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Of the many miscues Netflix (Nasdaq: NFLX ) CEO Reed Hastings and the team have made over the past nine months, perhaps the biggest was the full-on blitz to focus the company's efforts solely on growing the streaming subscriber customer base. If there were any questions regarding the plans Netflix had for its once profitable and pleasantly entrenched DVD customers, Reed himself put those to rest when he was quoted during a conference call in January, "We expect DVD subscribers to decline steadily every quarter, forever." That pretty much says it.
The streaming problem
The move to streaming content delivery, with the explosive growth of mobile computing, makes sense; the tropical storm-like winds are certainly blowing in that direction. The problem wasn't the decision to make the shift; that was a no-brainer. The problem for Netflix was: Why such a radical change so soon? Throwing the baby out with the bathwater is rarely a good idea, and in this case the little tyke was the ridiculously high-margin DVD business.
Reed's first-quarter letter to shareholders continued what is an ongoing trend: shouting from the hilltops about all the new (streaming) subscribers the company brought in. According to Reed, there were 3 million new customers In Q1, and that's a lot. But here's the thing: With all that subscriber growth, the streaming segment lost $36 million for the quarter, primarily because of international results (more on that shortly) and the mere 13.2% margins the domestic business generates.
The virtually forgotten DVD business? Not surprisingly, the segment lost more than a million subscribers; hey, people know when they're not loved. But the 10 million remaining DVD subscribers generated a profit of $146 million in the quarter. Want a side-by-side comparison? Domestically, there were a total of 22.2 million paid streaming subscribers the end of Q1, more than twice the shunned DVD folk. Even with that disparity, the streamers couldn't atone for the 45.6% profit margins the DVD subscribers generated.
Unfortunately for investors thinking there may be opportunity for some bottom fishing as the Netflix share price hovers near 52-week lows, razor-thin margins aren't the only concern.
You'll recall it was just over six months ago that Reed and the crew announced, with the appropriate amount of fanfare, the company's expansion into Ireland and the U.K. The stock proceeded to jump about 14% the day of the announcement, trading nearly 4 times the average shares; Netflix was going big time. What seemed to have gotten lost in all the hoopla were the potential problems of running up against two entrenched players: Amazon.com's (Nasdaq: AMZN ) Lovefilm and the biggest of the big boys, BSkyB. As usual, Reed pooh-poohed the notion of competition, essentially saying, "Don't you know who we are?" Fool writer Rick Aristotle Munarriz wrote a great article about the Netflix foray and describes in more detail what's happened across the pond since the expansion.
As discussed in previous articles, and reinforced by the U.K./Ireland fiasco, Netflix operated for years domestically with no direct competition and got a bit full of itself. As with any new business, build it and they (competition) will come -- and they did. But as with the scoffing of Amazon and BSkyB, Netflix didn't seem to think it would matter. An example? Reed's quote from January that "we don't do them favors and they don't do us favors," in reference to Warner Bros. and a tiff about a 56-day waiting period, reeks of a CEO with a relatively up-and-coming company that's a little too full of himself. Hey, it's Warner Bros., for goodness' sake. Don't need to kowtow to them, but c'mon.
In the past six months alone, some big players have started making noise in the Netflix arena. Google's (Nasdaq: GOOG ) poaching of Hollywood talent for its YouTube offering is a pretty clear indication that it means content business. Then there's the joint venture between Redbox kiosk owner Coinstar (Nasdaq: CSTR ) and wireless leader Verizon (NYSE: VZ ) . They finally gave us a few details about the partnership, which will include both streaming and traditional DVD rental alternatives. And it shouldn't be long before more cable companies join Comcast in offering similar services.
The timing off the jump to streaming hyperspace for Netflix, in conjunction with an expense-ridden international expansion plan, was ill-conceived. Then to add insult to shareholder injury, these major shifts were made while alienating the company's money-making cash cow -- DVD subscribers. Successfully shifting business models is all about timing, and Netflix was off, on several fronts.
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