Why Netflix Will Never Be Great Again

NetflixNetflix (NFLX) was a slasher flick on Tuesday. The stock fell 14% after posting mixed results and uninspiring near-term guidance.

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.
Clearly a stock doesn't take a 14% haircut if this is the whole story. Unfortunately, it's not even half of the story.

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?

The real Netflix-killer, though, would be a decline in streaming customers. If Netflix is right, it will be closing in on 30 million domestic streaming subscribers by the end of the year. That's a lot of homes, especially when you consider the chunks of the population that have already decided Netflix isn't for them or don't have the technological capability or desire to pay for video streams.

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.

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zmovie.tv/ and projectfreetv are free and have more movies and tv shows than netflix, why do they expect people to stay subscribed when there are better alternatives that don't cost a cent ?

August 13 2012 at 11:18 AM Report abuse rate up rate down Reply

We are snowbirds who spend 6 months in Arizona in our RV with no streaming capability. When we're home in Oregon, we have 3 discs and unlimited streaming. If Netflix goes to all streaming, we're out of luck (at least in the winter). There are thousands of us in the same boat. I'll be very sorry when Netflix goes to all streaming and they will probably lose a lot of customers like us..

May 03 2012 at 4:03 PM Report abuse rate up rate down Reply

Once netflix throttled down the way customers could get more videos on quick turaround they were lost to me and probably thousands of other customer, then to jack up the rates. What were they thinking. The sooner they go broke the better.

April 27 2012 at 9:17 AM Report abuse +1 rate up rate down Reply
John Cerullo

I have already noticed that Netflix is no longer carrying some of the great old films it previously had on DVD. Just another slap in the face to customers. I'll probably be bailing out soon. Too bad, really. The US Postal Service made Netflix and now Netflix is destroying itself by dumping on its customers on that chain.

April 26 2012 at 6:56 PM Report abuse +2 rate up rate down Reply
Jan Vones

It is insane how far Netflix has gone to alienate its customers. I dropped the by-mail service when they did us the (very insulting to one's intelligence) "favor" of almost doubling their rates. Now, with only the online service, if I search for a movie like Logan's Run that's not available for streaming it doesn't allow me to save it for later or suggest that I get it by mail. It doesn't even let me know the title exists at all!

I just tried out Blockbuster's one-month free by-mail service. Their selection is incredible compared to Netflix. But their turn-around time for returned movies is insane. They only process orders M-F. You can return disks to the storefront, and maybe the computer will show them returned when you get home, or maybe not. Last week I returned my disks on Thursday afternoon thinking the next items on my queue would be mailed Friday and I'd get them Saturday. On Friday they still showed "at home" status more than 24 hours after they had been check in at the store register. I went to the store to complain, and the clerk showed me his computer registered them as returned. No update all weekend then come Monday I get an email saying they have been sent and will arrive by Thursday! Netflix was like clockwork. Movie returned to the PO by 5pm Monday, Tuesday show the next movie is on its way, Wednesday noon it's in my mailbox. There's a huge difference between 48 hours and a whole week, or 10 movies a month with Netflix and 4 a month with Blockbuster even when you do the mailman's job and return the disk to their storefront.

These are both insane business models. Do we really need a genius like Herman Cain to come in and school these fools? How about a fully integrated, searchable and user-friendly database, with the option of unlimited streaming and, say, one by-mail title a week for $10.99?

April 26 2012 at 2:17 PM Report abuse +2 rate up rate down Reply
Barbara Allen Detwil

Netflix You should have left the way you were running things instead of trying to be greedy. These are tough times It was nice to be able to choose how you watched for one price. Thats why I cancelled .

April 26 2012 at 11:36 AM Report abuse +2 rate up rate down Reply
Antonio Angelo

The ceo lacks competitive spirit, listening in on the conference call with the ceo basically admitting they cant compete with hbo made me bury my head in hands, If this company wants to succeed they need to change their model over to a pay per view with premium content or create a premium channel that charges enough that they can afford decent content. They admit to chasing second rate content because they are targeting the value customer but the value customer isn't where the money is. Original content is another solution but they barely dipped their toes in the water and honestly i cant ever remember seeing a single ad for any show that is on their original content list.

I am not short on this company only because I hate shorting.

April 26 2012 at 3:13 AM Report abuse +1 rate up rate down Reply

"Reed Hastings" needs to be shown the door if Netflix wants to survive.

April 25 2012 at 6:49 PM Report abuse +2 rate up rate down Reply

We had Netflix for years, and then they decided to separate the disc service from the streaming service (Why, Netflix? We can only watch one movie at a time regardless of the delivery method!). Not enough titles on the streaming side, so we opted for the disc service -- which is now no doubt going to be phased out.

Netflix has just blown it for many of their loyal customers. They could have just bumped up the monthly rate *slightly* and left well enough alone. But, in trying to do what they no doubt thought was something to generate more revenue, they are now slowly "slipping into the abyss".

Doesn't matter to us -- we're looking for another provider anyway. Some of us customers don't take kindly to getting screwed over, no matter how insignificant it may seem.

April 25 2012 at 4:11 PM Report abuse +2 rate up rate down Reply

I am on the Netflix three at a time plan. It works really well. If you are rural and are on dial up thats about all you can do. Best thing they could do for me would be to have better movies and refine their selection process, takes awhile to get through all the junk they offer and foreign movies.

April 25 2012 at 4:11 PM Report abuse rate up rate down Reply