Is Netflix Streaming Its Way Towards Disaster?

Streaming is more efficient, but it's also a radically different business model — can Netflix handle it?

Netflix, through the simple device of using the post office to bypass video stores, has become one of the great success stories of the new entertainment economy. It now claims 16 million subscribers who pay a monthly flat fee for an unlimited number of rentals.  

For this mail-in business, Netflix did not need the approval of the studios. It simply buys DVDs, as does anyone else, from retailers such as Wal-Mart then mails them out to subscribers. What makes this form of rental  legal is the “first sale doctrine,” which holds that once a person buys a DVD, he can rent it out to others without the permission of the copyright holder.

Through that court-approved doctrine, Netflix created its mail-in empire. For a monthly charge of as little as $9 a month, subscribers get any movie they choose on the Netfix website. Whenever a subscriber mails back his DVD in a stamped address envelope provided by Netflix he receives the next DVD he has ordered. There are no late fees.

Rather than backing its trucks up to Wal-Marts, Netflix buys most of its DVDs from wholesalers. Its average price of about $15 per copy. (Some studios also supply lower priced DVDs in return for Netflix delaying its mailing them until  a month after they are in video stores.)

Last year, Netflix took in $1.67 billion in subscription fees. For its mailing business, its major expense, other than purchasing the DVDs, is postage and handling. It sends out about  2 million discs a day, which requires maintaining 50 distribution centers and buying over  a half billion dollars worth of postage. Because of these expenses, its operating profit was only about 12 percent.

Netflix is now attempting to reduce its  vulnerability to postage rate hikes by streaming movies over the Internet.  

Reed Hastings, the chief executive and co-founder of Netflix, explained that this new strategy is part of his concept that Netflix is not just as a mail-order house but a full-service home entertainment distributor since streaming provides movies in digital form on everything from ipad, and iphones, to game console and TV sets.

Over the last three years, this streaming experiment has garnered  a growing number of subscribers partially because it has been absolutely free to the subscribers of its mail-in service.

Next year, however, it plans to charge for its streaming service. If it succeeds in converting its mail subscribers to streaming, it will in effect create a virtual channel that directly competes with the three major Pay-TV channels, HBO, Showtime, and Starz.

The problem here is that while streaming movies is a more efficient way of delivering movies than the mail, it requires a radically different business model. Unlike with mail-in DVDs, the first sales doctrine does not apply to streaming. So Netflix needs to license the electronic rights from the studios, and that is extremely expensive.

In the case of new movies, studios license slates of 20 or so titles in so-called output deals for hundreds of millions of dollars. The average cost for a single title in such a deal is about $16 million for a two-year license.

Where Netflix can buy 10,000 copies of a major title for $150,000 to mail out, it will need to spend about $16 million to license it for streaming. Such a hundredfold increase in price can obviously be deleterious to profits especially since Netflix still has to maintain its mailing centers, and buy DVDs, for the subscribers who elect to continuing using the mail-in service either because they prefer DVDs’ higher quality and features or they don’t have the apparatus to receive digital streaming.

For the past 3 years, while building up its streaming service, Netflix found a temporary way around the licensing issue by making a sub-licensing deal with Starz Entertainment, a subsidiary of John Malone’s Liberty Media, which has its own output deal with Disney and Sony. paying Starz only $25 million a year for electronic sub-rights. Disney threatened to sue Starz, claiming that such a deal violated the output agreement, but Starz held that it could sub-license these rights because Netflix was merely a “content aggregator.” In any case, , the loophole will certainly be plugged in 2012 when Starz’ deal with Netflix expires. Not only will Disney likely demand additional payment for sub-licensing, but Starz itself has recently informed its other licensees that it will no longer discriminate in pricing, which means that Netflix will have to pay what everyone else pays for content

And Netflix’s renewal problem is not merely with Starz. It also managed to license in 2008 the electronic transmission rights until 2012 for television programs, such as “The Office,” from networks. At that time, syndicators were only interested in the broadcast rights for re-runs of these series, and, as the streaming rights had little value, they licensed them at bargain prices.  But the networks now have streaming, and video-on-demand of these programs on their own website, making it highly unlikely they will renew the expiring agreements.

The brutal reality is Netflix’s bargain days for streaming movies and television is coming to an end. As everyone else in the licensing game, Netflix will have to pay real world prices for content. Just the output deal it announced with three of the weakest studios,  Paramount, LionsGate and  MGM will cost it $200 million a year, a sum that exceeds its operating income last year. And if it wants the kind of output deals the other pay channels have, it will have to pay a great deal more than that.

Netflix, to be sure has brilliantly dominated the DVD mail order business. But, even aside from the immense cost of content, it must overcome three daunting challenges to succeed in the brave new world of cyber space.

First, it will have to compete directly with Pay-TV channels. HBO, which has nearly 40 million subscribers and a yearly cash flow of $1.8 billion, is not about to cede cyberspace to Netflix. It has just launched HBO GO which will stream to HBO subscribers “anything they want to see, anytime, anywhere, over their laptop, Iphone, tablet, Playstation”, according to Jeffrey Bewkes, the Chairman of HBO’s parent, Time Warner Communication. This includes not only the new titles it acquires through its $500 million output deals with Warner Bros, Fox, and Dreamworks, but its prize-winning original series.

Second, since there are few barriers to entry to cyberspace, Netflix will also have to compete in pricing Internet savvy companies, including Apple, Amazon, Hulu and Youtube, all of whom can offer similar streaming services.

Third, as Netflix’s streaming consumes more and more of the capacity of broadband carriers such as Comcast, it will have to contend with either restrictions or usage charges that will increase the cost of streaming.

If Netflix fails to meet these challenges, its bold move into streaming might be nothing short of a disaster.