Netflix Needs To Prepare For War

Aug.30.12 | About: Netflix, Inc. (NFLX)

In the battle for supremacy in the online video streaming arena, Netflix's (NASDAQ:NFLX) most serious wounds have been self-inflicted. The field is thick with competitors, but it isn't playing for blood. It seems as if they are content to sit around and wait for Netflix to fall on its sword. Surprisingly, this tactic actually appears to be working.

Netflix experienced its first self-inflicted wound when Andy Rendich, Netflix chief service and operations officer, announced that it would begin charging separate fees for its DVD and streaming services. The fee restructuring took effect immediately for all new subscribers and on Sept. 1st, 2011, for all current subscribers. The blogosphere blazed with outrage over the 60% price increase. Netflix CEO Reed Hastings managed to rub salt in the wound with his dismissive attitude toward the outcry from subscribers. Hastings' hubris is summed up perfectly in his now infamous quote: "It's something we'll monitor, but Americans are somewhat self-absorbed." Those are words I expect he would like to take back.

The next wound came 17 days after the price hike took effect for current subscribers, as Hastings offered some reflections and explanation for the price hike and announced that the company would be split up into Netflix and Qwickster. Netflix would be the streaming business and Qwickster would be the DVD by mail business. This would take place in a "few weeks" and would require subscribers to manage their DVD and streaming services from separate websites, with separate logins and passwords. The rage that had cooled to a simmer ignited and boiled anew, prompting Netflix to toss the idea.

These were the two wounds that received the most coverage over the past year, but Netflix still managed to inflict a series of smaller injuries through miscommunication and arrogance. The truth is that the market is partially to blame for Hastings' hubris. Despite shrinking margins, a weakening balance sheet and increased competition, the stock was bullet-proof. Netflix was the great Achilles that vanquished Blockbuster Video (OTC:BLOAQ), with a little assistance from Coinstar's Redbox (CNSR). But like Achilles, Netflix was not invulnerable. Consumer sentiment is its Achilles Heel. Before the price hike, consumers forgave Netflix for its obvious weaknesses because they loved the product and there wasn't a better one or even a reasonable alternative.


Apple (NASDAQ:AAPL) sells digital movies and TV shows through the iTunes Store, but buying content ad hoc is an entirely different animal than doing so on a subscription basis. Apple's primary objective in selling digital music, shows, and movies is to sell more hardware. While this does give movie studios and television networks an alternative to sell the digital rights of their content, which drives up content cost, it does not force subscribers to choose one service over the other. In fact, Apple has deliberately reduced competition by allowing a Netflix app to populate its mobile devices. Apple may decide to stop playing nice shortly with the re-launch of Apple TV. There are really high expectations for the re-launch, but the details are speculative at this point, which makes the competition just theoretical.

In February 2011, (NASDAQ:AMZN) announced that it would begin providing free video streaming with its Amazon Prime membership. Amazon Prime costs an annual fee of $79 and includes free Super Saver Shipping, free book rentals via its Kindle e-reader, video streaming, and a few other perks. Amazon's free streaming catalogue is miniscule compared to Netflix, but it is supplemented by the ability to rent or buy digital movies and TV shows for an additional fee, granting access to newer content than one can find on Netflix. It may be counterintuitive, but I believe subscribers aren't abandoning Netflix for Amazon Prime for a couple reasons beyond the disparity in the video library. Amazon Prime is too affordable and offers too many additional benefits. Amazon Prime doesn't force people to make a choice between its service and Netflix, so they simply don't. Subscribers can easily justify subscribing to both services: Netflix for streaming video, Amazon for free shipping, free e-book rentals, and the occasional rental of a new movie not available on Netflix.

Hulu is a joint venture between NBC Universal (owned by General Electric (NYSE:GE)), ABC Television Group (owned by Walt Disney Corp. (NYSE:DIS)), Fox Entertainment Group (owned by News Corp (NASDAQ:NWSA)), and others. Hulu is a free video streaming service that is paid for through advertising that streams prior to your video selection. Hulu Plus is the paid subscription version of Hulu and is perhaps the most similar product to Netflix of all of the competitors. Hulu Plus focuses on current television shows, airing them often just a few days or a couple weeks after they air. This makes them more a competitor of Comcast (NASDAQ:CMCSA), DirectTV (DTV), and Dish Network (NASDAQ:DISH) than Netflix.

None of the current competitors provide a reasonable justification for canceling a Netflix subscription. Their services are supplemental to the product that Netflix provides. Many analysts insist that content is king in the streaming arena, but I propose that value and convenience are the true power. Until Netflix prices itself out of the competition or a competitor comes along with an exciting offering, Netflix subscribers will stick around.

I think that it is obvious that subscription numbers are the only real driver for Netflix stock price. Netflix's story has never been about its fundamentals. True value investors wouldn't touch the stock. It has always been about subscription growth and whether it can continue.

Nothing has impacted this stock more than a threat to its subscription numbers. These threats so far have been based on decision made by Netflix or its handling of the fallout. No competitor thus far has made a dent. The increased cost of content resulting in increased financial liabilities and shrinking margins roiled some analysts, but didn't appear to impact the stock. Some analysts even believe that these increased commitments are a good sign, since expenditure for content should increase subscription growth. With subscription growth returning, so should follow the stock price. But just when Netflix seems to be getting back on its feet, a new competitor takes the field and seems to be playing for blood.

Verizon (NYSE:VZ) and Coinstar's (NASDAQ:CSTR) Redbox recently announced that they have begun internal alpha testing for a joint venture that will combine both physical content delivery via the 36,000 kiosks around the country and digital streaming in a subscription service. Details are still sparse, but this could be the first competitor that truly commits to battle Netflix in a life or death contest for supremacy of video streaming. While Netflix is intent on divorcing its streaming and DVD delivery services, Verizon and Coinstar are expected to integrate them. Redbox also offers video game rentals, which may provide an edge to the newer offering.

Netflix needs to prepare for war. They need to address their perceived weaknesses and build on their strengths. Here are a few things they can do to increase their chance of victory.

Fulfill a promise

During Reed Hastings announcement of Qwikster he mentioned that video games would be added to the DVD/Blu Ray delivery service. This is something that is necessary. Redbox already has video games in their kiosks but it is a per day fee that quickly adds up. If Netflix can provide this service at a flat subscription rate they can turn Redbox’s competitive edge back on them.

Go a Step Further

Why stop at sending video games through the mail? Netflix should take a long hard look at Steam. Steam distributes games and related media online, from small independent developers to larger software houses. Added new content is and should be a priority for Netflix. This could be the edge in content that all of the video streaming competitors simply can't/won't match. Netflix's Open Connect may be a step in that direction. I believe that there is a significant gap between casual gamers on Facebook (NASDAQ:FB) and hardcore gamers who play games like Activision's (NASDAQ:ATVI) "World of Warcraft" or "Call of Duty." Netflix could exploit that gap by allowing small and medium sized developers to publish and distribute games through its content delivery network. Adding a few new movies and TV shows a month is good; adding a catalogue of streaming video games could be a game changer.

Technical Innovations

Netflix has become much more than a video streaming company. It is a content delivery company that has access to millions of homes worldwide through our computers, televisions, game consoles, and a slew of mobile devices -- but that's not all. Netflix is taking a play out of Amazon's playbook and becoming a bonafide technology company. Providing the service it does comes with a lot of lessons learned, and Netflix is leveraging those lessons and its homegrown software tools, making them available to the public.

As real details emerge on the timeline, pricing, and service plans for the Verizon/Coinstar streaming service I expect to see Netflix stock price reflect consumer sentiment on the offering. This will be based on the expected impact to the Netflix subscriber base.

Moving forward, as in the past, Netflix subscription numbers will tell the story which means the largest stock price moves will likely be when those numbers are reported. The difference this time around that consumers may soon have a viable alternative to Netflix and may not be so forgiving the next time Reed Hastings steps in it. The battle is far from decided. There is much Netflix can do to increase its chance of victory or even co-existence with the new offering but one thing is for sure, Netflix can't afford any more self-inflicted wounds. This is war and until the battle unfolds Netflix is a traders stock, not an investment.

Disclosure: I am long DIS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.