Megan McArdle on Netflix's Self-Cannibalization

Megan McArdleis a senior editor for The Atlantic, where she writes about business and economics. Megan was interviewed by The Motley Fool's Tim Hanson at our 2011 Investing Conference, held in Arlington, Va. at the end of September. What follows is a lightly edited transcript of their discussion.

Tim Hanson: We are going to open up to questions in a minute. As people think about what they want to ask, I will finish my portion with this: The conference kicked off today with a pretty healthy debate about Netflix (NAS: NFLX) . It is a stock a lot of folks in the audience own. It is a service that many of the people in the audience subscribe to. You had a lengthy post about the company, so buy, sell, or hold Netflix?

Megan McArdle: As a person, I am rooting so hard for Netflix. I would buy the jersey and take the flag and stand by the side of the stadium.

Tim Hanson: Because you like the service?

Megan McArdle: I like the service. I hate my cable company. I would totally love for them to walk in. Here is how I view Netflix right now. You have got a company that has a good DVD business, but they know that, whatever, five, 10 years, someone is going to destroy that business, do to them what they did to Blockbuster, right? Someone is going to stream eventually. It might be the studios, it might be some third party they contract with, but someone is going to do it, and at that point Netflix is going to be like the world's greatest buggy manufacturer.

And so they did what almost no companies ever do -- they tried to cannibalize themselves first. And this is a really tough move, and I admire them so much for doing it, I am not sure they pulled it off and here's why. So this is a really lengthy answer, but I am going to explain why.

Tim Hanson: It gives us a lot of time to think.

Megan McArdle: So like I am not sure they pulled it off simply because the rights holders ... the way DVDs work, first-sell doctrine. You buy a copy of a DVD; you can do whatever the hell you want with it as long as you don't perform it, right? You can burn it, you can lend it to someone, you can rent it to someone. With streaming it is totally different, right? You have to secure the rights from the rights holders, and they can control how you do it. Basically the content providers; no one is going to go on Netflix. I saw people in my comments, and I go on the Dave Ramsey site, who is this evangelical personal finance guru who advocates like being really cheap and getting out of debt. People are like, "I am just canceling cable and using Netflix. It is totally stupid that the cable companies charge this much money. Netflix is going to kill them." But do you really think like the cable companies are going to carry all this stuff on their pipes and the content providers are going to give Netflix these films so that they can destroy the revenue stream, which is very lucrative for both groups? I didn't appreciate, I think, how close that they were riding to the edge. I thought that they might have the kind of mass that iTunes does, but they don't.

The fact is, the rights providers want a lot more money than Netflix is willing to give them because it is not a good value proposition at $30. And I don't know how they are going to bridge that gap. Maybe this production deal is going to do it and they are going to become more like a cable channel, but then they are going to have to start charging more like a cable channel. It is going to be a different business model. It's not what we thought was going to happen with them as a cable killer is I think at this point, unless something radically changes, clearly not going to happen, at least not in the near term.

And so the problem for them is because they know that DVDs are going away; it's a great business. They totally dominate in it. No one can attack them in this business, and this is the weird thing. It's a cash cow. Because who the hell else is going to go build all these warehouses near post offices, and build software? The problem is that every dollar you invest in one of those warehouses or in that software is essentially a sunk cost.

Eventually you are just going to lose all of that money; you'll never get it back. The warehouses will sell for pennies on the dollar. The software will be useless, etc. And so I understand why they are trying to separate these businesses, but I think they are floundering because they are genuinely caught in this horrible strategic bind. And the fact is, lots of innovators get crushed by [inaudible]. It happens all the time. GE didn't invent the CAT scan, but they are the people who made money on it. The company that invented it isn't even making; I'm not even sure they are in business anymore, but they are definitely not making CAT scanners.

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