Rest in Peace, Netflix

by James Brumley | March 19, 2012 8:42 am

Netflix NFLXA couple weeks ago when Netflix (NASDAQ:NFLX[1]) finally acknowledged it had been in talks with several cable-television companies as a possible distribution channel, the market cheered the news by buying into the stock.

Makes sense. Anytime a company opens a new revenue door, it’s an exciting prospect. Though the cable industry is losing customers, as a group it still provides cable programming to 58.3 million customers per year, and earns about $97 billion per year in doing it. Netflix, by comparison, services approximately 21 million subscribers. Even if only a fraction of cable customers add the Netflix service, the bump in revenue still could be a significant one for Netflix.

The enthusiasm and subsequent rally, however, lasted only a few hours — not because the cable company partnership idea was a bad one, but because investors likely sensed what those cable television companies already know: Netflix is an unsalvageable sinking ship, for a couple of unfixable reasons.

Content Versus Cost

Let’s not mince words here. When Netflix decided to make dramatic changes to its pricing policy[2] in the middle of 2011, it wasn’t part of some master plan to evolve the organization into something even more potent and profitable. The company was desperately trying to figure out how it could remain profitable when the cost of its content was increasing, but its pricing power wasn’t.

You might recall, shortly before (and around) the time of the pricing changes, Netflix was in negotiations to renew its contracts for access to the movies and television programs it was serving to subscribers. Now that Netflix had proven itself a worthy distributor, the content providers wanted a bigger piece of the pie.

Those negotiations did not go well. Indeed, they went so badly, Starz — owned by Liberty Media (NASDAQ:LMCA[3]) — turned down a hefty $300 million offer[4] and decided to stop supplying Netflix with movies and programming altogether. Similarly, Time Warner’s (NYSE:TWX[5]) HBO stopped selling DVDs (for rental customers) to Netflix at wholesale prices. If Netflix wants to offer them to its mail-in customers, it must pay retail price to get them first.

It’s unlikely any of this is news to most investors. In fact, most consumers probably are aware Netflix has been losing content — quality and quantity — during the past few months as programming providers decide not to renew their deals.

What most investors might not realize is that this trend is only going to further develop as time goes on, for one reason — Netflix is a middleman, but doesn’t add any value to the studios and distributors.

To be fair, it wasn’t always that way. Back in 2008 when online streaming television was new, Starz, Time Warner and other content providers didn’t mind throwing Netflix a bone just to see where digital TV went. Now that online television has actually gone somewhere worthy, though, the content providers want a bigger piece of the pie, or they’re not playing ball; they can digitally distribute their stuff through other venues on more favorable terms.

And they are, which underscores the second reason why Netflix as we know it can’t survive.

Geography and Delivery

Cablevision (NYSE:CVC[6]) now offers Cinemax and HBO content online through services called HBO Go and MAX Go. Comcast (NASDAQ:CMCSA[7]) soon will be offering its own streaming service called Streampix, at a slightly lower price than Netflix’s online-only option. More alternatives are on the way[8], too, each one of which is a threat to Netflix.

The fact that newcomers are flooding the market in droves should come as no surprise, since there is no real barrier to entry.

Starting a cable television company requires miles and miles of cable lines, satellite equipment, an entire staff of service people and technicians to distribute and install set-top boxes, and so on. That’s why it’s a rarity to have more than one or two cable providers in any given market — it’s just not fiscally feasible to support them.

Starting a digital online television service, on the other hand, really only requires a few storage servers and a place to put them. In all seriousness, anyone with some licensed programming content could start a digital TV service in a weekend in their garage. Geography is irrelevant.

That low-overhead situation was great for Netflix a few years ago when it was developing the industry. That same low barrier to entry, however, is preventing other players from entering the same market.

One could argue a competitor might have a different or inferior collection of content compared to Netflix, and perhaps they do. In business, though, there is one certainty — there’s always competition out there willing to give more and charge less.

Bottom Line

While there are only two key problems for Netfliix, they’re a pair of big problems. In fact, they’re fundamental problems that chip away at the very core of the Netflix business model.

Unless Netflix can find a way to convince studios and distributors to want less (not likely) and simultaneously convince cable companies to stop adding online offers of their own (also not likely), Netflix might find it’s powerless to stop its own bleeding.

Oh well. It was good while it lasted.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

  1. NFLX:
  2. dramatic changes to its pricing policy:
  3. LMCA:
  4. turned down a hefty $300 million offer:
  5. TWX:
  6. CVC:
  7. CMCSA:
  8. More alternatives are on the way:

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