Netflix's Big Mistake: Giving Up On DVDs

| About: Netflix, Inc. (NFLX)

Pretend, for a minute, that your best friend is the owner of a detective firm. He founded this firm when there weren't many others doing what he could do, and his business has grown tremendously over the past decade. In fact, his firm became the biggest in the industry, and other firms have been trying to catch up to him over the past few years. He has been able to make plenty of money while growing his customer base, as the customers are very satisfied with the value that they receive.

However, your friend sees a big shift coming. Detective work is going to change because of technology. He believes that customers aren't going to want his firm's traditional services anymore, which involve physical snooping. He thinks that, instead, he can leverage the internet to make his business much better - he can give his customers everything that they want, electronically, and save some of the costs by winding down physical operations.

So he decides that he's going to pursue this new business model. At first, everything proceeds favorably - his current customer base continues to grow, and often use both physical and electronic services. The makers of his hardware, software, and other things needed to run his electronic business, give him very low rates, as no other firms are managing to wring any value out of this new, electronic business model.

However, as the years go by, the firm faces a tough decision. Your friend still believes that electronic detective work IS the future, and that the physical work will be totally unneeded fairly soon. There's a problem, though - the physical work pays much better than the electronic work. In fact, the physical work pays $52 per hour, while the electronic work only pays $11 per hour. This is due to many factors; the most important one being that the physical assets (cars, binoculars, etc.) are purchased once and used for a long time, while the electronic assets have to be paid for each time they are used. Also, his electronic suppliers are beginning to charge much higher rates, as other competitors have launched similar businesses.

Still, your friend pushes forward with his electronic business model. He thinks that it might be a good idea to actually separate the businesses, but his customers, many of which like to use physical and electronic products, are very unhappy with this decision, so your friend changes his mind.

Despite his earlier successes, you're starting to get worried about the health of your friend's business. He knew that his electronic business model would make less money, but it appears that costs are spiraling out of control - in fact, the business is expected to lose money for the first time in years in the very near future. Your friend continues to try to make his business work by expanding geographically and producing proprietary material, but the costs of these gambles are very high, and the rewards are far from certain. You can't help but wonder if he'll be begging on the streets in a year - or if he'll be as successful as before.

That is how I understand the history of Netflix (NASDAQ:NFLX). Reed Hastings built a wonderful, successful business from scratch, by realizing that he could do a good job providing a soon-to-be-demanded service at a reasonable price. But he, perhaps correctly, realized that habits were changing and his initial business model might have problems in the future. He decided to dramatically shift focus from the extremely profitable DVD business (with a 52% margin) to streaming, with a much lower 11% margin. In many ways, the cost of this new "more efficient" business are higher, as content has to be purchased more regularly than it did when Netflix was buying physical discs.

I believe that the mistake wasn't pursuing streaming; that's clearly going to be a business for some company (or companies) in the future; rather, the mistake was abandoning DVDs. The DVD market is not dead yet; in fact, it can be an area of growth. Redbox (NASDAQ:CSTR) continues to prove that there is opportunity to make money renting DVDs, and the ubiquity of players (in 91 million households as of 2010, not counting video game consoles) means that a demand for discs will exist for a long time.

I believe that Hastings just made his move too early, and with too much conviction. Sure, it's nice to be able to stream some old TV episodes or a not-that-great movie on a laptop, tablet, or mobile phone. But it's also great to be able to have a new-release, blockbuster DVD waiting in your mailbox when you arrive at home.

It just doesn't make sense that Netflix is giving up on its DVD business at this point. It makes a ton of money, and the company knows how to operate it successfully. Instead of being blinded by future prospects, executives should simply look at the past; they'll see how successful their DVD golden goose has been, and how easy it is to allow it to continue laying eggs. If they choose instead to continue charging into streaming no-mans land, the company may not be around much longer.

I'm one of the many people who were pessimistic about the stock at much higher prices, but sat on the sidelines as the action unfolded. I don't have the conviction to attempt to short Netflix to zero - nor do I necessarily believe that zero must be the eventual outcome. However, the business is clearly in trouble, and management decisions over the next few quarters will determine whether bankruptcy or a return to former glory are in Netflix's future.

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