.99/mo that Netflix charges, it becomes a no brainier. The problem with Wall Street is they can't look past their nose. It's what they can make in the short term. And that is the problem with this generation-no patience; instant gratification

August 27 2010 at 9:42 AM Report abuse +2 rate up rate down Reply
scoldbg

Netflix rules. Can't beat it for the price. I dropped all my pay movies channels on cable ( they show the same stuff over and over for months) and just stream movies to my tv. Very cool. Has a large variety, B movies u never heard of lol, and all kinds of stuff ( Concerts, documenteries, old tv shows etc. ) Cant beat it with a stick

August 27 2010 at 9:28 AM Report abuse +2 rate up rate down Reply
flyboyshine

Netflix is the best thing since apple pie and the streaming feature is awesome as well. I would gladly pay $20.00 a month just for the streaming. Why would anyone ever even walk thru Blockbuster? My new Blu-ray player has more than paid for itself...

August 27 2010 at 9:23 AM Report abuse +3 rate up rate down Reply
zigzigsputnik

If they had to raise their rate a buck or two a month, I'd have no qualms. Netflix ROCKS!! :D

August 27 2010 at 9:10 AM Report abuse +2 rate up rate down Reply