Are Movie Studios Calling Netflix's Shots?

| About: Netflix, Inc. (NFLX)

It never ceases to amaze me how the media treats Netflix (NASDAQ:NFLX). After the company announced changes to its subscription plans, one story after another followed with pretty much the same headline and subsequent takeaway: Netflix Tells Its Customers to Ditch Their DVDs or Pay Up.

Brian Caulfield, over at Forbes, wrote one of the better, more novel reactions, noting that Netflix had no choice but to raise prices. Caulfield argues that the company's streaming selection "sucks" so bad that it desperately needs "to get some better movies for its streaming service, and that costs money." Well-stated.

I wrote an article yesterday afternoon reacting to the news. In it, I attempted to provide some alternative scenarios for the changes and price hike. I received several comments and emails asking for some more color on the possible explanation I provided at the end of the piece.

After talking to several people Tuesday afternoon and evening who are well-versed as to the inner workings of Hollywood and the movie industry, I was told that a scenario that was floated by me on Tuesday sounds more than plausible. The more I think about it, the more I think it sheds plenty of light on what's really at play here. If nothing else, it gets beyond the standard "they're ditching the DVD in favor of streaming" line.

Think about the logic here. As Peter Kafka points out at All Things -, a majority of Netflix's customers still pay to get DVDs by mail. It's not clear how many of these subscribers stream and take advantage of the soon-departing $2 per month DVD add-on.

Let's use 60 percent as a generous estimate of the portion of the Netflix subscriber base that streams. Now, let's assume that these users stick with streaming only at $7.99 a month. That translates into $1.3 billion in top-line revenue. Relative to the content, international expansion and, now, potentially increasing DVD delivery costs Netflix faces, that number represents a spit in the bucket. Just think about the hundreds of millions of dollars Netflix will have to dish out to renew the Starz (LSTZA) and Epix deals alone. And there's no guarantee that the composition of what effectively will be a brand new subscriber base will end up split 60/40 in favor of streaming. I did not even consider something Netflix surely does not want to think about -- a subscriber exodus and subsequent declining revenues on these changes.

Just about everybody is forgetting the kicker here. Netflix offers more and newer content through its DVD service. As Caulfield points out, the streaming selection pretty much does "suck," using his word. The initial reaction that this move will force people to stream and abandon DVDs seems off the mark to me.

I think Netflix expects more people to opt for DVDs than it would otherwise prefer in a perfect world. It also realizes that it's facing an EPS squeeze of epic proportion on rising content costs. While the company might not miss this quarter (I would not be surprised if it somehow mustered out a beat), it's coming. Netflix did guide down last quarter on Q2 EPS, but guided up on revenues, suggesting pressure on profits from rising content costs.

So why the "renewed focus" on DVDs as Netflix CFO David Wells tipped us off to a few weeks ago? Consider the position of movie studios in Hollywood. They do not want their DVD businesses to die, nor do they want to see new releases dilluted by the likes of Coinstar's (NASDAQ:CSTR) Redbox. At this point, the competing interests of the studios and Netflix meet.

The studios want to keep the DVD alive. Netflix knows it cannot afford to pay for the content it requires to be a streaming company only domestically, as it intends to be worldwide.

That said, could this move be a way for Netflx to make the studios happy and ensure it gets the best terms possible on streaming content? Netflix wanted to abandon its DVD business, sort of. Here's what the company had to say about DVD versus streaming in its Q1 letter to shareholders:

We believe that DVD will be a fading differentiator given the explosive growth of streaming, and that in order to prosper in streaming we must concentrate on having the best possible streaming service. As a result, we are beginning to treat them separately in many ways. Already, if you look at our signup page for non-members, it is all about streaming. Having said this, DVD rental is still a great business for us, and we are working on solutions to make sure DVD continues to be a profitable business for us in the years ahead, but it is not core to winning in streaming at this point.

There's some doubletalk there, but also a bit of foreshadowing. Maybe the DVD business has, all of a sudden, become "core to winning in streaming?" By placing a "renewed focus" on DVDs, Netflix makes the studios happy. In return, the studios could make sure that Netflix gets the best terms possible on streaming content. This is where Netflix has a leg-up on cash-rich competitors like Google (NASDAQ:GOOG) and (NASDAQ:AMZN). Neither, presumably, has an interest in buying up DVDs at the clip the studios would expect and shipping them around the country. Plus, Netflix has the infrastructure already in place.

One common reaction to this news appears on the mark -- Netflix is a pure streaming company internationally. Streaming serves as the model for the company known as Netflix going forward domestically. This move, however, will not directly or immediately support that aspiration, particularly if more subscribers opt for DVD delivery than conventional reaction to the news suggests.

If Netflix is able to stabilize itself and secure the content it needs to not only sustain, but improve its streaming offering it could, someday and to some extent, truly abandon DVDs all together. A very plausible situation could involve Netflix spinning off its DVD business at some stage down the line.

As Caulfield's piece makes clear, however, there's no way Netflix can get to that point without a much stronger streaming lineup than it has now. And there's no way it can secure the content necessary, at a price it can afford, to get there without the studios on its side. At day's end, it appears to me that the studios are calling the shots here. Netflix has no choice, as I see it, other than to make a deal with the devil known as the DVD, for the time being.

Believe it or not, I think this could actually turn out to be a positive for Netflix, assuming the story I string together is on or at least close to the mark. And I feel pretty confident that it is. For the time being, however, news of customer protests and an inkling of uncertainty heading into Netflix's Q2 earnings release next week might put some near-term pressure on the stock. A less-than-stellar Q2 call, particularly on the outlook for the rest of the year, would, finally, send the shares reeling. Based on that sentiment, I am long several out-of-the-money NFLX puts.

Disclosure: I am short NFLX.