Netflix Has a Bigger Problem Than You Think

Investors shouldn't be surprised by Netflix (NAS: NFLX) hosing down its domestic subscriber targets this morning.

Any rational person could see that the company and blinders-donning analysts were underestimating the consumer resentment spurred by Netflix's decision to begin charging subscribers on unlimited DVD plans for streaming access. That move resulted in a price increase of as much as 60% for those wanting to receive optical discs in the mail and stream from the dot-com giant's growing digital catalog.

The outcome isn't a shocker. Netflix was targeting 25 million domestic subscribers by the end of the third quarter two months ago. Now it sees just 24 million accounts in this country when its quarter comes to a close in two weeks.


Time for a Shyamalan twist
Penny-pinching couch potatoes may applaud the karma police. How dare they be hit with a price hike during uncertain economic times, just because they want to stream Mad Men while the postman plunks down a rental copy of Crazy People in their mailbox?

However, there's a surprising plot twist here. No matter how hard the media today will position this guidance update as the result of Netflix's brazen price hike, the defections have nothing at all to do with the move.

Yes, nothing.

Netflix still expects the number of subscribers on dual plans for streaming and discs -- the only group that is being affected by the pricing change -- to clock in at 12 million, exactly where it was earlier this summer.

The shortfall is actually coming from the rest of Netflix subscribers. Back in July, Netflix was forecasting 10 million accounts paying only $7.99 a month to stream. It now sees 9.8 million subscribers exclusively streaming. It was aiming for 3 million subscribers to be on disc-only plans, and now that target has been scaled all the way down to 2.2 million technophobes.

This may actually come as a relief to those worried about the impact of Netflix's price change, but it should be even more problematic for the model itself.

No streamers at this surprise party
Netflix knew it was taking a risk when it began pushing web-based viewing. Sure, it would save a ton of money in distribution, since it's far cheaper to beam a film through the Internet than to cover round-trip shipping. There is also the benefit of bypassing inventory logistics. There are no damaged discs or limited availability problems when it comes to digital delivery.

However, this move also eliminates one of Netflix's greatest competitive advantages -- a network of regional distribution centers -- from the equation. Only Dish Network's (NAS: DISH) Blockbuster could match that infrastructure, but in the streaming space the playing field is level.

It all boils down to a content-acquiring footrace. Netflix is comfortably ahead of the pack. The nearest rival offering unlimited streaming is (NAS: AMZN) with 8,000 largely dated titles. The rub here is that no streaming service will ever have access to everything that's available on disc, something that became perfectly clear when Starz (NAS: LSTZA) revealed two weeks ago that it would not be renewing its Netflix deal.

If you're still not worried about streaming's viability as a business model, let's take a look at churn. No matter how many people you think have signed up as new subscribers for Netflix's $7.99 a month streaming plan over the past three months, 200,000 more than that are cancelling. That is, in a nutshell, what Netflix is telling you this morning.

Again, you shouldn't be surprised. It's all too easy to cancel a streaming service. There are no discs in the house to return, or discs on the way. Online queues are easier to empty out when you're not at the mercy of the USPS. This plan is at the same $7.99 price point that it has been since its inception last year.

It's time to worry.

Herniated disc pain
What does it tell you when folks on disc-based plans -- the only plans to actually drop in price with this move -- are clearing out?

This is the one that really took me by surprise this morning. I figured that folks on dual plans -- if they had to choose one over the other -- would downgrade to disc-only plans. The competition is fierce here. Coinstar's (NAS: CSTR) Redbox and NCR's (NYS: NCR) Blockbuster Express kiosks continue to grow in number, but it's hard to beat Netflix's huge catalog, proven fulfillment process, and compelling value proposition.

Well, there are apparently fewer red mailers going out these days. Did Netflix do too good of a job of selling digital delivery? Was this just the most price conscious group in the lot, making it the first to fall in a summer of cascading consumer confidence? Either way, this guidance raises more troublesome questions about the Netflix model itself than anything related to the pricing elasticity behind this summer's ill-fated shift.

You have a problem, Netflix -- and it's not the problem that everyone one else thinks it is.

If you want to follow the plot twists in this saga as they occur, add Netflix to My Watchlist.

At the time thisarticle was published Motley Fool newsletter services have recommended buying shares of Netflix and, as well as buying puts in Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.Longtime Fool contributor Rick Munarriz has been a Netflix shareholder and subscriber since 2002. He does not own shares in any of the other stocks in this story. Rick is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.

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