Netflix (NASDAQ:NFLX) CEO Reed Hastings has a problem.

For the first time in seven years, DVD sales trailed movie theater sales in 2009. Moviegoers spent $9.87 billion at the box office, but sales of DVD and Blu-ray discs fell 13% to $8.73 billion, reports Adams Media Research. Rental revenue rose less than 1% over the same period, Adams estimates.

Admittedly, this is a bigger problem for film factories such as Sony's (NYSE:SNE) Columbia Pictures, Comcast's (NASDAQ:CMCSA) Universal Studios, and Viacom's (NYSE:VIA) Paramount Pictures. Hollywood depends on DVD sales to help recoup production costs, and studios tend to collect $17 for every DVD sold, and $22 for every Blu-ray disc sold, The Wall Street Journal reports.

Rentals are another matter. They're far less of a revenue driver for Hollywood, thanks in part to free rentals at U.S. libraries and the $1-a-night alternative offered by Coinstar's (NASDAQ:CSTR) Redbox.

For Netflix, rentals matter plenty. Hastings knows that he has to figure out how to capture the entertainment dollars consumers' are shifting from DVDs to other formats. He needs to make digital distribution profitable, and he needs to do it sooner rather than later.

Renting in ruins? Call the iPad!
If there's good news here, it's that studios are more likely than ever to work with Netflix. They have a common interest. Moviemakers need a profitable digital distribution mechanism to avoid big cuts in production spending. Netflix needs the same thing to keep its business moving forward. Hollywood is living through its own cliffhanger.

Enter Apple's (NASDAQ:AAPL) iPad, which debuted last week with little in the way of studio support. Moviemakers have good reason to be skeptical of the iPad; it's a shiny, mostly worthless piece of iCandy whose video capabilities are limited to iTunes downloads. It also doesn't support Adobe's (NASDAQ:ADBE) Flash technology.

Flash is important to the studios. Apple CEO Steve Jobs may complain about the functionality of Flash, and it may well be a target for hackers, but it's also a widely-adopted standard for media playback. Till HTML5 eliminates the need for Flash -- and, to an extent, Apple's own QuickTime -- the iPad is a decent e-reader that doubles as a hobbled video player.

Build a better video rental business
Yet the iPad is still likely to get everyday users trying and buying more video. Pixar's Up played impressively on the device during Jobs' demo, as I'm sure would most movies downloaded to the iPad. But at 16 gigabytes for the entry-level edition, this isn't a substitute for a good DVD library or streaming plan. No help for studios there.

Netflix could fill the gap, capitalizing on demand created by the iPad while offering revenue models that work for Hollywood. Here are three ways to make its Watch Instantly streaming service the distribution mechanism Hollywood wanted iPad + iTunes to be:

  • The "Buy This Movie" option. Digital distribution doesn't have to kill the DVD. Netflix could offer customers who rent the option to buy, and buy related flicks, either as downloads or DVDs. Studios would help set pricing.
  • The "Get It Sooner" option. Netflix already lets users keep a whole roster of films in their streaming queue, each available for playback at any time. As the company expands its streaming offerings, it could also allow customers willing to pay a monthly premium to get first access to popular new digital feeds.
  • The "See What's Playing" option. Netflix doesn't do much with ads and previews now, but it could. Consumers opting for lower-priced plans would accept rental limits or agree to view studio-selected pitches. Links to ticket purchasing sites might also draw in residual revenue.

What's important about these options is that none of them requires Netflix to own or create a tablet. Instead, Netflix streaming is a device-independent service that can potentially live on any TV, console, or tablet, and still deliver high-quality video playback. It's consistent with Netflix's stated goal of being ubiquitous on all devices.

Better yet, Netflix wouldn't have to change its pricing model to incorporate any of these new features. Consumers would still subscribe at any level they like, and receive a commensurate level of digital delivery services. One-offs -- such as movie purchases -- would be charged via Netflix accounts.

Kicking and screaming
Hollywood wouldn't like these changes at first. The benefit of DVD sales is that there's no long tail -- release the DVD, and within a quarter, studios collect tens of millions in high-margin revenue. (Pressing discs is cheap.)

In the longer term, Netflix's model, if it evolves as I'm proposing, could earn more for the studios by exposing customers to more movies and movie-related services more often.  But only if Hollywood executives are smart enough to act on the opportunity.

Think I'm wrong? Have a different view of the movie business? Make your voice heard using the comments box below.

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Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He had stock and options positions in Apple and a stock position at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. The Fool's disclosure policy wants to Godzilla throw down with Mothra again. For old times' sake.