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Netflix (NFLX)
Why Netflix Can Long Outlive the DVD
Netflix has been one of the winners of the recession. It has a simple, easy to use service that provides people with cheap entertainment. The stock is up 44% over the last year. However, the risk of obsolescence in the medium to long term is fairly large. DVDs are on the path to extinction and a business centered on delivering them in the mail obviously has some redefining to do. Even though there is a school of thought that believes Netflix is essentially helpless and will go the way of former darlings such as AOL, once online video becomes ubiquitous, Netflix and CEO Reed Hastings have a very real chance of surviving and even thriving in the new world order, provided they do certain things right and some chips fall their way -- and here's why.
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As a quick summary, Netflix's biggest advantage over Blockbuster (BBI: Charts, News, Offers) was that it could offer a much larger selection of titles as it was not constrained by the size and location of its retail outlets. Netflix also got some traction out of getting rid of late fees. The problem now is that more and more viewers are shifting to digital movies -- i.e. movies that they can stream online and/or have delivered straight to their TVs. To satisfy this market, Netflix launched the "watch it now" feature which streams movies instantly online. The two big issues are the level of competition in this field (you have everybody from illegal movie sharing sites to Apple's (AAPL: Charts, News, Offers) iTunes to premium movie channels such as Showtime and HBO) and the fact that movie studios are loathe to license their latest and greatest movies to Netflix for the company to make them available online. The movie studios still want to preserve the more lucrative market for DVDs and possibly even launch their own custom web offerings. In short, they don't want to hand over the movies to Netflix which really did not have to license DVDs from the movie studios because it made use of the "first-sale doctrine" of US copyright law which allows buyers of DVDs to rent them out without the consent of the studio. Of the two issues, the second is the bigger one. Yes, there is a lot of competition but Netflix is well-run and innovative enough to hold its own. However, it isn't clear how Netflix can remain profitable with the high licensing fees studios are bound to demand for digital versions of their movies.
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Therefore, some people have written off Netflix as a business that will continue to do well for the next 2-3 years and then enter into a long decline. However, Netflix has a realistic shot at proving the doubters wrong. Usually when a company is headed for extinction, they are the last to know and they do everything they can to preserve their business model without attempting to reinvent it. Netflix is the complete opposite. Nobody knows better than Reed Hastings that DVDs are about to go out of style and he has been thinking about what should be next for a long time. That level of awareness from the company is a huge factor. Netflix also has a huge amount of customer data at its disposal and it has famously built an algorithm which is great at predicting what movies a customer might like based on their previous selections. That is core intellectual knowledge (similar to the page rank formula at Google (GOOG: Charts, News, Offers)) which retains its value even after DVDs are passé.
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Now, whether Netflix can afford the licensing fees the studios will want will depend on whether it can monetize the content better than everybody else. To do that, it has to bring its service in front of more eyeballs than anybody else. The company's current strategy for doing that is to strike deals with television manufactures such as Samsung and Sony (SNE: Charts, News, Offers) (Netflix just announced a deal with the latter) and enable televisions sold by these companies to directly stream movies from Netflix. A better approach may be to go after cable companies and strike deals with them which could involve Netflix replacing their current on-demand offerings or the cable shops even creating a new channel for Netflix. There are fewer cable companies than TV manufacturers and working with the latter limits Netflix to customers who only have the latest TVs. Netflix could afford to pay the cable companies if the service was sticky enough for end-users who end up watching more movies than they used to with the cable company's antiquated movie services.
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And Netflix can make the service sticky by designing a slick user interface, by solving the problem of streaming content from PC to TV (there are some solutions in the market for this but they leave a lot to be desired) and most importantly, by applying its algorithm more broadly. Right now, customers have to select a few movies before Netflix can predict what they might want to watch next but Netflix could gather this data automatically by just analyzing what TV channels customers spend their time on and what kind of regular programming they watch or what video sharing sites they visit online.
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So, Netflix does have a shot in the new digital movie world if it executes well, strikes some key deals and leverages the algorithm more, keeps refining it and becomes the Google of predicting the best movie/TV show for the customer.
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