The mistake Netflix is making nowMarch 14, 2012: 5:00 AM ET
Yes, the streaming company pulled itself out of a tailspin of bungled decisions. But now it is on the brink of making an even bigger misstep.
By Kevin Kelleher, contributor
FORTUNE – For most of its history, Netflix had the rare knack of taking bold steps that proved shrewd in retrospect. Then, last year, it famously bungled a series of announcements before eventually righting itself. The company may be taking another misstep: moving away from its disruptive business model for one that, increasingly, resembles a traditional cable company.
Netflix (NFLX) CEO Reed Hastings has said he doesn't want to take on cable giants like Comcast (CMCSA). The reality is that, for many years, Netflix has offered its customers a welcome refuge from cable television. Sure, the number of homes with pay-TV is hovering around 100 million – about 87% of the total. But analysts expect 12 million homes to cut the cord within three years.
And why not? Services like Netflix and Hulu offer thousands of titles for less than $10 a month, and channels such as CNN, Bloomberg, TNT, ABC and NBC stream free programming onto devices like the iPad, often without commercials. Cable and satellite packages cost $65 a month or more for countless channels you don't enjoy, plus the few that you do. In the backward logic of pay-TV, consumers pay hundreds of dollars a year to end up watching hours of commercials.
When Netflix started streaming video five years ago, the company promised a different future for watching TV, one that would offer consumers the movies and TV shows they wanted at a fair price. But Netflix has faced challenges as it tries to add titles to its streaming library. And in response, the company is starting to act more like a the traditional kind of cable-TV model it set out to disrupt.
Most notably, Netflix is taking a page from HBO's playbook by branching into original programming. Last month, the company began streaming all episodes of Lilyhammer, a series starring Steven Van Zandt that was produced for Norwegian television. The company is working on other original shows, such as a David Fincher-Kevin Spacey production of House of Cards.
Like HBO, Netflix is using its original programs to market its subscription service to new customers. If the company can create enough must-watch programs, it can draw in new subscribers. Reviving a cult series like Arrested Development could draw in a small but loyal audience (there are rumors Netflix will also bring back another cult series, Firefly).
There is some practical logic behind this move. More subscribers will increase Netflix's profit margins. The company says it has 23 million streaming subscribers. That doesn't include the customers who have canceled Netflix accounts – Raymond James estimates 31 million in three years, although it's not clear how many of those were DVD subscribers. Many customers who have left Netflix could come back for original content and a larger library.
In the name of boosting its subscriber base, Netflix is reportedly talking with cable companies to include its streaming service into their cable offerings. Such partnerships could work: Bundling Netflix into cable might make some subscribers less likely to cut the cable cord, while Netflix would quickly add new subscribers and lower its margins. Barclays Capital (BCS) estimates that these deals could raise Netflix's Ebitda margins to 35% -- on par with HBO's -- from its 14% margin last year.
But there are signs that some big cable providers won't bite. Comcast, which recently launched a Streampix subscription service for its Xfinity TV customers, flatly stated it wasn't interested. Verizon (VZ), which is planning its own joint venture with Netflix rival Redbox (), may not be interested either, unless it's as a prelude to a takeover of Netflix, which some analysts have been predicting.
For Netflix, moving closer to the cable companies' traditional business model comes with its own risks. In the same way that Netflix's early brand was as a low-cost, convenient alternative to video-store giants like Blockbuster, its brand in recent years has been as a low-cost, convenient alternative to pay-TV. Moving toward a cable-TV business model could diminish that brand: why become the next HBO when many people are questioning HBO's model?
It may be because Netflix doesn't have much choice. Many of the company's recent moves are aimed at adding subscribers, which although necessary is just part of the equation. The other part is negotiating content licenses. Netflix has less leverage here, thanks to growing competition not just from Streampix but well-funded services such as Google Play (GOOG), Amazon (AMZN), Apple (AAPL) iTunes and Hulu.
So Netflix may need to play the cable companies' game to add subscribers, bring down margins and remain the leader online video. But moving too close to the cable industries' business – which has been ripe for an upstart to disrupt it for some time – risks diluting the Netflix brand. Given the company's PR foibles over the past year, Netflix may not be able to afford taking that risk.