Netflix's Honeymoon With The DVD Is Over

| About: Netflix, Inc. (NFLX)

The DVD brought Netflix (NASDAQ:NFLX) to the dance. While Reed Hastings did not quite leave the digital video disc at the altar, he has made it clear that the honeymoon is over.

Netflix has too many problems to count. The number is certainly higher than the box office hits you can stream from the service. We rarely discuss what might be one of the company's biggest issues. It never had a viable plan B - a bridge, if you will - from DVD to what we all just assume to be the future - instant video, a.k.a streaming. That's Hastings' vision and he's sticking to it, even if it brings Netflix to the brink.

While I do not debate Hastings' grasp of the future of entertainment, he has done a horrific job building that much-needed bridge between old and new. Consider two other companies in somewhat similar situations.

Some folks compare what Hastings is doing at Netflix to what Jeff Bezos is pulling off at (NASDAQ:AMZN). Of course, Bezos is sacrificing the near-term bottom line to heavily reinvest in his company's business. Big difference, Amazon sits on growing billion dollar revenue streams, including Amazon Web Services, which powers Netflix. The company also sets up relatively sure-shot international opportunities. Plus, Bezos has a history of pulling risky maneuvers off without the keystone cop-like antics of a green CEO like Hastings.

Tesla Motors (NASDAQ:TSLA) has a bridge built between sales of its inaugural Roadster and the forthcoming Model S. While the company does not necessarily operate from a position of strength like Amazon, it has done a remarkable job keeping things together as it attempts to dictate a small part of the future. No doubt, Tesla needed to raise cash, but, unlike Hastings, Tesla CEO Elon Musk put his own money on the line as part of the deal. Plus, Tesla generates additional revenue by providing electric vehicle components to other automakers.

By contrast, Netflix sacrificed its profitable DVD segment, putting itself in a dire situation. The words of the late Elliott Smith come to mind: I told the boss off and made my move. Got nowhere to go. Netflix needed something to bridge the gap. For my money, the company should have never abandoned DVDs. Ride that segment for all its worth. Why mercilessly kill off a profitable revenue stream that helped subsidize your streaming ambitions? It makes no sense.

Now Netflix is left with the worst possible situation on the DVD side. Sure, DVD customers are probably dropping like flies. On a theoretical level, that's great. Hastings is paving the way to the future, but at what expense? He's likely to be right about that future, yet Netflix probably will not be a part of it, due to his mismanagement and the unworkable competitive dynamics I've been yelping about for months.

We likely will get little if any color on this from Netflix when it reports Wednesday, but logic leads me to believe that the remaining DVD customers are heavy users. By completely divorcing the two segments, Netflix forces light DVD renters, who were paying attention (and how could they not have been?), to jump ship. People like my neighbor Ginger, however, who always have a red envelope or two in outgoing mail, will milk this $8 a month cow for all its worth. That means DVD runs the risk of becoming a drain on revenues, thanks to the high costs of servicing heavy users, instead of a way to subsidize streaming.

With the DVD business dying a not-so-slow death (Netflix will leave behind massive distribution centers like Wal-Mart (NYSE:WMT) leaves suburbs with empty big boxes), Netflix had no choice but to raise cash to keep content acquisition, international expansion and ramped-up marketing afloat. While Netflix continues to dominate the streaming landscape (though its market share has decreased), it relinquished its DVD title in 2012:

  1. Coinstar (NASDAQ:CSTR) - 37%, up from 25% in 2011.
  2. Netflix - 30%, steady from 2011.
  3. Blockbuster (NASDAQ:DISH) - 17%, from 23% in 2011.

In Q4, however, Netflix's share of DVD rentals hit a two-year low, clocking in at 25%. Hastings will try to spin this and any upticks anywhere on the streaming side as good news. Looking out to the future, it might be positive, but that's hardly a foregone conclusion. Given the attendant costs, there's no guarantee that streaming, even in the Netflix form of re-run TV, will ever be a profitable proposition unless you own and have control over the most sought-after content.

All of this to say, we should be in for another entertaining and possibly revealing (assuming you can read between the lines) Netflix earnings report and conference call after Wednesday's market close.

Disclosure: I am short NFLX.

Additional disclosure: Author is short NFLX via a long position in June $40 put options.