How Netflix Might Have Just Lowered the Price It Pays for Digital Content

Jul.13.11 | About: Netflix, Inc. (NFLX)

All of a sudden, I find myself at odds with Netflix (NASDAQ:NFLX).

Once again, the stock defies logic. Given the uncertainty and outrage surrounding its subscription plan changes, the stock should tank. Instead, it tapped another all-time high Wednesday morning at $304.79. There's not much more to do at this point in response to the stock's momentum other than sigh and keep your stop loss handy.

What baffles me even more, however, is the continued reaction from all corners that this move equates to Netflix telling DVDs to drop dead. As I explain in a previous Seeking Alpha article, I suspect that just the opposite is at play, at least in the near-term.

I still cannot comprehend the automatic assumption that consumers will abandon DVDs and opt for streaming. As I explain in the above-referenced article, the numbers just do not add up, quantitatively or qualitatively, to support that conclusion.

Here's what I think will happen: Amidst a considerable subscriber exodus, Netflix will see a bifurcated subscriber base. It will have fewer streaming customers and, as it said it would do, the company will renew its focus on DVDs. This move alone places a renewed focus on DVDs. I am not sure why that's so difficult for people to see.

Pursuant to what I wrote about the studios wanting to save their DVD businesses and the reality that Netflix could some day split in two, consider what this new world might mean for Netflix as it negotiates content acquisition contracts. Remember, that's the big kicker here. Netflix ultimately wants to be a streaming-only company. But, at this point, it likely knows it cannot afford the content to get there. As such, it has to make a deal with the devil known as the DVD.

While I fully expected the stock to crater on the aforementioned uncertainty and outrage, I do think if Netflix can charter rough waters over the next year or so, it will end up a stronger company. I still think the stock plummets significantly at some point over the next few quarters. It's tough to know if and when, however, because Netflix will likely not give us much subscriber metric color going forward. After a major correction, if things look like they are on track, NFLX might become a buy. But this is 2012-2013 talk.

Why do I say this? I believe the movie studios, for all intents and purposes, drove this subscription plan shift. Based on conversations I have had with people in Hollywood, this could give Netflix the opportunity to negotiate DVD deals alongside digital content terms. Think about it - by sweetening the pot on DVDs, Netflix helps the studios' cause. In return, the studios provide more favorable terms for Netflix to get its streaming business where it needs to be. The studios will also be happy if this move lowers the number of streaming subscribers. Contrary to popular belief, this is exactly what I think will happen.

Both the studios and Netflix find themselves in transition. This move, assuming my analysis is on or near the mark, helps both causes. It preserves DVDs as a viable business for the studios as they get more comfortable with a digital world. And it helps ease the very expensive shift to being a pure streamer for Netflix. A pure streamer that can offer a service equal in quality to what it can offer via DVD. Who knows, maybe Netflix will now find itself in a better position to negotiate for newer and fresher material via its streaming service now that it has thrown the studios more than a mere DVD bone.

NFLX should have been crushed today, but I've said that before. The stock defies logic. Equally as troubling, however, is the media's inability to think creatively and consider alternative scenarios that could be at play on this news.

Disclosure: I am short NFLX.

Additional disclosure: I am short NFLX via long position in NFLX put options.