Netflix’s Long-Term Business Model Flawed, Competitors Willing To Give Content Away

As much as Netflix says they aren't trying to create a subscription based content service that competes with cable, that's exactly what they are trying to do. The company is licensing exclusive content in an effort to try and retain customers and sign up new ones, but their long-term business model is flawed. Netflix thinks that having access to a series like Mad Men is enough to keep customers subscribed in perpetuity but the problem is that once a customer blows through the episodes and has nothing else to watch, they will cancel.

Netflix's CEO has compared their licensing of exclusive content to what HBO does, but that's a bad comparison. While cable channels like HBO have exclusive content, they also have fixed delivery time frames. This means that customers can only watch content when HBO wants them to, including modifying what content is available on-demand. When Netflix was the only service in the market to offer this kind of content, Netflix focused on the breadth of their library, not exclusivity. But with competitors like Amazon willing to give away the same content that Netflix is charging for, as a loss leader for their other products and services, Netflix is now scrambling by trying to get exclusive content to keep customers. The problem is that long-term, this approach by Netflix can't last because they have no way to compete against free.

Long-term, Netflix business model for licensing exclusive content won't work. When a competitor comes up with a way to deliver streaming content in breadth, think Amazon and Google, Netflix is done. Netflix can't afford to give the content away like Amazon, Microsoft, Sony and Google can and Netflix doesn't have any other products or services they can sell. In addition, when it comes to the digital delivery of video, the studios have complete control of the content, the MSO's own the last mile and Netflix's prior advantages in the physical world of DVDs completely disappears in the digital world. If Netflix doesn't own the content or delivery, then why would they have a superior service when others are willing to use movies and TV shows as a loss leader?

Some might argue that Netflix will just acquire a large library of content on an exclusive basis, but that won't happen. Studios make the most money by licensing the same content for many platforms, not just one. Netflix can never charge enough for their subscription service to make up for displaced DVD revenues and Netflix doesn't have enough money to license a large catalog of content on an exclusive basis when it is estimated that Mad Men alone is costing them $75-$100M for seven seasons. We all know that studios make their money by selling us the same content multiple times for different platforms. An on-demand offering for one low monthly price would kill the studios business model since consumers would not want to watch the content via other platforms if they knew it was already available on-demand any time they wanted. Netflix's model completely disrupts the studios window strategy for making money.

In addition, someone I was talking to about Netflix made a good point about the studios not wanting to be “iTuned” like the music industry was. The studios will try to encourage as many channels for content delivery even at the expense of short term profits to maintain longer term survivability. Having one company like Netflix control 80% of the streaming movie business, the way Apple owns 80% of the music market, is not in the best interest of the studios. For many years, Netflix's strategy was that no one else could have the breadth of content they have or be on as many platforms and devices. But that's no longer the case with Amazon and other competitors are starting to catch up very quickly. Now, Netflix is focusing their efforts on exclusive content, with the same strategy that Blockbuster had, thinking that content exclusivity would save them. In the long-run, it won't work.

Netflix is no longer the only game in town. With content subscription services from Hulu, Amazon and DISH, video on demand from the MSOs, services like Comcast XFINITY TV, and other competitors like Microsoft, Sony, Google and Redbox all entering the market soon, Netflix is going to get squeezed. This is the whole reason no MSO has bundled Netflix's service in with their cable TV offering, it's competition. I expect we'll see this happen for Netflix's service in Latin America, but that's more out of a necessity for Netflix since most consumers in Latin America don't have credit cards and Netflix will need to use the local MSO for billing purposes.

People always fall back to the argument that Netflix's content is better, but it comes down to what's "good enough" and what people are willing to pay for. Also, most seem to argue that Netflix is only $8 a month, but remember that Netflix is not a replacement for other services. So it's $8 a month of top of a $100 cable bill plus other services like Hulu Plus that a consumer might also be taking. And for a consumer that already has something like XFINITY TV and Hulu Plus or Amazon Prime, do they really need Netflix? You have to add up the value of all the services a consumer has and then compare it, as a whole, to Netflix's offering.

Netflix has the chicken and egg problem. To get subscribers, Netflix needs content. To get content, Netflix has to pay the studios which requires subscribers. Netflix is having to commit to up front massive payouts to studios for whatever content they can get. But if subscriber growth stagnates, Netflix could quickly find itself upside down in those agreements. From a financial perspective, Netflix has already estimated it won't be profitable next year as they expand into new territories in a clear sign that content costs are skyrocketing.

Long-term, Netflix is going to face some serious problems, some of which we are already starting to see. Netflix's continued need to increase their content library, and have exclusivity, has a lot of upfront costs that could increase monthly fees in the near-term and slow subscriber growth rates. And while Netflix content might be a bit better than the competition, competitors services will become good enough and make Netflix's cost of customer acquisition and churn increase. 2012 is going to be a very tough year for Netflix.

Updated: I've gotten a few emails from people saying that no one seemed to be making these arguments when Netflix's stock price was at $300 a share. Actually, many were. In September of last year, when Netflix stock price was at $165, I was making the very same arguments, as were others. So it's not about people all of a sudden piling on Netflix when the company is having trouble.

Disclaimer: I have never bought, sold or traded a single share of stock in any public company ever.