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Netflix Needs to Lose the Safety Net

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I turned off a few Netflix (Nasdaq: NFLX  ) fans last week, suggesting that it's time for the video-service giant to unload its DVDs-by-mail service.

A lot of people are perfectly happy with Netflix's disc-based offering, and they don't see any reason for the company to cash out of a cash cow.

I have nothing against Netflix. I subscribe to both its DVD and streaming platforms, and I've been a shareholder since shortly after its IPO nearly a decade ago. However, I left out a very important reason for Netflix to cut the cord sooner rather than later: Netflix by mail is a service that will deteriorate over time.

The law of shrinking numbers
"DVD shipments for Netflix have likely peaked," the company said last summer. It was just a few weeks into the third quarter, and CEO Reed Hastings was targeting a total of 15 million DVD-based customers for the end of September.

We now know that it didn't work out that way. Let's go over the count of subscribers on disc-based plans over the past three quarters.

  • Q3 2011: 13.93 million
  • Q4 2011: 11.17 million
  • Q1 2012: 10.09 million

Netflix has lost roughly a third of its disc-based subscribers in just three quarters, and the company is already on the record as expecting that number to keep shrinking "forever."

It gets worse.

In last July's guidance, Netflix was expecting 12 million of the 15 million disc-based customers to pay for both streaming and DVDs. These 12 million customers would be the heart of Netflix's hybrid service. They would be the people willing to pay the most for Netflix in its two flavors. Well, Netflix had just 7 million customers paying for both discs and streams at the end of March, a 42% decline in that time.

Listen to Whitney Houston

Netflix should sell its disc-based business to Redbox parent Coinstar (Nasdaq: CSTR  ) or DISH Network's (Nasdaq: DISH  ) Blockbuster before it's too late. Surely there must be a few daring private-equity firms that fancy themselves turnaround experts. After all, Netflix has publicly conceded that its DVD mail-order business is on a slow crawl to zero. Even if the business is a major profit contributor to Netflix, it will be worth less to a buyer with every passing quarter.

However, the real reason to move on is because Netflix's once sterling reputation is going to take a hit that will last longer than the Qwikster and price-increase flaps from last summer.

What do you think will happen to the quality of the disc-based service that so many people are enjoying as its membership base continues to shrink?

I've seen the future, and it has the angelic voice of Whitney Houston.

It's been more than two months since the award-winning singer died in California. An instinctive reaction at the time for fans was to revisit her most popular movie, Time Warner's (NYSE: TWX  ) The Bodyguard. Even though (Nasdaq: AMZN  ) had it available as a stream -- available at no additional cost to Amazon Prime shoppers -- Netflix had decided not to renew its licensing deal with Time Warner for the movie two months earlier. Netflix customers had to settle for a DVD rental, but too many of their fellow subscribers had the same idea.

"Very long wait" is the availability that greeted members when they put the Houston and Kevin Costner movie in their queues. I've kept it in my queue for sport since then, and it's still listed as "very long wait" even though it's now been 11 weeks since Houston's passing.

Battle Royale is another movie that been on "very long wait" for more than a month. The Japanese cult fave has a fairly similar premise to The Hunger Games, so it's been in heavy demand since The Hunger Games hit theaters last month.

In the old days, Netflix would probably have ordered a ton of additional copies. That was easy to do when disc-based subscription counts were climbing. Taking on extra inventory was no big deal when the company knew that it was only going to have a larger pool of potential renters down the line.

It's obviously very different now. There's no reason for Netflix to respond to these bursts in demand. If it hasn't happened already, it may not be long before Netflix cuts back on the purchases of new releases -- or concedes to push out availability windows even further.

Forget about the possibility of the end of postal delivery on Saturdays, which will slow down the round-trip mailing process. The quality of Netflix's DVD service will shrink along with its audience. Why wait until folks leave because they're dissatisfied? Packaging the disc-based service with the domain that it recently acquired and letting someone else try to make it grow again is the better play.

Streaming isn't enough now
Even those on streaming plans will argue that Netflix needs to keep its disc-based service close. The digital catalog is heavy on "rerun TV" episodes and dated celluloid.

Well, what if unloading the DVDs is exactly what the company needs to make its offering better? Maybe Netflix needs to operate without knowing that the safety net of DVDs is there to catch video junkies longing for fresher releases.

There are now more than 26 million streaming Netflix customers worldwide. If Netflix wasn't offering DVDs, wouldn't stingy studios think twice about not licensing their content when it would be the only way to reach those members? Both Netflix and Hollywood need the divestiture of the disc-based service to grow up.

Ancient Greek commanders and Spanish conquistador Hernando Cortes supposedly would burn their own ships when sailing into battle. Retreat was not an option. That's where Netflix is now. It has gone too far with streaming to bother with the original vessel that got it there.

Cortes asked his men to burn their ships. Now it's time for Netflix to burn its shipping.

Stream on
Motley Fool co-founder David Gardner has been a fan of Netflix as a disruptor for nearly a decade, but there's a new Rule-Breaking mutlibagger that's getting him excited these days. Learn more in a free report that you can check out right now.

The Motley Fool owns shares of Motley Fool newsletter services have recommended buying shares of Netflix, Coinstar, and The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber and shareholder since 2002. He owns noshares in any of the other stocks in this story and is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.

Read/Post Comments (7) | Recommend This Article (7)

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 30, 2012, at 8:04 PM, tom2727 wrote:

    They've been publicly trashing the DVD by mail business for years. Who exactly is going to buy it now? They won't get near what it's worth if they do sell.

    And why exactly should they jettison their safety net when their streaming trapeze is held together with dental floss and duct tape?

    I've been reluctant to short NFLX up til now, because I always figured if management got their act together they could pull out of their death spiral. The brand still has some value.

    But if they ever try selling the DVD biz, I'd be ready to short them to zero.

  • Report this Comment On April 30, 2012, at 8:45 PM, cfrdog wrote:

    i agree w/ tom27 as far who would buy dvd business.. I equate this with AT&T's recent Yellow Page sale. It generates cash but its dead. No growth. AT&T sold for about 1X earnings. Pathetic.... Reed saw the future but blundered by keeping the discs as pressure mounted to keep status quo. I'm not sure who would want to buy at this point but I'd get what i can for them OR reinvigorate the brand and DVD service somehow, perhaps by advertising on envelopes or something similar. Perhaps the POST OFFICE would buy them! ha at any rate Netflix is not a stock i want to own as there is no competitive advantage and nobody would even want their streaming biz b/c of it....

  • Report this Comment On May 01, 2012, at 10:43 AM, dlchase24 wrote:

    Do you realize the huge gap in available content "burning" the DVD business would create? I agree they need to focus on streaming, add TONS of additional content and continue to reduce the need of maintaining all those discs, but dropping it altogether would be crazy.

    I only have streaming, and it's frustrating when I want to watch a movie and see it's only available on DVD. At least I have the option, however, of picking up the DVD subscription for a month and getting the disc.

    If you also consider that with Amazon, if you can't watch it via Prime, you can spend $3 to $4 and rent it via streaming, the risk would only seem to increase.

    Instead of picking up the DVD subscription through Netflix, customers could turn to Amazon and rent or another VOD service.

    I agree streaming needs to be the focus, but until they narrow the content availability gap between DVD and streaming, it's a necessary safety net.

  • Report this Comment On May 01, 2012, at 3:33 PM, tgauchat wrote:

    Doesn't anyone care about the huge quality gap btwn streaming and Blu-Ray discs? 5.1 or 7.1 surround sound, extras, and possibly 3D? These features aren't coming to streaming very soon and will risky violating bandwidth caps! I hate the current state of streaming!

  • Report this Comment On May 01, 2012, at 5:59 PM, 48ozhalfgallons wrote:

    tgauchat: "Doesn't anyone care about the huge quality gap btwn streaming and Blu-Ray discs? 5.1 or 7.1 surround sound, extras, and possibly 3D?"

    Apparently not. I believe streaming is best for TV and flops. I'll be returning to Hastings (the store) when Netflix drops the mail service. First rate video and sound are the thrill of a 72" screen; not so streaming.

    Streaming is to video as In vitro and pink slime are to meat.

  • Report this Comment On May 01, 2012, at 10:33 PM, Proctoid90 wrote:

    Netflix unfortunately has nearly lost the battle, lets be honest the content fro streaming stinks. Unless you are a movie junkie who just has to see every old movie made you will miss a lot. Netflix has bet the farm on streaming at the sacrifice of everything else. The got the consumer proposition correct, this is what the consumer wants, but they don't own the content and the content suppliers don't want this. You can't sell something you don't have or don't make. Perhaps a better plan would have been to be people's "Movie Provider" vs. their movie streamer. This means they should have the movie kiosks with Netflix branding, they should be streaming, they should be doing DVD by mail and (gasp!) they should be renting/selling DVD via streaming like Amazon. They are letting in way too many competitors by focusing everything on something they can't control. I have recently canceled my longterm netflix account (streaming and DVD) and switched to Amazon. They have a catalog of old movies and TV shows I get with Prime that I sometimes watch, but they also rent nearly anything for $2-5 dollars. My family complained endlessly about netflix and no good movies available, now they are happy and trying to bankrupt me with Amazon rentals. I sold my Netflix 1.5yrs ago (missed the big runup, needed $ for something) and have no plans to buy again, this ships has likely sailed.

  • Report this Comment On May 07, 2012, at 12:58 AM, funspirit wrote:

    I don;t think i agree with this column, though it is well written. some valuable comments here as well.

    Although this information was not available at the time this column was written, Microsoft has basically announced the DVD is going the way of the dodo.

    I am short netflix btw, even though I used to love its service, I don;t have that much time to watch movies so amazon prime suits me just fine with the free two day shipping

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