Is Netflix Screwing Itself Over By Focusing On Streaming?

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Since it was founded in 1997, Netflix has quickly risen to become one of the dominant providers of home video entertainment. After rendering Blockbuster's business model woefully outdated, Netflix has made a big bet on streaming, partnering with hardware manufacturers to offer its digital distribution services over many platforms. You can now buy dozens of phones, Blu-Ray players, and video game consoles that stream Netflix movies, and that number grows every day.

Recently, Netflix made substantial changes to its pricing plans, introducing a streaming-only plan for $7.99, while jacking up the pricing of its DVD/Blu-Ray plans. The net effect of this will likely be to drive more people towards the streaming-only plan, while causing some attrition for its higher end plans. This makes sense in the short-run; after all, Netflix's disc subscribers require Netflix to spend over half a billion dollars on postage per year and maintain costly distribution centers. But by focusing on streaming for the future, is Netflix screwing itself over?

Edward Epstein (author of The Hollywood Economist) has a post at The Wrap laying out the potential pitfalls with this plan. The crux of the issue is that digital streaming is an entirely different market than DVD rentals, primarily due to legal reasons. With DVDs, the "first sale doctrine" allows Netflix to purchase a DVD and rent it out to anyone without getting the permission of the copyright holder. Obviously, licensing digital content is a whole different animal:

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.

Netflix recently made a deal with Epix to get rights to films by Paramount, Lionsgate and MGM. That deal is said to cost about $900 million over the course of five years, not cheap by any measure and maybe not as good a value as buying DVDs (although of course, the eventual saved costs on distribution and postage may make this profitable). Moreover, Netflix recently offered to pay between $70,000 to $100,000 per episode to stream current episodes of hit primtime shows.

Many of Netflix current content deals — deals that have made Netflix Watch Instantly such an appealing option for many subscribers — were cut during a time when people had no idea what the hell digital streaming was or how to value it. This is why we can get Starz movies and episodes of The Office on Netflix; Netflix cut a backdoor deal with Starz for the streaming rights to its content, and its content deals for TV shows happened before properties such as Hulu or were as big as they are today. When these deals come up for renewal in 2012, you can bet that the price for this content is going to be much more onerous for Netflix.

In addition, Netflix faces increasing competition from a variety of sources. HBO is launching its own portal, HBO GO, which will allow HBO subscribers to stream HBO movies and original series. Meanwhile, Amazon is launching a Netflix competitor, and the new video games service OnLive may soon offer movies to subscribers. Time Warner CEO Jeff Bewkes (who, to be fair, has a horse in this race; Warner Bros. is an investor in OnLive) recently declared that Netflix hasn't shown it can compete seriously in the content distribution space.

Netflix CEO Reed Hastings strikes me as a monstrously intelligent guy; I'm sure Netflix has run financial models and done a great deal to predict what will happen if Netflix's future is streaming-only. But with the world of content delivery in such upheaval these days, and movie studios loathe to cede power to Netflix the way the music industry ceded power to Apple, Netflix may face a more difficult road ahead than its current profits and growth would indicate.