Netflix: A Disruptive Model With Long Legs

Aug. 2.11 | About: Netflix, Inc. (NFLX)

As a long-term cable television analyst, it seems to me that Netflix's (NASDAQ:NFLX) streaming services is a profoundly important industry change. It is at least as big as--if not bigger than--the advent of basic cable services like CNN, ESPN and MTV. In my view, it will accelerate penetration of high-speed broadband services on cable and fiber-optic services provided by telcos, but it will also accelerate the demise of premium pay television and pay-per-view.

The cable television operator will be caught in a Hobson’s choice. Consumers will demand greater bandwidth for broadband services while at the same time cutting demand for high-end premium television services.

How will this work? Cable television operators have always sold premium services as a tier above digital basic services. In terms of demand, consumers must purchase digital basic services in order to purchase premium services.

In micro economic terms, this means that demand for premium services is dependent on demand for basic service and has to be far more elastic than demand for basic services. The higher the price elasticity, the greater the increase or decrease on quantity demanded for small decreases in price. The same holds true in the opposite direction. Price increases lead to declines in quantity demanded. Since demand for cable services is at a maximum because cable is in most households already, it has reached maximum penetration and cannot respond to lower prices. Increased prices will dramatically cut demand.

As is clear, consumers can purchase streaming Netflix services without purchasing any other services except for high-speed access. Consumers also have many other uses for high-speed access and view access to Netflix as an add-on that is part of the rich experience of broadband access.

In economic terms, demand for Netflix and other streaming services is inelastic, both in terms of price and income with respect to the demand for premium television services. Therefore Netflix and such other services will have higher price flexibility and stability compared to premium television services either subscription or à la carte.

What are the implications? Clearly, Netflix at $15 a month for unlimited streaming remains a tremendous bargain to consumers. We think $25 or $30 per month will NOT lead to significant decreases in subscriptions because Netflix is still at a highly inelastic point on the demand curve. At the same time, Netflix subscriptions will be as robust, if not more so, than cable television basic services in times of economic turmoil. Consumers under financial pressure will tend to hold on to Netflix and other such services longer than subscribers to pay television and possibly even tiered levels of basic service.

What are the implications for cable television service? In the current environment, consumers will likely continue to pare back their purchases of premium television services and to replace those with streaming services like Netflix and others. We also believe that cable television operators will respond to increased demand for bandwidth and broadband speed by reallocating bandwidth from television services to Internet services.

Internet streaming will become the leading method of household access for all forms of premium entertainment. Cable television will likely hold its position as the preeminent supplier of ad supported and basic services. Its tremendous broadband capacity allows it to package seemed entertainment news and sports channels for easy consumer access. Netflix and such services, on the other hand, provide a vast array of choice for premium entertainment and will likely push cable premium services into extinction.

We believe Netflix's advantageous position vis a vis the consumer is in general the strongest business model we have studied in thirty years, save basic cable. Certainly it hs more robust than Blockbuster, and more robust than Showtime (owned by CBS but less than a 10% contributor) and probably HBO (owned by TIme Warner (NYSE:TWX) and a susbtantially larger business). These business are outdated packaging models. About the only way they can compete on a level playing field is for the cable operator to waive the basic cable purchase requirement, and no cable operator is going to do that.

We expect the studios and their pay TV partners to attempt to manage the release windows for their films to prevent further incursions by Netflix. We believe they will fail. However, in our view, Netflix has yet untapped pricing power, and future growth would argue that Netflix will be able acquire first window rights for most films in the not too distant future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.