What Netflix Needs in 2006

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2005 was a breakthrough year for Netflix (Nasdaq: NFLX). The company managed to rocket its way back to profitability despite a fierce price war with Blockbuster (NYSE: BBI). It was able to keep Amazon.com (Nasdaq: AMZN) out of the stateside DVD rental business, too. The company's turnaround rewarded investors with 121% gains in 2005. But 2006 brings a whole new slate of challenges -- and at least one big question to be answered.

With 4 million early adopters on board, will Netflix's growth be scarcer in 2006? Wal-Mart (NYSE: WMT) bowed out of the business, sending its online clients to Netflix, but is the coast really clear as long as Amazon is waiting in the wings? We are now one year closer to the feasibility of a more widespread video-on-demand platform; will Netflix have its response ready? And perhaps the most pressing question of all: When will Netflix start renting video games?

Over the weekend I caught a Gamefly.com ad on Cartoon Network. Yes, a slick televised ad. I've been seeing a whole lot of Gamefly lately. Every week, Best Buy (NYSE: BBY) has been pitching the service in its sales circulars. I bought my Xbox 360 from Toys "R" Us in a bundle that included two free months of Gamefly.com service. Much further behind, but still in the game, is GameZnFlix (OTCBB: GZFX.OB). In November, it began offering its service on a trial basis at some Circuit City (NYSE: CC) stores.

Netflix can't afford to let Gamefly get much bigger. More importantly, it can't leave the video-game rental market open for Blockbuster to start mattering online, or for Amazon.com to enter the online rental market with a vengeance.

Video-game rentals have plenty of shortcomings. They cost more than discs. They tend to have a shorter shelf life. However, renters are more likely to hold on to a game longer than a two-hour flick. That would be significant for a company like Netflix, which subsidizes shipping costs both ways.

Netflix, a market-thumping Motley Fool Stock Advisor recommendation, owns online rentals. For now. It has four times as many subscribers as Blockbuster, its only real notable competitor in the DVD market -- and Netflix needs to keep it that way. Should the company offer games as part of its existing service, or roll out an entirely new game-rental service via its current network of distribution centers? That's for Netflix to decide. Both would work, but it'll need to choose soon.

With the successful launch of the Xbox 360 and this year's expected debuts of the PlayStation 3 and Nintendo Revolution, gamers will be lured to rentals now more than ever. Most of the new systems' games are priced $10 higher than current titles, making gamers all the more eager to try a game before shelling out $60 for it. Launching a game rental service might not be Netflix's biggest question for 2006, but it may hold the greatest ramifications in the long run.

Netflix, Amazon, and Best Buy are Motley Fool Stock Advisor recommendations.

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Longtime Fool contributor Rick Munarriz is a Netflix shareholder and plans to stay that way. He has been a subscriber and investor since 2002. The Fool has a disclosure policy . Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.