It finally happened. The once-booming market for mail-delivered DVD subscription plans peaked back in June. I know. The news is coming to you several months too late. That's the way it goes, though. You don't know when you've hit the top until you're heading downhill.

I had to wait until this morning's Blockbuster (NYSE:BBI) earnings report to confirm what I feared four weeks ago would happen.

"We're a few weeks away from what may be a one-two punch when both companies post their 3Q financials," I wrote at the time, when Blockbuster was quietly talking down its Total Access growth prospects to analysts. "It's OK to hope for the best, but brace yourself for the worst, just in case."

Netflix (NASDAQ:NFLX) delivered on its side of the bargain. The company had a blowout third quarter, tacking on 286,000 net subscribers after shedding 55,000 during the second quarter.

"We'll still have to wait until Blockbuster's report before we can gauge the growth of the sector," I noted as the resident party pooper.

In a video interview the following day, I told the Fool's Mac Greer that Netflix investors would be in an odd position this week, actually rooting for Blockbuster.

Well, it wasn't enough. Blockbuster's Total Access plan went from 3.6 million subscribers to just 3.1 million members during the quarter, weighed down by increases in plan price and scaled-back marketing efforts.

The end result? The market of film buffs subscribing to monthly plans to have their DVD rentals delivered by mail has shrunk from 10.3 million to 10.1 million over the past three months.

Net Adds




Q3 2007




Q2 2007




Q1 2007




Q4 2007




Q3 2006




Q2 2006




Q1 2006




Source: Netflix and Blockbuster press releases.

It's not the end of the world. The problem is that the world may be smaller than the companies think.

Flicking off the flicks
Adams Media Research and internal Netflix estimates peg this as a market with more than 20 million subscribers in four to six years. The second quarter setback at Netflix was a downer, but Blockbuster was there to pick up the slack. Now we find ourselves knee-deep in a quandary.

Where did Blockbuster's cancellations go? Some showed up at the Netflix doorstep, of course. However, way too many vanished. Maybe some have taken to the piecemeal digital delivery plans offered by companies like (NASDAQ:AMZN) and Apple (NASDAQ:AAPL), though anecdotal evidence points to slow starts on those fronts.

So how big is the market for subscription plans? Netflix has been promoting scaled back plans at lower price points to attract new members. They are all profitable, though it has to be unsettling to find the average Netflix subscriber paying less than ever now.

And if worrying about the market peaking two quarters ago isn't daunting enough, digging into Blockbuster's report brings up other reasons to fret.

Blockbuster's brainy disappointment
The leading bricks-and-mortar chain isn't retreating. It's just less reluctant to treat its online service as a loss leader. That may be sweet news for Netflix investors at first, but let's see what's really going on at Blockbuster.

Blockbuster posted a loss of $0.15 a share before severance and lease termination charges during the third quarter. That is flat with last year's showing. The company is embarking on a structural overhaul that will shave $45 million in annual expenses.

Sales dipped as the company closed stores, although existing locations worldwide posted a 3.5% gain in comps. Here is where it gets interesting. Rental revenue at the store level inched just 1.1% higher, while merchandise soared 14.2% higher. CEO Jim Keyes came from 7-Eleven, bringing along many of his key executives. They aren't transforming Blockbuster into a celluloid-themed convenience store, though obviously they're doing a good job of getting folks in the store to buy more impulse items. The merchandising success is taking place at its stores outside of the country, but it's really just a matter of time before the initiatives come home (literally and figuratively).

That has always been at the heart of making Total Access work. If folks come in to exchange flicks or redeem freebie coupons and walk out weighing the same, Blockbuster has failed. The key is to get folks to spend time and money in-store, something that Netflix will never have the luxury of doing. If Blockbuster turns itself around as a retail concept, Total Access doesn't have to be a moneymaker. It would be a traffic magnet.

That would be a problem. Netflix is seen as an all-weather winner. It is the cost leader during price wars. It has the most subscribers, now by an even wider margin, when times are good. However, the battle is moving away from the postbox. Yes, Netflix has a great online streaming service in place, but it's lacking in titles.

I have argued that Netflix should expand smartly into video game rentals, though that too is a market where companies like Microsoft (NASDAQ:MSFT), Sony (NYSE:SNE), and Nintendo (OTC BB: NTDOY) are rewriting the playbook with digital distribution.

Where does Netflix grow from here? If the future holds more of what we saw this time around -- where Netflix grows by just over half the amount of net Total Access defectors -- that potential market of 20 million families may be halved.

It finally happened, my fellow Netflix investors. The moment that you haven't been waiting for.

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