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In 2011, when Netflix (NASDAQ: NFLX  ) split its DVD-by-mail and streaming businesses (effectively raising prices by as much as $6 per month), the company precipitated a storm of customer outrage. Netflix's plan to spin off the DVD business as "Qwikster" was eventually abandoned, but the damage was done. While the streaming business has recovered, Netflix's DVD-by-mail service has shrunk to just over 8 million subscribers as of last quarter, down from 14 million at the time of the split.

In reaction to this blunder, Netflix has renewed its emphasis on maintaining customer-friendly policies. However, while it's important to keep customers satisfied, Netflix has taken this goal to the extreme, as exemplified by the recent "bulk release" of the company's flagship original series, House of Cards. By releasing all 13 episodes at once, Netflix may have made its customers happy at the expense of profitability. If Netflix continues this policy for its other original series debuting later this year, shareholders could be in for a nasty surprise.

Building loyalty?
Netflix's biggest challenge at present is that competitors have been growing their streaming offerings recently, and none faster than (NASDAQ: AMZN  ) . Amazon has picked up a number of high-profile shows for its Prime Instant Video service in recent months, many of which were previously available on Netflix. With Amazon rapidly increasing its offerings, charging less ($79 per year or $39 for students, versus $96 for Netflix), and throwing in free two-day shipping on physical purchases, Netflix needs a "differentiator" to keep subscribers on board.

Indeed, Bank of America analysts recently estimated that Netflix loses 5% to 6% of its subscriber base every month. The main justification for Netflix's expansion into original content with series like House of Cards is to increase subscriber loyalty and reduce so-called "churn." High churn becomes a bigger worry the larger Netflix's subscriber base becomes. With around 20 million paid domestic subscribers at the end of 2011, Netflix needed to add at least 1 million subscribers per month just to stand still. However, if the membership base doubles to 40 million, Netflix would have to add 2 million subscribers per month to offset churn.

By offering original shows that are not available elsewhere, Netflix aims to mimic Time Warner's (NYSE: TWX  ) success with HBO. (A Netflix spokesman recently stated, "Part of our goal is to become like HBO faster than HBO can become Netflix.") HBO has built a worldwide subscriber base of 114 million households by offering a combination of second-run movies and original TV shows. While HBO still experiences significant churn of approximately 3% monthly, reducing churn to that level would be a big win for Netflix and could help the company maintain its domestic growth for a longer period of time.

Binge-viewers wanted
Unfortunately, Netflix's decision to release all 13 episodes of House of Cards on Feb. 1 did not support the ultimate business goal of reducing churn. Netflix CEO Reed Hastings has said that customers want the convenience of being able to watch shows at their own pace. In particular, Netflix is catering to the desires of "binge-viewers," who want to watch the whole series at once. However, in trying to be customer-friendly, Hastings gave customers the ability to watch the whole series within a single month --  and thus pay for only a month of Netflix service.

Since customers who want to see House of Cards can watch the full season in one month and then cancel, the series will not have much of an independent impact on churn. By contrast, if episodes were released one at a time over the course of several months, Netflix could expect fans of the show to keep the service for at least those months. In releasing all the episodes at once, Netflix is gambling that the show will attract new members, who will then find other content they enjoy and decide to keep the Netflix service. To put it a different way, if subscribers pay for one month of service to binge-view the full season of House of Cards, Netflix would need to attract more than 6 million additional viewers to meet Season 1's $50 million production cost.

Giving away the store
Moreover, not all viewers are actually paying. While I applaud Netflix's decision to make the first episode of House of Cards available for free to "hook" people, the company's policy of offering free one-month trials for all new users will allow many people to watch the full season for free. Additionally, Netflix has been aggressively courting former members with free "trials" for returning members. (As a former Netflix member, I received at least four emails last fall offering me a free month if I rejoined the service. I got my free month, enjoyed House of Cards and other content, and then canceled.) In the short term, Netflix may boost its subscriber numbers this way, but the company is not maximizing the value of its investments in original content.

In short, Netflix's business model seems flawed. The company spent too much for the rights to House of Cards to give the show away for free (or at most, $7.99) to binge viewers. If original content is meant to reduce churn, it needs to be released in a "serial" manner that forces viewers to keep the service. That might seem less customer-friendly, but it would better ensure Netflix's long-term health.

Can Netflix fend off its growing competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why we've released a brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.

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  • Report this Comment On August 19, 2015, at 1:41 PM, Kirashka wrote:

    While I agree with a few of your points, I disagree with more of them.

    1. Netflix isn't going anywhere - And by this, I mean they aren't going out of business as a result of this "flawed business model" you mention.

    In fact, if I had to choose a job ANY of the companies that are (in fact) trying to play catch up with Netflix, I wouldn't. Why is that? Because Netflix is leading the pack where it pertains to the treatment of their employees by taking care of that which SHOULD be most important to all of us: our families. This money-driven economy needs to take a step back and re-evaluate its moral compass and underlying values, something Netflix is doing better than all of the fortune 500 companies...combined.

    2. Binge-watching - This is by customer demand, and it appears to be working for them.

    I, personally, have evaluated all of the companies that provide similar services...and I came right back to Netflix in the end. Wny? Because they want my business back, AND they're willing to do what it takes to earn it. Did you catch the 2nd to the last word there: EARN. Customers don't owe a company their business, it is the company's job to perform in a way that entices the customer. If they don't, they do not deserve patronage, period.

    Enough of this: I bought the brand because of the name on the label. I've seen some truly hideous "designer" clothes, and no, it isn't because I don't understand fashion. They were simply awful, unflattering and unwearable for most occasions, not to mention impractical. Who needs a wardrobe full of ugly dresses that you'll only wear once, and wish you hadn't even done it then? Not I!

    3. Lack of conformity - What is really upsetting your fruit basket? Is it the bottom line, or the fact that they are taking a market share of loyal customers away from the conformation pack? You know, those businesses that provide sub-par services for premium prices, and claim that they do this for their customers.

    If the business model you are wanting them to follow is the New American standard: More profit for less work, I would like to say "I'm shocked", but in truth...I'm really, REALLY not. Here's a news flash for you though, the customers are skiddish as of late, and they aren't looking for more of the same. In fact, they are looking for deals, company loyalty (as in to them, not the other way around, which comes later) and those companies that offer something different.

    Netflix offers all 3 in one package. My only real complaint is the one you did mention: streaming vs DVD/Blu-ray split. One thing they should have done early in their inception: contract with ISP's for service-based contracts. Why? The entire reason I cancelled my Netflix subscription a couple of years ago, was because AT&T (in one of their "wonderful" upgrade offers) sneaked in a clause that took away my "unlimited data".

    Up until then, it really HAD been unlimited, and when I was offered a new service contract...suddenly it was limited to 250 GB/month (or some ridiculous low number). That may not seem like a small number to non-streamers, but its ridiculous for anyone who isn't making a profit from their streams, like those of us who are paying for a service that streams data in, for instance. In truth, the ISPs are doing A LOT of damage to businesses like Netflix, which seems like it could be grounds for a legal suit.

    Either way, we all know AT&T is definitely in it for the profits, as are Cox, Comcast and a few others. You would think, with their ridiculous monopoly on the market already, that they could afford to upgrade their servers to accommodate better for their streaming customers (AT&T that is), but no. Seems like there was a warning about companies like that when I took business classes, as monopolies really are NOT beneficial to customers. Less competition = total market share = ability to drive rates up and up and up.

    In truth, the WORST thing Netflix could ever do for their customers is this: Sell out. If they allowed a super-giant to absorb them, their customers would be the ones paying for it hand over fist. This happens over and over again as new companies grow large enough to take even a small percent of market share from their large competitors, BAM, buy them out, use their great new ideas/tech, and then dismantle their companies (by laying off local workers and shipping production overseas). Does that about sum it up?

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