Netflix's Management Has Learned The Wrong Lesson

Sep.19.11 | About: Netflix, Inc. (NFLX)

I’m almost dumbfounded after reading about Netflix’s (NASDAQ:NFLX) new plan to split its DVD and streaming services. A few months back, Netflix decided to end its bundled streaming + DVD plans, charging for both services separately. For most customers, the new scheme resulted in a 60% price increase. At the time, my take was that Netflix was trying to divest its DVD segment and believed it could more easily do so by splitting the two segments. My problem was that I viewed it as extremely unlikely that any potential buyer could get as much value out of NFLX’s DVD segment as Netflix itself would.

Now Netflix is completely splitting the two segments, rebranding the DVD business “Quikster,” and launching a separate website for the service. By making this move, Netflix CEO Reed Hastings has suggested that it’s pertinent for Netflix to “evolve with the times” and not go the way of Borders, the now-bankrupt book retailer. Yet, both as a Netflix customer and an investor, I can’t help but to feel that Hastings is learning the wrong lesson.

Netflix’s Value Proposition

Hastings views streaming as “the future”, as he should, but he seems to completely ignore the competitive advantages the company has in working towards that future. No other major company in America can offer a streaming and a DVD-by-mail service under one roof. Streaming may be the future, but unfortunately, only about 15% - 20% of content is now available via that channel. As a consumer, this can be extraordinarily frustrating.

Last year, when I re-activated my account with Netflix, I did so on the assumption that I could use the streaming service, but get an occasional DVD when something I wanted to watch wasn’t available online. It worked out very well. For the first few months, I watched a lot of the streaming content, before the selection started to wear thin. At that point, I got into the TV series, “Curb Your Enthusiasm”, which was only available on DVD. A few months later, I started shifting back to more streaming. This pattern continued on till this past summer. Essentially, my experience has been one of going back and forth between the two services; utilizing the DVD service to make up for the huge gaps in the streaming service.

As I said, no other company could offer this. At the same time, I thought Netflix was crazy for offering the service for as cheap as it did. It was $8.99 when I first signed up. It was then raised to $9.99. I would have been willing to pay $12 or $13 to continue the service as it was. Netflix was valuable to me precisely because it was an all-in-one service. If it had been streaming-only or DVD-only, I may have never signed on, but the ‘bundling of services’ made it valuable to me as a customer.

Instead of utilizing this major competitive advantage, Netflix seems to be determined to destroy it.

The Wrong Lesson

Borders may have failed because it did not evolve with the times, but Barnes & Noble (NYSE:BKS) has survived. It developed an online presence early on and unveiled its e-reader, the Nook, back in 2009. The lesson isn’t that radical restructuring of B&N helped it through a rapidly changing environment; it was that B&N had to move with the times and more importantly, the customers. If you can’t meet the needs of your customers, your business will fail. It’s that simple. Netflix’s shift towards separating its two main business segments is a classic case of ignoring the customers’ needs.

By lining itself up as a ‘streaming-only’ service, Netflix makes Hulu, Amazon (NASDAQ:AMZN), and Redbox look vastly more attractive in comparison. Meanwhile, I question the continued economic viability of the DVD-by-mail service as a stand-alone unit. DVD-by-mail makes sense for customers that are heavy users, but we’ve always known that Netflix hates those customers anyway. Netflix’s throttling strategy was one of the company’s first major controversies and the practice was dropped after lawsuits and media pressure. Yet, it made it abundantly clear that Netflix did not want high-volume DVD renters, as it was losing money servicing those customers.

Only problem is that in the age of streaming, low-volume DVD rental may not make much sense from the customers’ perspectives. If I watch 3-4 movies per month, even if I have to pay $3 to stream each video, that can still be a better deal than Netflix’s DVD plans. Of course, this service will still be of value to some customers, but its appeal will obviously weaken over the next five to ten years.

The End Game: Divestment

This once again brings me back to the idea that Netflix wants to divest its DVD segment. It seems thoroughly obvious at this point. Not only are the two segments priced separately now, but the two websites will be completely unaligned. What other purpose could this serve, aside from making it simpler to sell off the DVD segment to an outside buyer?

The idea is flawed, however, because the DVD segment has more value to Netflix than it does to any other company. This means that Netflix is dependent upon finding a sucker that will overpay for the business. If they are successful, then maybe things work OK, but I question the strategy all the same.

Netflix would have been much better off keeping its streaming and DVD plans aligned. This was precisely what provided the company with a competitive advantage. Hulu can't offer it. Amazon can't offer it. Dish Network can't offer it. Only Netflix can bridge the gap; and now the company is determined to blow up the bridge in order to “shift into the future.” Unfortunately, the odds have been increased that it could be a future where Netflix is no longer “top critter”.

While I do not believe that Netflix will go the way of Borders or AOL’s (NYSE:AOL) dial-up service, I do believe the company’s massive growth phase might be over, and that it is shifting from a mass-consumed product into a more niche market. The company will survive, but don’t be shocked to see the stock price continue to fall back towards the $100 mark over the next few years.

My Position

As for me personally, I began buying puts on Netflix in 2010, based on a similar thesis to the one outlined by Whitney Tilson at the end of last year. Those puts were dead money until last week, when they went from being huge losers to going back into the black. While I will continuing holding onto my established put positions, I have no intention of increasing my position, or initiating a new one.

In the short-term, I do believe that NFLX will beat earnings estimates, as the price hikes should make up for some of the customer churn, but my bigger issue is with the long-term value proposition and the fact that NFLX no longer appears overwhelmingly superior to all alternatives.

Disclosure: I am short NFLX.

Additional disclosure: I own long-dated puts on NFLX.