Netflix Has a Bigger Problem Than You Think

Investors shouldn't be surprised by Netflix (Nasdaq: NFLX  ) hosing down its domestic subscriber targets this morning.

Any rational person could see that the company and blinders-donning analysts were underestimating the consumer resentment spurred by Netflix's decision to begin charging subscribers on unlimited DVD plans for streaming access. That move resulted in a price increase of as much as 60% for those wanting to receive optical discs in the mail and stream from the dot-com giant's growing digital catalog.

The outcome isn't a shocker. Netflix was targeting 25 million domestic subscribers by the end of the third quarter two months ago. Now it sees just 24 million accounts in this country when its quarter comes to a close in two weeks.

Ouch!

Time for a Shyamalan twist
Penny-pinching couch potatoes may applaud the karma police. How dare they be hit with a price hike during uncertain economic times, just because they want to stream Mad Men while the postman plunks down a rental copy of Crazy People in their mailbox?

However, there's a surprising plot twist here. No matter how hard the media today will position this guidance update as the result of Netflix's brazen price hike, the defections have nothing at all to do with the move.

Yes, nothing.

Netflix still expects the number of subscribers on dual plans for streaming and discs -- the only group that is being affected by the pricing change -- to clock in at 12 million, exactly where it was earlier this summer.

The shortfall is actually coming from the rest of Netflix subscribers. Back in July, Netflix was forecasting 10 million accounts paying only $7.99 a month to stream. It now sees 9.8 million subscribers exclusively streaming. It was aiming for 3 million subscribers to be on disc-only plans, and now that target has been scaled all the way down to 2.2 million technophobes.

This may actually come as a relief to those worried about the impact of Netflix's price change, but it should be even more problematic for the model itself.

No streamers at this surprise party
Netflix knew it was taking a risk when it began pushing Web-based viewing. Sure, it would save a ton of money in distribution, since it's far cheaper to beam a film through the Internet than to cover round-trip shipping. There is also the benefit of bypassing inventory logistics. There are no damaged discs or limited availability problems when it comes to digital delivery.

However, this move also eliminates one of Netflix's greatest competitive advantages -- a network of regional distribution centers -- from the equation. Only Dish Network's (Nasdaq: DISH  ) Blockbuster could match that infrastructure, but in the streaming space the playing field is level.

It all boils down to a content-acquiring footrace. Netflix is comfortably ahead of the pack. The nearest rival offering unlimited streaming is Amazon.com (Nasdaq: AMZN  ) with 8,000 largely dated titles. The rub here is that no streaming service will ever have access to everything that's available on disc, something that became perfectly clear when Starz (Nasdaq: LSTZA  ) revealed two weeks ago that it would not be renewing its Netflix deal.

If you're still not worried about streaming's viability as a business model, let's take a look at churn. No matter how many people you think have signed up as new subscribers for Netflix's $7.99 a month streaming plan over the past three months, 200,000 more than that are cancelling. That is, in a nutshell, what Netflix is telling you this morning.

Again, you shouldn't be surprised. It's all too easy to cancel a streaming service. There are no discs in the house to return, or discs on the way. Online queues are easier to empty out when you're not at the mercy of the USPS. This plan is at the same $7.99 price point that it has been since its inception last year.

It's time to worry.

Herniated disc pain
What does it tell you when folks on disc-based plans -- the only plans to actually drop in price with this move -- are clearing out?

This is the one that really took me by surprise this morning. I figured that folks on dual plans -- if they had to choose one over the other -- would downgrade to disc-only plans. The competition is fierce here. Coinstar's (Nasdaq: CSTR  ) Redbox and NCR's (NYSE: NCR  ) Blockbuster Express kiosks continue to grow in number, but it's hard to beat Netflix's huge catalog, proven fulfillment process, and compelling value proposition.

Well, there are apparently fewer red mailers going out these days. Did Netflix do too good of a job selling digital delivery? Was this just the most price-conscious group in the lot, making it the first to fall in a summer of cascading consumer confidence? Either way, this guidance raises more troublesome questions about the Netflix model itself than anything related to the pricing elasticity behind this summer's ill-fated shift.

You have a problem, Netflix -- and it's not the problem that everyone else thinks it is.

If you want to follow the plot twists in this saga as they occur, add Netflix to My Watchlist.

Motley Fool newsletter services have recommended buying shares of Netflix and Amazon.com, as well as buying puts in Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Longtime Fool contributor Rick Munarriz has been a Netflix shareholder and subscriber since 2002. He does not own shares in any of the other stocks in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.


Read/Post Comments (26) | Recommend This Article (36)

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  • Report this Comment On September 15, 2011, at 1:16 PM, jefffawcett wrote:

    The problem Netflix has that I NEVER see anyone address is the reason I personally no longer subscribe - customers running out of things worth watching. How many movies a year are released that are worth even $3 to see? I was on the 4 movies a month plan, there certainly aren't 48 new films a year that interest me, especially since I catch the blockbusters in the theater. Even after plowing through all those great HBO and Showtime series, after a few years it gets harder and harder to justify the price when by definition you are watching things that interest you less and less.

  • Report this Comment On September 15, 2011, at 1:18 PM, dorinay wrote:

    Thank you fool for finally waking up to the storm! DVD business is fading quickly and the streaming business is much more costlier with many more competitors. They are the next Blockbuster.

  • Report this Comment On September 15, 2011, at 1:40 PM, hellomojo wrote:

    @jaffawcett - Amen!!.. Your exactly right. We have had Netflix for 4 years or so; streaming and 1 disk at a time plan. I could care less about any of the content they currently stream and its almost work to find a disk that I want to watch. My wife still watches alot of the tv series via stream..but you can find most of that for free now so its kinda pointless. We just changed to streaming only but expect that will get canceled before too long. The Studios might not believe it but their content is NOT worth that much....as Netflix will soon find out.

  • Report this Comment On September 15, 2011, at 1:46 PM, TMFBent wrote:

    As dorinay notes, streaming makes delivery cheaper, but it doesn't make content any cheaper. Most likely, the opposite will be the case, to an extent and expense no one can yet estimate. Remember, NFLX paid once for a disc, and could send it to as many people as possible until it broke. That doesn't hold in streaming. Netflix will have to pay a fee for every time it feeds a movie, and this may increase content costs substantially. Even Netflix has no idea how much, as evidenced by the way the Starz deal fell apart.

    Rick's right. Netflix is losing a competitive edge here, and quickly. Streaming video is something many outfits can accomplish, and soon enough, a more liquid market for content costs and subscriber fees will likely drive returns down.

    I would not be surprised to see Netflix turn into the next Iomega, myself.

  • Report this Comment On September 15, 2011, at 2:14 PM, burr0081 wrote:

    @jefffawcett -- Spot on. I agree with the commentary about general headwinds facing Netflix (competition, price of content, lower barriers to entry), but I think this is an item that gets overlooked in understanding why Netflix's churn is so high, and why their top line number for maximum subscribers at a given time may be lower than people think.

    I have subscribed to Netflix twice. Once in about 2005-06, when it was discs only, and once from 2010 to recently, when I got both discs and streaming. Both times I canceled because I basically ran out of things I wanted to watch. Even at $16, the price isn't bad, if you have content you want to watch. HBO costs about the same. But these services are only a good value if I can find say 5-10 hours of unique content I want to watch per month. Lately, I've had trouble finding that on Netflix.

    I'll likely subscribe to Netflix again in another few years once a backlog of content develops that I want to see. But under Netflix's current model, it's hard to see me ever becoming a more or less permanent customer. I suspect a lot of othe people are in the same boat.

  • Report this Comment On September 15, 2011, at 3:02 PM, chadscards1274 wrote:

    I think there are a couple of pieces missing here. First, NFLX did and I'm sure will lose some existing subs completely. This accounts for a subtraction from both the streaming and the disc subs count. Second, I think you're exactly right that the DVD only subs were probably more price conscious. Think about it, if you signed up for NFLX and got the 1 disc with unlimited streaming for the old pricing then you hear prices are going up to basically $16 in many cases people may shoot first and ask questions later. Rather then trying to decide whether to keep the streaming only versus the disc only they may just cancel and decide it's easier to go to Redbox and get their once in a while DVD fix.

    Just a correction to another comment. NFLX generally licenses content from a company at a set amount for a set amount of time. Their content is not a cost per stream so the argument that their costs scale up with more subs is just completely wrong. The more subs the less they pay per person.

    Long story short, I think the bigger question is what happens going forward depends a lot on NFLX ability to get good content, in a year or so no one will be talking about this price hike because it will be something in the past. 3rd Q probably is the worst of it, 4th Q gets a little better. Next year will be a better picture of what will NFLX growth longer term look like.

  • Report this Comment On September 15, 2011, at 3:46 PM, pvisf wrote:

    I disagree on the major point.

    Yes, Netflix may have jumped too quick on the price increase and scared off the value customers. However, streaming is the future of video content.

    Netflix was right to jump on this market and take an early lead. - Look how quickly Blockbuster tanked because they thought they had more time -

    Content will decide this race, and as long as Netflix has the most, it will win.

  • Report this Comment On September 15, 2011, at 5:08 PM, dcgatlanta wrote:

    Fantastic article! This is the content that sets the Fool apart. Thank you Rick!

  • Report this Comment On September 15, 2011, at 5:13 PM, portanchor wrote:

    I sold my NFLX back in July, as much as I believe and practice buy-and-hold it's hard to think any stock is going to go up forever. Seeing any PE run past the 50 mark reminds me too much of the dot bomb days. Keep it for your grandkids if you must otherwise take your profit and find something new. I think most Fools are still way ahead on this multi-bagger.

  • Report this Comment On September 15, 2011, at 5:17 PM, stan8331 wrote:

    Netflix has in the neighborhood of 40,000 movie titles and an excellent recommendation engine. If you can't find anything to watch, you're just not that into movies.

    Kiosks have a place in the market but there just aren't that many people who want to go back to the bad old days of driving to the store, lines and late fees.

    I keep hearing a lot of TALK about supposedly formidable streaming competitors. I have yet to see a single one actually emerge. Nobody in the streaming market offers anything close to an equivalent competitive value vs. Netflix. Not Hulu, not Amazon, not Apple, not Blockbuster, not Google, not Vudu.

    Netflix had no choice but to alter its pricing because it does currently have to pay twice for the same content, disc and streaming. This is a transitional period - some people will undoubtedly be unhappy with the current streaming catalog. The old Netflix pricing model simply didn't allow for upgrading the streaming catalog. If discs were the wave of the future there would be no need to build up streaming, but we all know that's not the case.

    I have to wonder how many Starz movies any of the pundits opining about the loss of Starz have actually watched. It's NOT a high quality catalog and Netflix would have been very unwise to overpay to support a failing Starz business model.

    Until a competitor comes along and actually offers an equal or better deal, versus just talking about it, I'm not going to worry about my NFLX investment.

  • Report this Comment On September 15, 2011, at 5:21 PM, SkippyJohnJones wrote:

    The big winners here are the Comcasts of the world. I am more willing to pay $75 a month for everything I could ever want to watch (sports, news, sitcoms, serial dramas, and movies) than pay $16 a month for a hodge-podge of 80's TV and "new releases."

    Cable has on demand, and cable subscribers get access to content owners' streaming services on mobile devices and computers. Hell, even pay-per-view becomes a better proposition now that Netflix and Redbox have to wait 28 days longer for the few exciting new releases.

    Netflix needs an order of magnitude more content, and I suspect the rates would have to go much higher than even the new plans to achieve this. Even if Netflix had a catalog exponentially larger than its current offering, it would be missing local programming and sports. These are two very large pieces of television viewing, and would prevent most viewers from cutting their cables. If Netflix could somehow clear this hurdle and win the primary position, the Cable companies would bite back by making the internet much more expensive to replace their lost TV revenue.

    So in summary, Netflix at $16/month is useless for many viewers. Netflix at $30/month still wouldn't be nearly as dynamic as cable. Netflix at $50/month won't get any business.

    One final point - the content producers need live TV. Commercials and regular schedules allow for promotion of new shows in a way that nothing else can replicate. Even if Netflix could make Warner Bros. and Viacom more money than the cable providers and broadcast networks, they would be foolish to support the upstart in favor of their longtime partners. We've probably all seen 50 commercials for the new NBC show "Up All Night" purely as a result of watching something else on the NBCU family of channels. We've all discovered a new show purely because it follows immediately after one of our favorite programs. The Netflix recommendation engine doesn't hold a candle to the old model, and content owners know it.

  • Report this Comment On September 15, 2011, at 6:12 PM, BfloTapps wrote:

    Glad I sold most of my position on this when it was up. This was the best stock I ever owned but it just got to rich.

    They had a huge moat but a 60% rate hike built a nice bridge over it. The selection on Netfix streaming was never very good. Why would I pay for it when I can get it bundled with free shipping from one of my other favorite stocks AMAZON ?

  • Report this Comment On September 15, 2011, at 6:40 PM, walt393 wrote:

    @MHenage - In response to your comment that "Their content is not a cost per stream so the argument that their costs scale up with more subs is just completely wrong. The more subs the less they pay per person." This is correct in the short term but wrong in the long-term. The reason why Starz's new deal was to be priced around $300MM instead of the original price of $30MM is because of Netflix's large increase in subscriber count. Like you said, Netflix was able to leverage that fixed cost of $30MM over the past few years as they spread the cost across an increasing user base, and the positive economics from that arrangement is largely the reason they have been so successful. It was widely recognized as a huge mistake by Starz and you can be sure content providers will not make the same mistake again. Now, as content providers renew contracts with prices based on user count, they make sure they will benefit from user growth in the future. Shorter contract durations means the cost of content starts to resemble a variable cost rather than a fixed cost.

  • Report this Comment On September 15, 2011, at 6:49 PM, memoandstitch wrote:

    You all got it wrong. The killer here is ads. Remember, it's ads that allow the cable companies to pay huge dollars for the content.

    Since netflix doesn't show ads, it can never compete for content. You (viewers) need to realize that you can watch a lot more content if you are willing to watch a little bit of ads.

    I'm not saying it's a good idea to watch ads but that's how the world works. Viewers help pay for the content by watching ads.

  • Report this Comment On September 15, 2011, at 7:02 PM, hiddenflem wrote:

    I actually think a lot of people didn't see it coming. Head over to caps and notice all the people still going long even after the announcement that they were changing their price structure. They blew it and once they lose their customers it is for life.

  • Report this Comment On September 15, 2011, at 8:27 PM, TMFBent wrote:

    @ walt393

    Thanks for picking that up. Costs for streaming are not the same as costs for DVD because there's no way content providers are going to let the content go for the same price when the user base is huge. They're going to charge more, making sure they maximize their take. With a physical DVD, there was nothing they could do once the disc was purchased to recoup more dough if the thing was loaned to more people. They will not make that mistake with streaming content.

    @stan8331

    No competition? Please. Hulu's TV catalogue is a lot better, with new content, and its streams are, on both my systems (Xbox and internet-ready Samsung TV) much better quality than Netflix, with much niftier aps as well. As for movies, iTunes, Amazon unbox, Zune and Vudu are all viable competition on a per-unit-rental basis, again with much higher quality streams, in my experience.

    The fact that Netflix is currently bigger doesn't make it better, and it doesn't make it without competition. Consumers will eventually wake up.

    After I work through the last HBO series I need on disc, it'll be goodbye NFLX discs for me, and if the streaming library doesn't improve, it'll be Hulu plus a la cart Zune, Vudu, and iTunes.

    As for Netflix's decision engine -- it's overrated. It specializes in trying to get you to watch low-fee garbage that won't cost Netflix much money. Amazon has a better idea of what I'm interested in, and I don't need my hand held by Netflix anyway.

  • Report this Comment On September 15, 2011, at 8:37 PM, TMFHousel wrote:

    I bought a season of a TV show on iTunes recently, and it hit me all the sudden that Netflix's moat is much, much weaker than some assume.

  • Report this Comment On September 15, 2011, at 10:25 PM, Darwood11 wrote:

    I am a Netflix subscriber (both streaming and DVD) and I also own stock. Bought it at a good price and sold 2/3 at a wonderful price. Do I regret not selling the remaining 1/3 of my shares? Not at all.

    The issue is content, and providing that content.

    Netflix has a viable plan, but doesn't control the content. I thought it was ludicrous when Starz made a deal with Netflix for $30 million. Now they've jumped to $300 million. I think that says a lot about the capability of the Starz management.

    When purchasing technology or media companies in nascent industries, I think it's prudent to realize that the companies, and sometimes the entire industries, are truly a "work in progress." Is Netflix's model null and void? I don't really know. I do think they may be vulnerable to content hoarders. Am I really concerned? No. When I purchase a company such as Netflix, which reached multiples of about 50, I expect that at some point, and probably sooner because of the incredible efficiency of communications, that the rest of the world will quickly come to some conclusion about the possibilities of these markets. This is not rocket science. That may be a source of discomfort to a few who purchased NFLX at $290.

    I suggest that we consider the general model of new technology expansion. First there are "early adapters" and ultimately there is "wide dissemination." This too, isn't rocket science. Remember, the PC was invented 30 years ago, in 1981. (To put this into perspective, the Boeing 707 was first flown in 1958. 30 years earlier, Boeing was introducing a biplane as it's new fighter, and in 1928, "Boeing introduced America's first airliner designed specifically for passenger comfort and convenience. The Model 80's fuselage was made of welded-steel tubing covered with fabric, and its wooden wingtips were removable so the airplane could fit into the primitive hangars along its route."

    My point of this history lesson? The model that Netflix has developed will change. Is Netflix a viable stock for the long run? Probably not. I say that not because of the model that Netflix has, but because of the problems inherent in technology providers.

    Note however, that Apple has done very well with it's Itunes model. Of course, that uses a proprietary storage and replay system, which is not inherent in the streaming model.

    My spouse and I have the lowest priced Comcast service; I'm not sure they offer it any longer at about $20 per month. I have no interest in buying the $75 per month package (or higher). We do have the dual DVD/Streaming package from Netflix. I consider it a bargain compared to the high end HBO and competitive packages. The bottom line, I want to be able to order what I am interested in, but I won't pay upwards of $50 a month to have access to that content. I should also add that I have access to a range of movie theaters owned by Classic Cinemas, which run slightly delayed full screen movies for $4. So if I really want to see "Captain America" on the big screen, I can, for a bargain.

    The bottom line is, there are quite a few content providers, and the astute consumer, of which my spouse and I consider ourselves to be, will pick and choose whatever it is that works to their personal advantage.

  • Report this Comment On September 16, 2011, at 11:11 AM, Threedollarbill wrote:

    I think there will always be churn with a company like NFLX. I found it a bad move to raise their rates during our current economy. I went to the disc only feature, and dropped the streaming. I wondered which one, disc or streaming would prevail? If they'd gone to streaming only, I would have dropped out entirely and sold all my stock. I don't think that many people are set up for streaming yet. Yes, I can stream over my computer, but it didn't work that well, sometimes pixel, then stopped and started, quite irritating at times. Perhaps more people have higher tech systems in their homes than I do, but watching a movie over the computer in a computer chair is not very relaxing, and I did it only from time to time. It certainly wouldn't work for a family & friends situation.

    There's no way Redbox or Blockbuster kiosk offer much in movies I'd want to see--they offer the top ten hottest movie content, but don't expect much else.

    No one has mentioned yet, about the growth aspect of NFLX streaming only features in other countries yet, and if that will pick up more subscribers/growth: Mexico, Canada, etc.

    I'd wondered if some other business has changed and gone back to their other model as they saw the change was a wrong move--new Coke, old Coke?

  • Report this Comment On September 16, 2011, at 11:11 AM, Daxxer wrote:

    I am a new investor and a new SA subscriber. After buying into NFLX just the other day based upon the Fool's recommendation of CORE and NOW, I feel completely misled.

    Someone at TMF fell down on the job and it has cost me dearly. To say I am unhappy is an understatement.

  • Report this Comment On September 16, 2011, at 2:53 PM, doriana wrote:

    You were misled. I too am a SA subscriber and was an avid Fool, but after their pride in picking one of their greatest stock picks got in the way of NFLX very clear challenges, I will be unsubscribing. Even when the sour news started poring in, they continued to prop up NFLX as a great strategic buy—I shorted NFLX several weeks ago based on rational and logical reasoning and examination. When a stock is in trouble they ought outline the risks and not say it is still a good buy. Even with the 40%+ drop from their high, it is still an extremely risky move, but still they will persist.

  • Report this Comment On September 17, 2011, at 9:11 AM, craffle wrote:

    The playing field in streaming is not exactly level Netflix has a huge advantage because it is pre-installed on many tvs, blu-ray players and other devices and Blockbuster is not. This may change in time but for now, advantage Netflix.

  • Report this Comment On September 17, 2011, at 11:19 AM, joeddd wrote:

    Netflix is in trouble BIG TIME. The problem is multifold: Content, Business Model, Ease of Competitive Entry, Bandwidth Limitations.

    I'm not a long winded writer, so you'll just have to read between these lines, but...

    The problem with Content is highlighted by the Starz problem. This is a big deal, in a way, Netflix's growing subscriber base is a handicap.

    The problem with their business model is that as they move to streaming, the barrier for entry is very little. There is nothing about their streaming network that some other company couldn't easily do (like Amazon, or Comcast, or Dish), etc.. They used to have an advantage in this area when it was about logistics and efficiency, but no longer.

    Ease of Competitive Entry in a streaming world is the same as the problem with their business model above.

    Many streaming customers will have to pay additional download fees if they go over their set maximums. Recent policy changes by AT&T as well as Comcast highlight this problem. This is an additional cost for power users.

    The streaming model favors the content providers and the entities that OWN the distribution medium (Cable Companies, Wireless Companies, etc...)

    The problem that I see for Netflix is that unless they can tie up (exclusive) content at a good price, they have nothing. In my opinion, there is nothing Netflix can do to improve their situation. Nothing. It's over as a growth story (I'm not saying their out of business, I'm saying they are not a growth story and from an investment point of view, they might as well be over as a business)

    Just my two cents.

  • Report this Comment On September 18, 2011, at 6:26 PM, walt373 wrote:

    Many of the points made in these comments are longer-term problems like competition, increasing content costs, etc. What may surprise you is that Netflix actually has some very serious problems that could manifest as quickly as in the next year.

    All it takes is a quick look through their financial statements to realize their financial strength is much weaker than most would expect for such a successful company. The balance sheet is levered 5-to-1, accounts payable are ballooning at a truly extraordinary rate, cash flow is weak (negative ex-accounts payable), and they have $2 billion in off-balance-sheet commitments due in the next few years.

    Assuming subscriber count doesn't totally fall off a cliff, revenues will get a bump in the current quarter due to the price hike, but if Netflix starts to see net subscriber losses after that leading to declining revenues, watch out below. There's a very real possibility Netflix will be in financial distress.

  • Report this Comment On October 12, 2011, at 2:32 PM, steven107 wrote:

    There is/was a company named Zediva that was trying to do a hybrid of Netflix's two delivery methods so that they could use the copyright rights of physical disk rental while "streaming" the audio/video/remotecontrol results of a physical disk in a physical player via an "extra long cable" (across the internet) to the renter on the other end. ;) neat workaround, but I looked them up today to see if they still exist and looks like they are taking their first legal shot across the bow and the ship is taking on water.

    Dunno if they have IP to this method, but if the appeals hold up (not crossing my fingers) it would provide a streaming method that doesn't require content licenses.

  • Report this Comment On October 12, 2011, at 2:34 PM, steven107 wrote:

    meant if they can get current defeat overturned on appeal and hold through further challenges.

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