Netflix Not Necessarily Sustainable

| About: Netflix, Inc. (NFLX)

Several people have recently asked me if I thought Netflix had a viable business model. To be honest, I never thought much about that question until this month when Fortune magazine annointed Reid Hastings CEO of the year. The stock has been on a tear in 2010 – so it got me thinking, is Netfix sustainable?

Netflix is type of company I love to root for. It’s the nimble smart company that takes market share from slow incumbents despite all the odds stacked against them. Blockbuster (BBI), Walmart (NYSE:WMT), and Amazon (NASDAQ:AMZN) all went after the fledgling company. Coinstar’s (NASDAQ:CSTR) Redbox inked deals with all of the chain stores to put their DVD kiosks in their establishments. Netflix was no match for these industry insiders and deep pockets. But they all pulled back or lost the battle to the startup (blockbuster = ch. 11). Kudos Mr. Hastings.

Now they are at it again. They are completely revamping their business model to lead the charge to real-time streaming content. Two-thirds of Netflix subscribers already use streaming - a figure expected to rise rapidly. It’s a risky bet to gamble their entire DVD business, but probably a smart one. Like DVD’s in the mail, they are moving aggressively hoping to gain a critical mass of content and subscribers to give them a sustainable first mover advantage. So the question is can they beat the odds again ?

At first blush, it seems like they can. They inked deals with many of the movie and TV studios such as Disney (NYSE:DIS). They cornered the hardware providers like blue-ray, smart phone, and the numerous media center offerings with “Netflix inside.” Like they did with DVDs, they no doubt have the widest array of streaming content compared to their competitors like Apple TV. Unlike the first time around however, the price to play has gone up considerably.

Netflix claims that they only need $9 per subscriber to make a profit. In a world of cheap or free content, I tend to agree. But that’s not the case anymore. They paid $1B over five years to MGM (NYSE:MGM) and other movie studios for their content. Sure they are padding their libraries with cheap second tier content online such as ABC family, but the good stuff costs a lot more now. The “28 day” delay rule is still in effect in which they can’t offer premium content from the top movie studios. HBO and the other premium providers still refuse to work with them. Bottom line, content costs are going up not down. $9 per subscriber works great in a cheap acquisition cost model but not when the big boys start charging real dollars.

It all comes down to bargaining power (remember Porter’s 5 forces?). Netflix has distribution and a growing customer base. Warner Brothers and NBC have the content that people want. Disney embraces Netflix. Warner despises them. How much is an “entourage” show or “harry potter” movie worth? That’s the million dollar question. How much can a distributor command versus the manufacturer (studios)?

How much would you pay for entertainment content? That’s the key to Netflix. In a $9/month world, Netflix wins. That means the content is more commodity priced which tips the scale to Netflix who has established strong distribution. If it’s more along the lines of your $50/month traditional cable bill, then the content guys win.

Times are different now. Back when music was free (Napster), Apple (OTC:APPL) was successful in convincing all the studios to allow them to charge 99c per song in its Itunes store. They all feel robbed now – they will never get to the levels of sales as they did during the peak of compact discs. Bestselling Ebooks go for $20; not much cheaper than their hardback predecessors. The NY times and WSJ charge monthly subscription fees now to access their website. Content providers are no longer timid to charge as they once were in the net infancy days.

I'm still rooting for the boys in red. As respectful as I am of what Netflix has accomplished over the years, I think that online content distribution becomes ubiquitous over time (much like the movie houses which all filed for bankruptcy in the 90s while the studios thrived). Netflix will definitely survive; I just don’t think their $9 nut will net them as much as they think it will in the future.

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