Cynics will argue that they saw this coming. Netflix is, after all, the company that alienated couch potatoes after a poorly received rate increase last summer and its short-lived Qwikster fiasco.
There were a few positives out of Netflix's quarterly report.
- Netflix added nearly 3 million more streaming subscribers than it lost during the first three months of this year.
- After bracing investors for a sharp deficit, Netflix posted a much smaller loss than what Wall Street was expecting.
- Netflix's first quarterly deficit in years may be a one-off. Going by the midpoint of its guidance, the video service may return to profitability as soon as the current quarter.
- The international expansion that was on hold until the company got its financial house in order is ready for fresh passport stamps. Netflix revealed that it will enter a new European market by the fourth quarter of this year.
Rendering a New Model
Netflix posted a sequential decline in revenue. You don't see that every day, especially for a subscription service that just tacked on nearly 3 million more users to its subscriber base. The problem at Netflix is that it also lost nearly 1.1 million members of its original disc-based service. These are typically customers paying more -- and, in some cases, far more -- than the $7.99 a month that Netflix charges for its unlimited streaming service. A lot of members are also downgrading to cheaper Netflix plans that include fewer movies, which is evident as disc-based revenue shrinks faster than the head count. It's a weaning process. Downgrading a plan is a stepping stone to bolting from a service altogether.
"We expect DVD subscribers to decline steadily, every quarter, forever," CEO Reed Hastings told an analyst three months ago.
The defections have been swift. There are now fewer than 10 million paying customers on disc-based plans. You have to go back more than three years to find the last time Netflix had fewer than 10 million disc-based customers.
The future, according to Netflix, is streaming. The company is probably right, but that's also unfortunate for its bottom line.
Netflix's 23.4 million domestic streaming customers generated $67 million in contribution profit during the first quarter of the year, and it's losing more than that as it expands its streaming service overseas. The much smaller base of disc-based customers provided $146 million in contribution profit.
Consumers aren't necessarily tiring of optical discs as cheap rentals. Coinstar (CSTR) is experiencing strong double-digit growth at its Redbox kiosks, and the company raised its outlook earlier this month. You can bet that many folks canceling Netflix's disc-based plans are flocking to Redbox kiosks when they need a rental.
The real problem now is where Netflix is taking its growing streaming business.
You Must Be Streaming
The good news for Netflix is that it expects margins to continue to improve for its streaming service. Its content-licensing deals are usually a flat rate over a number of years, so a growing user base helps offset the stiff fixed costs. The bandwidth costs of serving up streams through content-delivery networks continue to shrink over time, too.
However, what happens if the growth stops? Netflix is forecasting 7 million net additions on the domestic streaming side this year, in line with what it experienced in 2010. Despite a strong first quarter, it's naive to expect that strength to continue.
Redbox has already gone public with its plans to roll out a digital streaming service with Verizon (VZ) later this year.
Amazon.com (AMZN) has done an admirable job in a little more than a year to build up a catalog of 17,000 titles that it offers to Amazon Prime shoppers at no additional cost. As Amazon expands its reach into video streaming and Redbox debuts a service that should also undercut Netflix on price, it won't be easy for Netflix to grow.
It also doesn't help that cable providers and premium movie channels are trying to make their offerings more compelling by granting customers streaming access to on-demand content at no additional cost. Netflix has had the benefit of growing its streaming smorgasbord service largely uncontested until last year. All of that is changing now.
It's a Long Way Down
It's way too easy to cancel a streaming service. It's not as if there are discs in transit or a queue that can't be blazed through over a weekend of streaming. It isn't a coincidence that Netflix recently stopped providing its monthly churn metric. If your subscriber turnover is going to jump, why volunteer that information?
What happens if Netflix hits the ceiling? What happens if the competition succeeds in eating into Netflix's user base?
We're already seeing margins crash for disc-based customers. What do you think will happen to Netflix if video subscribers start to decline? Given the billions in commitment to content deals, what happens when those costs have to be divided by a shrinking membership base?
As a Netflix investor since 2002, I hope I'm wrong. I'd rather see an upbeat romantic comedy than the creature feature this may become.
Longtime Motley Fool contributor Rick Munarriz does own shares in Netflix. The Motley Fool owns shares of Amazon.com. Motley Fool newsletter services have recommended buying shares of Netflix and Amazon.com. The Motley Fool has a disclosure policy.