ReadWriteWeb DeathWatch: Netflix

Unlimited streaming made Netflix the Blockbuster-buster, but the company’s value has dropped 75% in the past year after its price hike/Qwikster fiasco. Can original content and overseas expansion reverse the slide?

The Basics

Netflix began as a mail-order alternative to renting videos from Blockbuster: perfect for folks looking for a larger catalog and a lack of late fees. Over time, it one-upped the giant video chain, adding instant, on-demand viewing and helping drive Blockbuster into bankruptcy.

in 2010, Netflix’s streaming content surpassed the DVDs it delivered, and streaming is now its flagship service. Nearly every home entertainment device offers a Netflix application, and the company’s streaming products account for 20% of peak downstream traffic in the United States.

But Netflix has had a shaky year. Twelve months of user churn since its widely criticized price-hike fiasco have rattled investors, and mixed earnings results were not enough to right the ship. Netflix returned to profitability and added 1.1 million streaming video subscribers, but the growth was slower than investors had hoped for, and a loss of 850,000 DVD subscribers negated many of those gains. Overall, concerns about domestic growth won the day, lopping off a quarter of the stock's value on Wednesday. The stock closed Friday at $58.92, less than a quarter of its 2011 high of more than $295 per share.

The Problem

Netflix has three core problems with its business model, and only one of them has an easy solution.

1. Content: Netflix competes with its partners, and that’s a tough spot in a business so dependent on playing well with others. Cable ISPs dedicate a fifth of their Internet bandwidth to Netflix, see nothing in return, and lose a ton of revenue that might have gone toward on-demand purchases. If they rebel and begin data throttling for video services, Netflix’s performance could suffer dramatically.

Just as important, large movie studios and content providers prefer the cable companies' pay-as-you-go model, which allows greater pricing flexibility and a higher potential payout for popular content. Several high-profile studios have already defected (most notably Starz-Disney, followed by Epix, which was supposed to replace it).

Meanwhile, Netflix' forays into original content are making content deals even tougher. Recently, HBO doused expectations of its programing showing up on the service with an emphatic “We are not in discussions and have no plans to work with Netflix.” HBO won’t be the last content provider to say, “no thanks.”

2. Costs: Running an all-you-can-eat video streaming service is a lot like owning a gym: You need to engage customers enough to justify a renewal, but if they over-use your service, you can lose your shirt building the infrastructure to accommodate them. Netflix works with Content Distribution Networks (CDNs) like Akamai to mitigate these costs, and it has recently moved toward creating its own infrastructure. But until bandwidth is free, basic math will always matter.

3. Craziness: With its enigmatic, charismatic and nutty CEO (more on him below) behind the wheel, Netflix has matched years of smart business moves with nearly as many bouts of downright wackiness. Minor head-scratchers include the decision to remove user preference profiles from streaming accounts, while leaving them there for DVD subscribers. More disastrous decisions include the 2011 price hike that led to nearly a million user defections, and the so-stupid-SNL-made-fun-of-it Qwikster debacle that angered users and led to an executive shuffle.

The Players

Reed Hastings, Founder and CEO:  Reed Hastings has vision and understood the importance of streaming early on, but execution has sometimes been a problem. And he doesn't seem to understand his users at all. In an open letter to the community, Hastings apologized for his poor choices, and he's surrounded himself with cooler heads. Letting his managers participate more actively will be key to his future success.

Kelly Bennett, CMO:  

Kelly Bennett is a recent acquisition from Warner Brothers, and an integral part of righting the ship. A solid foil to the mercurial Hastings, his first goal is restoring a sense of normalcy after the Qwikster flop. His work in international marketing will help guide the company's global expansion, and his studio connections might help calm some nerves. 

The Prognosis

While some renegade analysts see immediate opportunity in Netflix stock, the prevailing view is that things will get worse before they get better. Original content is a necessary long-term play, but even a couple hit shows won’t match the broad appeal of the content Netflix has already lost. Studios demanding a bigger cut of the pie will further strain margins and profits. If its market cap (currently just above $3 billion) drops much lower, the service may become an acquisition target or potential partner for a content company.

Can This Company Be Saved?

Netflix is doing all the right things on the infrastructure side, but its success is tied to content. To return to king-of-the-industry status, Netflix must maintain a core of content subscribers actually want to watch. While some of this depends on having the cash to pay for it, Netflix can sweeten the deal by providing access to new markets. The company’s expansion into Latin America – particularly markets in which television distribution is effectively locked down – could open new distribution channels for studios and ease domestic deals. In many ways, its all up to Kelly Bennett.

The Deathwatch So Far

Research In Motion: Things are hurtling downhill even faster than expected. Massive losses - more than 11 times worse than expected - and new delays in its Hail Mary BlackBerry 10 operating system update have made the company’s dire situation even harder to ignore. And over the weekend, a federal jury found RIM liable for $147 million in patent damages to Mformation Technologies.

HP: No change in status

Nokia: The mobile phone giant’s quarterly revenue and earnings exceeded expectations and it has reduced its cash burn rate, but the company lost money yet again and saw its debt ratings cut to junk status. And it still hasn’t cracked the U.S. smartphone market as it halves the retail price of its flagship Lumia 900 to $49.99.

38 Studios: No change in status

Barnes & Noble: No change in status

Sony: No change in status

Groupon: Groupon's stock price recently hit an all-time low on a downgrade from Evercore Partners, and a perceived weakness in social companies, led by Zynga.

T-Mobile USA: No change in status