Why Netflix May Be Doomed

By Danny Vena - August 28, 2012 | Tickers: AMZN, CSTR, CMCSA, NFLX, VZ | 0 Comments

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The organ plays a slow dirge.  The sound of soft weeping hangs in the air.  Mothers hush their children in quieted tones.  A pyre crackles in the distance.  Silicon Valley is draped in black.  A mournful bell tolls.  The once beloved technological son is no more. 

As an investor with a sizable holding in Netflix (NASDAQ: NFLX), the leading provider of internet movie streaming, should I be worried?  Many say that it is just a matter of time.  Are they a victim of their own hubris?  Will this be a case studied by future business students around the world as the perfect example of the definitive fall from grace?  Is it possible for Netflix to regain some of their former glory? 

It is said that those that do not learn from history are doomed to repeat it, so a review of recent events and the current competitive landscape seems in order.  This will help determine if the thesis is irreparably broken, and if Netflix should be prepared to meet their maker. 

The Golden Child Falls from Grace 

Prior to July of 2011, it seemed Netflix could do no wrong in the eyes of customers or investors.  Customer satisfaction was off the charts.  The stock price had risen steadily from $51 in January 2010 to over $300 in July 2011, a gain of nearly six times. 

Until that time, Netflix included streaming at no charge in their higher priced DVD plans.  Netflix then made a couple of ill-advised decisions, which sent Netflix customers and investors fleeing in droves.  They announced a new pricing structure which separated the DVD and video plans and effectively increased the price of the combined plans by 60%.  While the increase in most plans was far less, this was the percentage increase that was trumpeted in headlines across the country.  60%!  This move surprised and outraged many customers.  Then, to add insult to injury, Netflix announced that they would separate the DVD and video services.  Customers would be forced to maintain separate accounts for each of the two services.  Many that had remained loyal customers saw this as the last straw.  Over the coming months, nearly 800,000 customers canceled their memberships and the stock price began a downward spiral.  While it is laudable that Netflix reversed course before the separation ever occurred, the damage was done.

The Current Competition 

Netflix is the de facto leader in the burgeoning streaming market.  This lead was born of their first-mover advantage, their knowledge of their customer preferences and the lack of any serious competitors in the field.  However, several possible competitors have emerged that may end the reign of the current leader in streaming. 

Verizon Communications (NYSE: VZ) has teamed up with Coinstar (NASDAQ: CSTR) to create a streaming service which they hope will compete with Netflix.  You probably know Coinstar by their ubiquitous self-service Redbox kiosks.  This collaboration marks a turning point:  until now, the telco’s and cable companies have only sought to bring streaming to their existing customer base.  Verizon, it seems, has greater aspirations.  Additionally, as Netflix pushes forward in their effort to dominate the streaming market, they are neglecting their DVD market, even as Coinstar endeavors to steal market share.  Earlier this year, Coinstar spent $100 million buying Blockbuster-branded DVD kiosks operated by NCR Corp.  Allowing Coinstar to take control of the DVD market by default may prove to be a strategic error for Netflix.  DVD customers still provide an important revenue stream that would buy Netflix time while they grow their base of streaming customers. 

Another formidable would-be competitor in the streaming market is Amazon.com (NASDAQ: AMZN).  Amazon currently only offers streaming as a value added benefit of Amazon Prime, a membership program which charges $79 per year for unlimited 2-day shipping.  Recent reports indicate that Amazon is lagging Netflix in the amount of content available for streaming – 17,000 titles vs. 35,000.  While Amazon has not expressed an interest in offering the streaming as a stand-alone service, a change of heart, combined with Amazon’s deep coffers, could spell trouble for Netflix.  Amazon could easily beef up their offerings and give Netflix a run for their money.  Amazon already competes with Netflix in the UK, through their ownership of Lovefilm, the UK’s version of Netflix. 

Finally, many believe that add-on services will eat into Netflix’ customer base.  Streampix, a service of Xfinity by Comcast (NASDAQ: CMCSA) costs subscribers an additional $4.95 per month, $3.00 less that Netflix streaming service cost of $7.99.  HBO Go, is a similar service for HBO subscribers at no additional cost. There is no love lost between Time Warner, the parent of HBO, and Netflix.  Time Warner’s Chief Executive Jeff Bewkes has previously made some very divisive comments regarding Netflix saying “It’s a little bit like, is the Albanian army going to take over the world?  I don’t think so.” 

The Key is the Virtuous Cycle 

The secret to Netflix stratospheric growth had been what they described as the “virtuous cycle” where having more content gets the company more members, and then it can pay more for content.  However, Reed Hastings himself admitted it's only an effective cycle as long as the content cost growth tracks subscriber growth.  A review of Netflix subscriber count over the last several quarters is enlightening.

While the subscriber count is moving in the right direction after the events of last year, I would submit that Netflix has a limited amount of time before their “virtuous cycle” becomes a vicious cycle. 

The Crux of the Matter 

There are currently two questions that remain unanswered:  Will competition in the market drive up the cost of content to the point that Netflix can no longer afford to pay? Will the presumed competitors provide compelling enough alternatives that Netflix subscribers will sign with the competition and abandon Netflix? 

Let me be clear: I have been an investor in Netflix since August of 2007, and this former Wall Street darling still makes up 4% of my portfolio.  I am also a long-time Netflix customer.  Once upon a time, this was a fantastic investment.  In the past, I had blocked out the market noise and held my shares when many said that Netflix was doomed.  I ignored the pundits when they said that the second coming of Blockbuster would crush Netflix.  I remained steadfast even as Amazon, the king of online retail - who has toppled more than one well established legacy competitor, entered the fray of online streaming.  I even kept the faith last summer in light of the public relations fiasco that was the price increase and it’s equally dysfunctional cousin “Qwikster.”  Through all this, I have held my shares, trusted Reed Hastings and watched my investment first grow from my average cost of just under $38 per share, grow to over $300 per share and tank to its current price in the low $60’s.  I have nothing to lose and plenty to gain if Netflix were to return to their former glory. 

Netflix may well emerge from their self-imposed exile from investors good graces.  Every Netflix investor should keep a keen eye on the subscriber numbers.  If those numbers continue their upward trend or even accelerate, Netflix at least has a chance to compete in the streaming market they once dominated.  If their subscriber numbers show signs of falling, then this virtuous cycle becomes a vicious cycle – and its curtains for Netflix.

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