Netflix: Why This Movie Will Have a Happy Ending in the Long Run

Sometimes taking a big step forward can be perceived as taking a step in the wrong direction. That seems to be the case with Netflix's deal to add movies from Paramount, Lionsgate and MGM to its Watch Instantly service's inventory.

Last week, Netflix (NFLX) said it signed a deal, valued close to $1 billion, with Epix, a pay-TV channel on cable and satellite systems that distributes movies from the three studios. Netflix already has similar deals with the Starz channel (Walt Disney Studios and Sony Pictures) and smaller niche distributors like classic-film collector Criterion.

The move is one that Netflix will need to make if it wants to wean itself off the DVD-by-mail model that involves costly postal fees and is being threatened by the rise of online video. Yet it drew two bearish notes from Wall Street analysts and triggered a stock-rating downgrade, which has weighed on Netflix's stock price this week.

This is strange because Netflix at first rallied on the news. Before the announcement early on Aug. 10, the stock was at $116.90, then it surged 17% to $137.22 a week later. But once analysts started looking at the number -- Morgan Keegan estimated the $1 billion, five-year deal will cost $1.11 per subscriber, enough to erode profit margins -- the stock fell to as low as $123.61, marking a 10% drop from its recent high.

Taking the Long-Term View

The stock market seems very unsure whether to applaud or jeer this move. In the end, though, the bullish case is likely to prevail over the concerns. The concerns center around three factors, which are likely to trouble Netflix in the short term but can be overcome in the long run. And Netflix's online movie strategy has always been built for the long run.

The first concern is margins. The Epix deal will weigh them down until the company can bring in more subscribers -- it will need at least 2 million signing up for its cheapest plan to break even on the deal. If Starz comes back and demands more from Netflix later on, or if Netflix needs to sweeten the pot to lure HBO and others to the table, margins could decline further.

The second concern is that Netflix may already be saturating its market. Yes, it's signing up 4 million subscribers a year, but many of them are scaling down to the cheapest option of $8.99 a month for one DVD by mail at a time and all you can eat on the Watch Instantly option. In that respect, the Epix deal was a terrible idea, since it's pushing up costs when revenue per subscriber is declining.

Another concern facing Netflix is competition, not just in the form of cable and satellite television but increasingly from other online movie formats like iTV from Apple and industry-backed initiatives like Hulu. As The New York Times pointed out recently, the number of pay TV customers ready to cut the cord and move to online viewing is less than you might think.

Luring the Holdouts

Let's take these problems one by one. Netflix knows it will never be a key player in online video unless it builds a critical mass of inventory to make it a must-have service, the way people see cable TV today. The Epix deal was one Netflix needed to make, and by making it on more generous terms for Epix than many analysts expected, it has a better shot at luring holdouts. Those holdouts, like HBO, know they will need to embrace online streaming one day. They just want to wait for the best business model.

And while revenue-per-subscriber is declining, this was something Netflix surely expected all along. DVD-by-mail fees are high because of the friction and costs of the postal delivery system. While postal fees go up every year, streaming costs are falling. As Bloomberg reported, digital distribution of TV is getting ridiculously cheap -- 3 cents to stream a standard movie and 5 cents for high-definition movies. Netflix passes much of these savings on to the studios, yet another incentive for the holdouts to stop holding out.

Netflix will not only be able to stomach the cheaper subscriptions, but the $8.99 for limitless movie watching is going to be very attractive to customers, even those with cable or satellite TV. What's another $9 a month for movies when you're already paying $130 a month for all those crappy TV shows?

A Great Experience for Watching Movies Online

Finally, Netflix has been readying for competition for a long time. And it's done so in one of the most devious and effective ways: By offering the best experience for watching movies online. When the iPad debuted, it was Netflix's app that was called the tablet's killer app. Watching a Netflix film on the iPad is a happier experience than anything even Apple has come up with. Or Amazon, for that matter, and Amazon has been trying to rent and sell movies for some time.

So whether or not people ever work up the courage to cut their cable cords, they will sign up for Netflix as the experience of watching an Internet-streamed movie improves. How many times do you hear people complain about cable and satellite TV -- the anti-consumer policies, the high monthly fees, the dearth of quality programming? The most frequent complaint about Netflix's Watch Instantly is its inventory isn't big enough. As we've seen, the company is working on changing that.

Is Netflix facing some turbulent times in the next year or so? Probably: Margins will drop, investors will complain and the short sellers who have long circled the stock will try to push it down. But Netflix's user-friendly interface and its $8.99 all-you-can-eat plan will bring in subscribers. That will draw in more deals with stubborn studios. And eventually Netflix will become what it has wanted to be all along -- the place we go to watch movies on the Internet.