Amazon's Loss Is Netflix's Gain

Cheer up, Netflix (Nasdaq: NFLX  ) investors. (Nasdaq: AMZN  ) is pulling out of the DVD-rental market in Europe.

I know. I can hear you now. "Who cares? Isn't Netflix just a domestic operator? Was it ever going to butt heads with Amazon in Britain and Germany?"

Those aren't the right questions to ask. The key takeaway is that the Amazon brand is retreating from the physical distribution of DVDs. So why is Amazon leaving the market? Does this mean Amazon has zero interest in acquiring Netflix? If this move is indicative of Amazon's push to deliver more products digitally, won't that harm Netflix in the long run?

Now, those are the questions you should be asking, even if you won't like the answers.

Why is Amazon leaving the market?
Amazon's move yesterday to hand over its DVD-rental subscribers to Lovefilm isn't necessarily the end for the online-retail giant in this niche. If anything, Amazon will become Lovefilm's largest shareholder.

That's important. Between Lovefilm's 600,000 subscribers and Amazon's 300,000 users, Amazon is now a key investor in a hot European brand that will reach three times as many film buffs as Amazon did on its own.

Worrywarts in the Netflix camp may also begin feeling twitchy over the move. An important factor keeping Amazon out of the domestic rental market -- beyond what once was cutthroat pricing pressure from Netflix and Blockbuster (NYSE: BBI  ) -- is the literally taxing quandary over setting up regional distribution centers in most states to provide overnight delivery using conventional postage. The argument goes that the moment Amazon pitches its tent in a particular state, it will have to automatically collect sales tax for all of its orders -- not just rentals -- in that state.

So why would a Netflix pessimist be donning the tinfoil hat? Well, if Amazon is simply a passive investor in Lovefilm, and Lovefilm eventually makes the stateside push, Amazon may be able to skirt the taxable implications throughout its e-commerce operations.

Why is Amazon leaving the market? It isn't leaving the market at all.

Next question.

Will Amazon still make a play to acquire Netflix?
Stateside, Amazon has focused on promoting the sale of digitally delivered media products. It's pushing video through Unbox, audio through MP3 downloads and now Audible (Nasdaq: ADBL  ) , and e-books through its Kindle electronic reader. These are high-margin products that come with minimal fulfillment costs, and they're perpetually in stock. So why would Amazon still want a piece of Netflix?

Don't overthink the question. Of course Amazon would like to claim Netflix's audience. Netflix closed out 2007 with nearly 7.5 million subscribers, after all. We're talking about 7.5 million families that are passionate about media consumption, with the means to pay for monthly subscriptions. For every product that Amazon wants to deliver digitally, Netflix is holding many of the likely early adopters, with the funds and appetite to deliver the goods.

Amazon is unlikely to acquire Netflix whole, but don't overlook the possibility that Amazon may want Netflix to be at least as close as Lovefilm now is in Europe. Amazon wants to be on good terms with Netflix to reach its desirable membership base.

Consider, too, that Netflix has holes that Amazon would plug perfectly. Netflix is a master of massaging data, for example. It dishes out recommendations after poring through the picks and pans of its users to deliver accurate results. However, Netflix's attempt to move dated inventory by promoting the retiring discs to its subscribers as sale items has been uninspiring. Netflix could certainly use Amazon's muscle, if only as an e-tail partner.

It wouldn't surprise me to see Netflix and Amazon as healthy partners in the future, but little more at this point.

Last question?

Won't Amazon's digital push hurt Netflix?
Amazon and Apple (Nasdaq: AAPL  ) are now selling digital rentals at reasonable price points. Netflix, meanwhile, has been no slouch in rolling out Web-based streaming, and it's hoping to be Mac-compatible by the end of the year.

However, Netflix is limited to mostly obscure indie offerings that can accept meager revenue-sharing proceeds, along with a handful of older studio titles. That may change in time. In fact, I predict that Netflix may eventually begin charging for recent releases delivered digitally, in an attempt to appease apprehensive studios that would rather settle for dollars through Amazon or Apple rental than pocket change through Netflix.

If Netflix takes that step, it will remain the DVD rental leader, but with the incremental revenue stream of digital delivery to boot. Since the older titles are likely to remain part of the Netflix free service, it also has a library of gateway offerings to get its subscribers hooked on digital delivery.

Netflix may not be the leader in a digitally delivered future, but it will be a leader. That's enough reason to welcome the future with open arms.

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