Thursday, August 27, 2009

Is Netflix' head in the clouds?

Netflix has completely changed the viewing habits of movie renters. The days of renting movies individually, for a fixed period and with limited selection are over. It shows in the relative growth and market values of Netflix and Blockbuster. The Netflix subscription model allows for a concurrent number of DVDs to be rented and you can turn them over as fast or as slow as you like. If you are on a 3 DVD plan as I am, you can have perhaps 30 movies a month for the princely sum of just $17.99. And those movies are any from its 'long tail' library. Compare that to a per movie rental price or even a premium cable channel like HBO.

More recently, Netflix added "Watch Instantly" a smaller selection of movies that can be watched as video streams in a Microsoft Silverlight compatible browser. This viewing is unlimited and included in the DVD subscription price. With high quality content, both movies and older t.v. programming, Netflix has started to obsolete the traditional cable companies' offerings, especially "pay per view".

As a result I long ago canceled my expensive cable subscription and used the web to get my information and Netflix to deliver my movies.


Well, perhaps not for Netflix.

Consider for a moment what the effect of streaming movies means. Firstly Netflix looks like it is doing the technologically smart thing. Netflix wants to migrate more of its infrastructure to "the cloud" which makes perfect sense, especially for a rapidly growing company. Weightless bits on scalable, virtual servers, streamed across the internet to your screen without a human to direct the flow. Netflix presumably pays the content owner a license fee and has a server deliver the movie for minimal bandwidth costs. Sounds good until you realize that the "all you can eat" subscription model means that there can be a lot more consumption. Unemployed at home? Just queue up those movies and watch all day. Each view is costing Netflix something. Then consider your plan. Do you need to pay for the 3 DVD plan, or the 1 DVD plan with the same unlimited streaming? It is a recession right? Cut that plan cost to a minimum.

The logic seems to me that the member base will likely start to reduce their plan costs while retaining the unlimited streaming. It is likely that DVD watchers like me already are unprofitable for Netflix based on mail and handling costs. Unless streaming content is much more profitable, Netflix may find itself with rising license fee and bandwidth costs and declining revenue. Trying to raise subscription fees will be hard.

Now consider the internet carriers. So far Netflix has surfed the net neutral web with ease. But streaming content uses up bandwidth; a lot of bandwidth. We've already seen cable carriers start to restrict bandwidth rates and consumption. So far this has been justified by all those "illegal file sharers using BitTorrent". Netflix is clearly legitimate, but increased use of streaming could start to saturate the available bandwidth, especially with cable carriers. Then what? Either the carriers will start to demand extra money from Netflix to handle the traffic, or they will ask that from their customers. In the former, Netflix' profits are squeezed. In the latter, customers will start to get annoyed and may start to cancel their Netflix subscriptions if they cannot get the service they expect.

And what of the content providers? The more Netflix' business grows, the more vulnerable it is to demands from the content providers for higher fees. Without content, Netflix has no business, so it is supremely vulnerable to the demands of content owners. That can only mean cost will rise and those providers demand higher viewing fees.

My sense is that Netflix' business model will not scale. Fixed subscription revenue with variable consumption costs will tend to drive increased consumption, squeezing profitability, possibly into the red. It seems only a matter of time before something gives. Initially I would expect to see Netflix suffer declining subscriptions per member as members switch plans to reduce DVDs and opt for more streaming. Depending on the relative profitability of the DVD and streaming business, this may affect profitability positively or negatively. Finally the carriers and content providers will demand bigger pieces of the revenue pie and Netflix will be forced into accepting reduced margins or trying to raise rates and losing customers.

I hope I'm wrong. I really like my Netflix service. I hope the love affair won't be fleeting.