Netflix has a bit of an identity crisis.
The company recently announced that it was launching its streaming service to Scandinavia, another move in its strategy of expanding its global footprint. However, in the U.S., many consumers still see Netflix (NFLX) as a rental company. At the end of the second quarter, it had 9.2 million disc rental subscribers. And although that figure is down from 14 million subscribers in the third quarter of 2011, Netflix generates significant gains from that division.
Just how much so if impressive. During the second quarter, Netflix disc rentals contributed just $291 million to its revenue, but offered up a staggering 46% margin, or $134 million in profit. Meanwhile, Netflix’s total streaming revenue — both domestic and abroad–– hit $598 million. However, the streaming contributed a net loss of $6 million, due to a whopping $89 million loss in the international streaming segment.
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And yet, Netflix often seems to act as though its rental division doesn’t exist. In a letter to shareholders in July, Netflix spent its entire opening summary touting its streaming business and celebrating its standing as a Web leader. “We have enormous challenges ahead, and no doubt will have further ups and downs as we pioneer Internet television,” Netflix wrote in its note to shareholders, forgetting about its DVD business. “We are making progress in every market we serve, and see a once-in-a-generation opportunity ahead to build the world’s most popular TV show and movie service.”
That Netflix is treating the DVD business with seeming disdain isn’t all that surprising. Last year, when the company was in the midst of widespread user outcry over its decision to raise the price on those with DVD-and-streaming subscriptions by 60%, Netflix announced that it would spinoff its disc-rental operation. The new company, called Qwikster, would help Netflix unlock its potential, the company said at the time.
Soon after, the move was determined to be too costly, and Netflix was forced to ditch its plans and stick with its DVD rental operation. The very fact, though, that Netflix would feel forced to hold on to an operation that’s generating significant profit for its business is puzzling. After all, as a public company, it has a responsibility to shareholders to maximize value. It appears that at least right now, they’re getting the most value from DVDs even if streaming is the future.
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Netflix continues to expand its streaming service globally, offering it in Canada, the U.K., Ireland, and Latin America. Those moves have made at least some analysts question whether rapid expansion is really best for Netflix’s future. “We expect Netflix’s ‘growth at all costs’ business model to negatively impact its shares,” Wedbush analyst Michael Pachter wrote in a research note to investors in January.
Pachter went on to say that Netflix’s rapid expansion significantly harms its financial standing. It’s a sentiment that Sterne Agee analyst Arvind Bhatia shared with his clients in a research note last month. “The challenge for Netflix currently is to manage already rising content costs at a time when the international business is expected to sustain losses for some time,” Bhatia wrote. “Ultimately, we believe the solution for Netflix is to raise prices slightly.”
But is that really a viable solution? The last time Netflix raised its prices, the company was met with a deafening outcry. And that only affected those who had both its streaming and DVD plans. If Netflix follows up with a hike on its 24 million domestic streaming users and nearly 4 million international users, who knows what could result?
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Earlier this month, research firm NPD reported that physical discs accounted for 62% of all rentals in the first half of the year. Subscription streaming only took 25% market share. And although total physical DVD and high-definition Blu-ray rentals were down 17% over the last year, according to NPD, streaming has little chance of taking over in the next couple of years.
Given that — and the fact that Netflix is profiting so heavily off of its rental customers — it would seem that it would want to capitalize. Instead, the company lost 850,000 DVD subscribers in the last quarter, and didn’t seem to miss them. Why did Netflix lose those customers? It’s not that customers aren’t renting DVDs – it’s may be that Netflix hasn’t done enough to keep them. “In our view, the ability to stock Warner Bros. DVDs on their respective street dates (and roughly two months ahead of Netflix) has made Redbox rentals even more appealing to rental consumers, and negatively impacted the perception of the quality of Netflix’s own offering,” Pachter wrote to investors last month. “We believe that this has contributed to Netflix’s loss of DVD rental customers, down over 800,000 in the second quarter.”
Regardless, Netflix has made its strategy known: it’s a streaming company that happens to offer disc rentals. And it’s not changing that strategy for any reason. “Our core thesis is that we can build a large defensible global business as an Internet network for TV shows and movies,” the company wrote in a note to shareholders last month. “We can’t wait to serve a global audience with an amazing Internet video experience.”
