Netflix Needs to Rethink Strategy

February 25, 2007 was a red-letter day for Netflix (NASDAQ: NFLX). It marked its one billionth DVD delivery since the service was launched in September 23, 1999. The happy NFLX top brass decided that the lucky recipient from Helotes, Texas would be a free lifetime member. The occasion also had NFLX changing its TV advertising tagline for the first time to “Over one billion movies delivered so far. Zero late fees.”

Things then looked hunky dory for NFLX, and in fact 4 months earlier, on October 23, 2006 it had announced FY-07 guidance that was above analysts’ estimates. That was when the stock moved in a higher orbit until hitting a 52-week high of $30 on December 1, 2006.

NFLX finished the Q1-07 with return on equity at a healthy 23.42% on the back of total quarterly revenue of $303.69 million and a net income of $25.58 million.

The stock however is continually slipping since December 2006. The market is not amused that NFLX has seen new subscribers reducing by 55,000 against an increase of 481,000 in the previous quarter (Q1-07) and of 303,000 in the same quarter last year (Q2-06).

The phenomenal decrease is attributed mostly to its competitor Blockbuster’s (NYSE: BBI) innovative Total Access program.

Belated actions like the reduction of the price of its popular 3-out unlimited plan by a dollar to $16.99 a month just prior to Q2 results haven’t gone down well with the market. Analysts reckon this would shave off roughly $70 million from its pre-tax profits for the year, a sum larger than its operating income it has had so far.

And now a week back NFLX has announced a further cut in the price of the popular program to $15.99 a month. Expectedly, the stock has slid.

The skirmish with BBI is taking toll on NFLX’s pricing, it doesn’t speak well of the company’s strength. Markets always take a dim view of price wars. NFLX is bloodied and so is its main competitor. Unfortunately, much as I am a devoted customer of Netflix, I think, as a business, this sector truly sucks. I would not invest in it.

Although the company maintains that $15.99 a month for its popular program is simply a price test, investors are not convinced. The grapevine has it that NFLX is set to be served for Amazon’s (NASDAQ: AMZN) dinner sooner than imagined.

Even Microsoft is speculated to be an unexpected suitor. After all, didn’t the giant take on board Reed Hastings, NFLX’s CEO just 5 months back? However, acquiring Netflix would be a bad idea for Microsoft.

NLFX, the world’s largest online DVD rental service provider, presently has a market cap of a shade higher than $1.16 billion, a relatively small asking price for a strategic acquirer. However, they need to rethink the strategy completely, and reduce the pure logistics positioning.

Netflix has a great brand, huge traffic, yet its position as an online advertising venue has not been exploited much. What about movie launches on Netflix?

Also, Netflix should look into buying a Flixter type of social networking service to enhance its community function, as well as generate reviews and discussion in form of user generated content. It is a perfectly positioned Web 3.0 play that does a poor job of everything except Commerce.

Finally, it is not clear to me why Netflix should not become a “studio” and produce proprietary content. It has the audience and the distribution relationships. It could very easily diversify out of this low-margin logistics business model, and become a real player in the Online Film segment.