How Netflix Is Profiting From AOL's Failure

A coworker of mine recently compared Netflix (Nasdaq: NFLX  ) to the AOL (now part of Time Warner (NYSE: TWX  ) ) of the late 1990s. As a shareholder of Netflix, I was glad to hear him use phrases like "untouchable" and "no real competition," but I had to protest when he said the words "eventual burn-out."

I strongly believe that Netflix is using AOL's 20th-century business plan to learn exactly what not to do. It's zigging where AOL zagged -- and it's right on the money.

Ameriflix?
First, let's be fair to my coworker by starting with some comparisons of modern-day Netflix and 1999 AOL:

1. Online subscription businesses. AOL supplied Internet access, and Netflix delivers movies and television shows for a flat, monthly fee. Each generates revenue by acquiring and retaining customers month after month.

2. Pioneers of their industry. AOL gave Internet access to the masses, peaking at over 30 million subscribers. Netflix created the online DVD rental business in 1999 and has since grown subscribers at a compounded rate of 64% per year.

3. Savvy marketers. AOL became famous for blanket mailings of CDs offering a gazillion free hours of service. If it cost AOL a couple of dollars to create and mail a CD, it would only take a tiny percentage of recipients to become customers at about $23 a month in order for AOL to make massive profits.

Netflix, like credit-card company Visa (NYSE: V  ) and grocery store Safeway (NYSE: SWY  ) , also uses direct mailing to its  benefit, as well as free trials, but it spends most of its marketing in online remnant ad markets. These are the non-premium ads you see throughout the Web, at the bottom of pages, in pop-ups and pop-unders. These tactics are working increasingly well for Netflix. In the fourth quarter of 2008, subscribers grew 26% year over year with 8% less marketing spending.

These three comparisons make Netflix and AOL look very similar, and you can make an argument that eventually Netflix's omnipresent ad-buying won't sustain its growth, just as AOL's CD carpet-bombing fizzled out.

But I have three good reasons why Netflix is succeeding by using AOL's history as a guide.

1. Focus. In AOL's case, it was the lack of focus. It initially grew its business by providing Internet access to millions. AOL was great at marketing it, and pretty good at delivering it.

So, what did it do? It spent more than $4 billion on Internet browser Netscape, long ago put to rest by Microsoft's (Nasdaq: MSFT  ) Internet Explorer. It shelled out $525 million on Moviefone. It also made an $800 million investment in Gateway.net (what?), spent $1.1 billion on Mapquest (Google (Nasdaq: GOOG  ) went the better and cheaper route and developed its own map technology), and, oh yeah, there was that more than $100 billion merger with media conglomerate Time Warner.

What do any of these companies have to do with providing Internet access to consumers' homes? AOL simply lost focus of its main goal.

Netflix, on the other hand, is the epitome of laser-focus. How many Netflix acquisitions can you name? It does nothing other than rent movies and TV shows through its website, and it's the unchallenged best at it with 80% of their market. In fact, Netflix has recently shuttered non-core projects like the Red Envelope division and the practice of selling used DVDs. I'd recommend that every CEO in the world read the second paragraph in the Netflix blog announcing the change:

As you know, our core business is delivering great movie rentals to you on DVD by mail and instantly to the computer and TV, so we've decided it makes sense for us to focus exclusively on that. [emphasis added]

2. Vision for the future. Part of AOL's failure was that it didn't react fast enough to the consumer shift from dial-up to broadband. Years of underinvestment left AOL unprepared for this shift.

Netflix, on the other hand, is prepared for the new medium of its industry: digital delivery. Sure, Netflix is only dipping its toe into the digital waters -- it's planning for many more years of growth in the $8 billion DVD rental industry -- but by the time it peaks, Netflix should be ready. By lining up content licensing agreements and perfecting the art of streaming video now, it  should be ready to meet consumer demand.

3. Customer satisfaction. Late-1990s AOL was accused by 37 state attorneys general of "overselling" Internet access to its members, meaning it sold more connections than it had the infrastructure to support.

Predictably, this led to lots of unhappy customers and eventually, fewer paying ones.

Once again, Netflix learned greatly from this lesson. Netflix recently increased pricing on Blu-ray enabled accounts. This might seem odd given the heat it has taken on the low availability of Blu-ray discs, but it's exactly the right move.

Demand too high to support supply? Increase prices and reinvest the profits. It's an Econ 101 lesson that AOL must've played hooky on.

For more Foolishness:

Jeremy Phillips (TMFMoby) owns shares of Netflix. Netflix is an active recommendation of Motley Fool Stock Advisor, which you can try free for 30 days. Google is a Motley Fool Rule Breakers recommendation. Microsoft is a Motley Fool Inside Value recommendation. The Motley Fool's disclosure policy has never failed.


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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 April 21, 2009, at 5:33 PM, JPDemers wrote:

    "by the time it [digital delivery] peaks, Netflix should be ready."

    Let's hope they're ready well before the peak! The way to dominate a fast-growing market is to be in it early, and grow with it. Delivering HD movies to millions of subscribers is going to take epic amounts of storage and bandwidth. NFLX still has time to blow it the way AOL blew it, if they fail to build infrastructure at least as fast as the demand is growing.

  • Report this Comment On April 21, 2009, at 6:01 PM, TMFMoby wrote:

    @JPDemers: "Delivering HD movies to millions of subscribers is going to take epic amounts of storage and bandwidth."

    This is exactly what Netflix is betting on for the next five years. They're happy to be the last man standing in the DVD rental business until it becomes cost effective to deliver HD movies digitally. A Blu-ray disc is 50 Giga-bytes. That's a lot of data for 42 cents each way, and really cannot be matched by anyone right now, though it probably will be within five years.

    Check out our budding Netflix SWOT Analysis on our wiki for more on that front: http://wiki.fool.com/Netflix#Netflix_Swot_Analysis

  • Report this Comment On April 21, 2009, at 10:44 PM, azmfool wrote:

    My view, you hit two nails on the head. The Time Warner merger was, in 20/20 hindsight (or maybe not), a spectacularly bad way to chase after content. But I think it was the change in the method of delviery from dial-up to broadband that really killed them.

    AOL did try to market services after broadband hit critical mass, but think about this - you were already paying for a telephone connection when AOL and dial-up came along. Once the broadband providers hit their stride with content of their own (Comcast, Cox, etc.) why would you pay an additional fee to AOL?

    The difference could be Netflix being savvy enough to form strategic partnerships and stay ahead of on-demand cable, where content is still minimal.

  • Report this Comment On April 21, 2009, at 11:16 PM, TMFMoby wrote:

    "The difference could be Netflix being savvy enough to form strategic partnerships and stay ahead of on-demand cable, where content is still minimal."

    Great point. Netflix investors need to keep an eye out for this relative to the consumer demand/ability to pay for this medium.

    It's also important that Netflix doesn't overinvest in that arena before it becomes sustainably profitable. For example, an analyst came out today with a sell rating on NFLX citing Youtube and Hulu as threats even in the short term. There is simply no way either of these companies can profitably stream movies with the current US broadband infrastructure. That's why you see companies like Time Warner consider limiting bandwidth usage:

    http://www.pcmag.com/article2/0,2817,2344773,00.asp

    And that's before you consider the cost of licensing the content itself. Definitely keep an eye on on-demand cable as azmfool points out, but also watch out for Netflix chasing demand that isn't there yet.

    Disclosure: Long on Netflix

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