Is Netflix Doomed?

Love MicroFlix? You'd rather loathe it, apparently.

You can't envision Microsoft (Nasdaq: MSFT  ) and Netflix (Nasdaq: NFLX  ) combining. You think it's a rotten deal. "At the end of the day, I don't really see Netflix needing to sell to anyone. They're doing a great job as it is," wrote one CAPS All-Star.

Fair point. Netflix, now 10 million subscribers strong, crushed Street estimates in the fourth quarter. Yet CEO Reed Hastings and his team aren't settling. They're asking members whether they would be willing to pay $9.99 more per month for streamed access to HBO's original programming. Take a bow, sirs.

Or don't. Another reader argued that all Netflix has going for it is a mail-order DVD business that Hastings will one day be forced to mothball, and that Microsoft would be, um, silly to pay billions to acquire it.

Really? Netflix is doomed? Teetering toward disaster as downloadable media destroy the market for DVD-by-mail? I'm not buying it.

A brief history of disruption
That's not to suggest that DVD-by-mail isn't a mature business. Certainly it is. Between Blu-ray and Hulu, among other services, we're witnessing wholesale changes in how digital media are packaged and delivered.

Obsolescence is sure to follow at some point; it's a natural byproduct of innovation. But we also tend to romanticize the process. Tales of the Next Big Thing, told by the Silicon Valley cognoscenti, captivate us. We come to believe that terrestrial radio is dead, slain by Sirius XM (Nasdaq: SIRI  ) . Or that CDs are dead, muted by Apple's (Nasdaq: AAPL  ) iTunes. Or that books are dead, made irrelevant by Amazon.com's (Nasdaq: AMZN  ) Kindle e-book reader.

All three technologies are still alive, though Westwood One isn't any better off than Sirius XM is right now and CDs are beginning to look like drink coasters (sales dropped 15% last year).

Yet the point remains; we often overstate the impact of new technology. Take Napster. Today's above-board music downloading service began as a controversial file-sharing system in 1999 that practically birthed a black market for ill-gotten tracks. Apple opened the iTunes Music Store four years later, but it took five more years -- till last April -- for it to become the top U.S. music retailer, surpassing Wal-Mart (NYSE: WMT  ) .

The rub? A decade after Napster and half a decade after iTunes, the recording industry still sells CDs. (My guess is Beatles albums, mostly. The Fab Four have yet to strike a deal with iTunes or a competing service.)

Can I at least get a standing 8-count?
So if we're only now seeing the death of CDs, isn't it fair to think that DVDs -- and DVD-by-mail -- have plenty of fight left, like an aging boxer who still packs a wicked right cross? Most of the video download services operating today first arrived in 2006.

Netflix, meanwhile, is charging a premium for Blu-ray rentals and quietly taking ever-bigger bites of the DVD rental market:

Year

DVD Rental Revenue*

Netflix Revenue*

Est. Market Share

2008

$7,500.0

$1,364.7

18.2%

2007

$7,500.0

$1,205.3

16.1%

2006

$7,500.0

$996.7

13.3%

2005

$6,500.0

$682.2

10.5%

2004

$5,700.0

$500.6

8.8%

2003

$4,500.0

$270.4

6.0%

6-YEAR TOTAL

$39,200.0

$5,019.9

12.8%

Sources: Capital IQ, The Digital Entertainment Group. *Numbers in millions.

Eat that, Blockbuster (NYSE: BBI  ) .

No doubt Netflix's core business is going to suffer a shift at some point. Hastings has said as much. But he also has years to figure out how to make the transition smooth for customers and investors. You're welcome to bet that he won't be able to. Just don't ask me to do the same.

Grab the popcorn. Further Foolishness is about to begin:

Apple, Amazon, and Netflix are Stock Advisor selections. Microsoft and Wal-Mart are Inside Value picks. Try either of these Foolish services free for 30 days. There's no obligation to subscribe.

Tim had stock and options positions in Apple at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. Its disclosure policy wonders if anyone will be playing Rush's 2112 album in 2112.


Read/Post Comments (13) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 24, 2009, at 12:12 PM, Joelshann wrote:

    While there is a move toward the ubiquitous (and ambiguous) entertainment model that hinges on "out there, somewhere, I can get whatever I want" there is enough of the population for which ownership represents a key identity structure. DVDs will go away. Blu-Ray eventually. But there will remain some element of concrete ownership--be it tiny flash chips full of movies, or something else--that will undergird the rental business.

    Hastings is like Jobs (with regards to Pixar)--he'll sell at his perceived top, when a perfect storm of competition looms on the horizon. Microsoft would be a fool not to acquire the consumer base (eventually), and Hastings doesn't just sit on the MSFT board for nothing. Like it or not, MicroFlix--or whatever you want to call it--is a likely future.

  • Report this Comment On February 24, 2009, at 12:14 PM, dmlyons25 wrote:

    Although netflix is making money, their service is horrible. I had been with them for awhile now, but switched back to blockbuster due to the availability of new releases. Blockbuster has way more copies of new releases coming out then netflix. I would have new releases as 1, 2 and 3 in my que with netflix but still not get them. Instead, I would get other movies that were not at the top of my que. When I called them to inquire about it, I was told that they did not have enough copies for everyone to go around. Furthermore, those new releases at the top of my que then we to a very long wait and you could not get those same movies that you wanted for several weeks. It was very frustrating. In the long run, I think many people will switch back to blockbuster b/c you will at least get the new releases sent to you every week where with netflix you will not. I have talked to a few co-workers that have netflix and they are having the same problems. If they do not up their inventory, that will ultimately be their demise.

  • Report this Comment On February 24, 2009, at 1:07 PM, warbowl wrote:

    And let's not forget Coinstar's 100% owned Red Box. Sure, in the long term, they'll suffer losses to digital downloads, but there's a whole mess of value-oriented, instant-gratification-needing, tangible-loving, low-tech-minded consumers who don't have the set-up to stream movies from computer to TV and would rather grab a movie from the red kiosk. Even once digital downloads do catch on, who can compete on price with $1 movies? And let's not forget Blu-Ray, which will slow the move to digital, and the massive special features that DVDs offer. It will be a long time before digital downloads can offer the same special features breadth and depth of DVDs.

  • Report this Comment On February 24, 2009, at 1:14 PM, jkellynewyork wrote:

    okay say MSFT is to pay $2.5 billion, at 10 million customers, that is $250 per customer - I dont think so

    Tim - your numbers are showing that rental revenue has peaked, and NFLX rev growth and growth in market share is slowing ... that does not look that pursuasive ... also look out for explosive growth in revs at redbox, these guys at coinstar are to hit NFLX as they contniue to expand and make their presence known - look at alexa.com ranking growth for redbox.com - most if not majority use NFLX for newer release DVDS which are considerably cheaper than VOD- redbox is going to take these customers

    you talk about making transition smooth - but you dont get that NFLX is nothing special in streaming - they are dependant on others - including cable internet pipeline - if the model was to be anything big, it can easily be adopted by amazon, apple, and the like

    go ahead and make your bets - but the real fact is NFLX insiders are dumping huge amounts of shares - so did NFLX largest shareholder Goldman - these are telltale signs - if they aint betting neither am I

  • Report this Comment On February 24, 2009, at 1:21 PM, AQCon wrote:

    Tim Beyers, the answer to your question is a resounding YES!

    Netflix is doomed. Doomed by their business model.

    We've all heard that Reed Hastings came up with the idea for Netflix when he returned a movie rental about one week late and had to pay crazy late fees.

    So he created a service for people like him--people who are too busy to watch and return movies but don't want to incur late fees.

    The problem with this model is that if their customers are not responsible enough to return a DVD right away then how could they be responsible to care for the dvd's in their possesion?

    4 out of 5 dvd's that I get from Netflix are scratched or otherwise damaged. If I report the damage, I am penalized by Netflix.

    (A damage report tends to delay shipment of the next title in my queue.)

    I, like many other subscribers, stopped reporting the damaged DVD's altogether.

    The other major flaw in his business model, is "throttling" for which he was sued by class action and settled.

    I finally got wise to what Reed Hastings was doing and here is my solution:

    Suspend your monthly membership just before it expires.

    Keep tabs on your dvd queue and as soon as all the titles you wish to watch are available, reactivate your membership. It may take a few months for that to happen, but then you'll be able to at least get dvd's on a semi-regular basis and not "what makes financial sense to Reed Hastings." In the interim, you can get all you want from RedBox.

    Netflix needs to realize that even the frequent renters will soon tire of watching movies and will become infrequent renters if he stops throttling. If he continues to throttle, those frequent renters will jump ship.

    (Throttling: Netflix customers who pay the same price for the same service are often treated differently, depending on their rental patterns. Therefore, "unlimited rentals," only applies to those who tend to keep each title for a few days at a time.)

    Netflix defends their Throttling practice as follows:

    "In determining priority for shipping and inventory allocation, we give priority to those members who receive the fewest DVDs through our service,"

    Netflix's revised policy now reads. The statement specifically warns that heavy renters are more likely to encounter shipping delays and less likely to immediately be sent their top choices. Few customers complained about this "fairness algorithm," according to Netflix CEO Reed Hastings.

    That is because these complaints are meaningless.

    Reed Hatings ignores their complaints and ultimately explains their exodus to standard rates of churn.

    Don't buy it. Netflix is doomed if they continue this despicable practice.

    Oh and if you think the instant viewing feature will save Netflix, think again--Netflix has begun to add time limits to the instant viewing titles--another annoying reason to dump Netflix.)

  • Report this Comment On February 24, 2009, at 1:26 PM, trurl9 wrote:

    Vinyl records still exist. I saw turntables at Best Buy the other day. Netflix and similar models exist for bleeding edge folk, but the tail of the bleeding edge comet hosts all those who prize vinyl, vhs, casettes and 8-track - well maybe not 8-track.

  • Report this Comment On February 24, 2009, at 1:28 PM, hershalsavage wrote:

    Politely disagree about their Customer Service. We had been Blockbuster members for years and had been very unhappy with their service (both my mail and in-store by "surely teenager").

    Netflix has blown them out of the water in my experience. Both in terms of CS and selection. We'll be sticking with Netflix.

  • Report this Comment On February 24, 2009, at 1:53 PM, AQCon wrote:

    Post Script:

    Once Netflix's "fairness algorithm" flags your account as a "frequent renter" you are doomed.

    Apparently, it is almost impossible to remove that scarlet letter from your account without closing it and creating a new account under a new name--assuming it is even worth the trouble.

    Are you wondering if you are being throttled?

    Ask yourself these questions:

    Do you see "Long Wait" and "Very Long Wait" next to new releases in your dvd queue?

    Have you received dvd's from distribution centers located out of state?

    If you answered yes, you are being throttled.

    While complaining to Netflix CS will fall on deaf ears, you may want to speak up in forums such as these, where Wall Street is listening.

    Reed Hastings, SHAME ON YOU (for throttling and not offering a credit for damaged dvd's).

    I guess I'll have to wait for the day when Netflix drops the DVD by mail model and goes with Instant Viewing exclusively.

  • Report this Comment On February 24, 2009, at 3:01 PM, friojefe wrote:

    Why even use netflix, when you can go to the redbox and get the most popular videos for $1.00 per day

  • Report this Comment On February 24, 2009, at 5:05 PM, jkellynewyork wrote:

    friojefe - redbox is exploding in rev growth and they are bettering the online system for reserving titles and renting movies- the problem is that redbox still has a limited set of locations - bricks & mortars, including a huge number of blockbuster locations have been shutting down due to costs and people flocking to mail order cause there is no longer a blockbuster around the corner - kiosks dont have these overhead concerns. i for one lost the blockbuster on my corner and would have to walk about 10 blocks to get to the nearest blockbuster so I dont use them anymore. the prob with redbox is limited capital to expand - I started using NFLX but quickly dumped them after being throttled - redbox was going to do a IPO last year to raise capital but pulled for obvious reasons - so it may take longer to install units but they are coming albiet slowly - once these things are on every other block, you will see them take a huge percentage of market share from the DVD rental business. they recently opened the first one in manhattan - big cities with a huge population in limited space is where they will do especially well

  • Report this Comment On February 24, 2009, at 7:06 PM, JPDemers wrote:

    Certainly DVDs-by-mail is a doomed business, and the market is inexorably moving toward digital downloading or streaming. The only question is, who will be master of that particular universe?

    Cable company VOD service? Hulu? Apple? Netflix on-demand service? From the customer's viewpoint, it's all the same thing, and the market will break down along the usual lines of price and service. The latter is going to depend on who manages to ink the most deals with the major studios for digital transmission rights.

    My idea of a real winner is "iFlix" -- Apple buying Netflix (they could just write a check), and bringing that customer base (already sufficiently computer-savvy) into the iTunes movie store. Getting a movie there is already as easy as getting a tune for your iPod. The only customers who'd stick with the mailers would be those still using dial-up modems. There's no reason to think that Apple can't work their magic on the movie business.

  • Report this Comment On February 25, 2009, at 2:27 PM, tholyoak wrote:

    Redbox has the same problem as Netflix does when it comes to new releases - there are not enough copies to meet demand. Their new tactic of putting in old classics is only going to make it worse.

    I bought the Roku box for watching Netflix movies on my TV at the end of 2008. My family now uses that much more than DVDs. I am on the one at a time plan with Netflix, so I can get the instant streaming, and I gradually get the new releases as my turn finally comes. If I really want to see something without waiting, I reserve it at Redbox.

    If Netflix were able to put the new releases online for on demand viewing, they wouldn't need to send any DVDs at all to a lot of customers, and they'd save a lot of money. The only reason I personally would then want to use physical DVDs at all is to use them in my Clearplay DVD player on the ones that need editing for my family's viewing standards.

  • Report this Comment On July 23, 2009, at 4:05 PM, raider1234 wrote:

    In the end once broadband speeds become fast enough p2p will end up winning. They will ultimately force content providers to releasing their content online for free on an ad-supported basis such as hulu. That is only if the content providers are lucky enough to not be pushed out of their middleman market on the internet altogether.

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