Netflix Needs to Lose the Safety Net

I turned off a few Netflix (NAS: NFLX) fans last week, suggesting that it's time for the video-service giant to unload its DVDs-by-mail service.

A lot of people are perfectly happy with Netflix's disc-based offering, and they don't see any reason for the company to cash out of a cash cow.

I have nothing against Netflix. I subscribe to both its DVD and streaming platforms, and I've been a shareholder since shortly after its IPO nearly a decade ago. However, I left out a very important reason for Netflix to cut the cord sooner rather than later: Netflix by mail is a service that will deteriorate over time.

The law of shrinking numbers
"DVD shipments for Netflix have likely peaked," the company said last summer. It was just a few weeks into the third quarter, and CEO Reed Hastings was targeting a total of 15 million DVD-based customers for the end of September.

We now know that it didn't work out that way. Let's go over the count of subscribers on disc-based plans over the past three quarters.

• Q3 2011: 13.93 million

• Q4 2011: 11.17 million

• Q1 2012: 10.09 million

Netflix has lost roughly a third of its disc-based subscribers in just three quarters, and the company is already on the record as expecting that number to keep shrinking "forever."

It gets worse.

In last July's guidance, Netflix was expecting 12 million of the 15 million disc-based customers to pay for both streaming and DVDs. These 12 million customers would be the heart of Netflix's hybrid service. They would be the people willing to pay the most for Netflix in its two flavors. Well, Netflix had just 7 million customers paying for both discs and streams at the end of March, a 42% decline in that time.

Listen to Whitney Houston

Netflix should sell its disc-based business to Redbox parent Coinstar (NAS: CSTR) or DISH Network's (NAS: DISH) Blockbuster before it's too late. Surely there must be a few daring private-equity firms that fancy themselves turnaround experts. After all, Netflix has publicly conceded that its DVD mail-order business is on a slow crawl to zero. Even if the business is a major profit contributor to Netflix, it will be worth less to a buyer with every passing quarter.

However, the real reason to move on is because Netflix's once sterling reputation is going to take a hit that will last longer than the Qwikster and price-increase flaps from last summer.

What do you think will happen to the quality of the disc-based service that so many people are enjoying as its membership base continues to shrink?

I've seen the future, and it has the angelic voice of Whitney Houston.

It's been more than two months since the award-winning singer died in California. An instinctive reaction at the time for fans was to revisit her most popular movie, Time Warner's (NYS: TWX) The Bodyguard. Even though Amazon.com (NAS: AMZN) had it available as a stream -- available at no additional cost to Amazon Prime shoppers -- Netflix had decided not to renew its licensing deal with Time Warner for the movie two months earlier. Netflix customers had to settle for a DVD rental, but too many of their fellow subscribers had the same idea.

"Very long wait" is the availability that greeted members when they put the Houston and Kevin Costner movie in their queues. I've kept it in my queue for sport since then, and it's still listed as "very long wait" even though it's now been 11 weeks since Houston's passing.

Battle Royale is another movie that been on "very long wait" for more than a month. The Japanese cult fave has a fairly similar premise to The Hunger Games, so it's been in heavy demand since The Hunger Games hit theaters last month.

In the old days, Netflix would probably have ordered a ton of additional copies. That was easy to do when disc-based subscription counts were climbing. Taking on extra inventory was no big deal when the company knew that it was only going to have a larger pool of potential renters down the line.

It's obviously very different now. There's no reason for Netflix to respond to these bursts in demand. If it hasn't happened already, it may not be long before Netflix cuts back on the purchases of new releases -- or concedes to push out availability windows even further.

Forget about the possibility of the end of postal delivery on Saturdays, which will slow down the round-trip mailing process. The quality of Netflix's DVD service will shrink along with its audience. Why wait until folks leave because they're dissatisfied? Packaging the disc-based service with the DVD.com domain that it recently acquired and letting someone else try to make it grow again is the better play.

Streaming isn't enough now
Even those on streaming plans will argue that Netflix needs to keep its disc-based service close. The digital catalog is heavy on "rerun TV" episodes and dated celluloid.

Well, what if unloading the DVDs is exactly what the company needs to make its offering better? Maybe Netflix needs to operate without knowing that the safety net of DVDs is there to catch video junkies longing for fresher releases.

There are now more than 26 million streaming Netflix customers worldwide. If Netflix wasn't offering DVDs, wouldn't stingy studios think twice about not licensing their content when it would be the only way to reach those members? Both Netflix and Hollywood need the divestiture of the disc-based service to grow up.

Ancient Greek commanders and Spanish conquistador Hernando Cortes supposedly would burn their own ships when sailing into battle. Retreat was not an option. That's where Netflix is now. It has gone too far with streaming to bother with the original vessel that got it there.

Cortes asked his men to burn their ships. Now it's time for Netflix to burn its shipping.

Stream on
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At the time thisarticle was published The Motley Fool owns shares of Amazon.com.Motley Fool newsletter serviceshave recommended buying shares of Netflix, Coinstar, and Amazon.com. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.Longtime Fool contributorRick Munarrizhas been a Netflix subscriber and shareholder since 2002. He owns noshares in any of the other stocks in this story and is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.

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