Dark days ahead for Netflix?

July 12, 2012: 11:45 AM ET

Rising content costs, a touchy business model, and fierce competition. It looks like Netflix is for a bumpy ride.

By Don Reisinger, contributor

FORTUNE -- Netflix has had better days.

Everybody knows the story of the innovative technology company's rise. Founded in 1997 offering movies-by-mail, it sent tremors through the traditional DVD rental business. Then the company began streaming media over the Internet and quickly took that market by storm. In 2010, Netflix's (NFLX) streaming accounted for 20% of peak time U.S. Internet traffic. Last summer, that figure jumped to 25%. By the fall, Netflix was gobbling up nearly 33% of peak hours traffic.

By then, however, Netflix's issues were slowly coming to light.

The trouble started last summer when the company announced that it would break out its streaming and DVD rental plans. The move seemed innocuous enough until Netflix said that prices would rise by 60%. Customers balked. Soon after, Netflix announced that it would spin off its DVD business into a new operation called Qwikster. Once again, the torches and pitchforks came out. Perhaps worse, the plan was announced before Netflix realized that spinning off its DVD-by mail business would be extremely costly. Ultimately the scheme was abandoned.

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Since then, Netflix has surfaced from time to time to announce international expansion and report financials, but it has lately tried to stay out of its own way. But even monastic silence cannot hide the company's financial performance has plummeted over the last few quarters, culminating in a $4.6 million loss in its last-reported period ended March 31. During the same quarter in 2011, Netflix generated a profit of $60.2 million.

Don't think investors haven't noticed. In the last 12 months, Netflix's stock has dropped 72% to land at $82.99 per share. The issues investors see with Netflix span several areas, including ill-advised management decisions and last year's poorly devised pricing changes. But they're also concerned with Netflix's rising content costs -- and associated availability issues. (Netflix did not respond to request for comment for this story.)

Earlier this year, Starz left Netflix after the companies couldn't come to terms over content costs. With it, Starz took over 1,000 movies and television shows that Netflix users had enjoyed. The loss was the latest in a long line of blows to Netflix's content library. A quick glimpse at the streaming service's offering reveals many older films and TV shows as well as some original Netflix programming, like the show Lilyhammer, which has yet to prove out.

Making matters worse, Netflix's content partners know how much power they have over the company. They want a significant slice of revenue. And if they don't get it, they're taking their content with them. In the past, record labels tried a similar tactic with Apple (AAPL). But Steve Jobs had leverage, and knew those labels needed iTunes as much as iTunes needed them. Netflix has no such leverage. With Amazon (AMZN) Prime Instant Video, Walmart's (WMT) Vudu, and even HBO Go gaining popularity in the streaming space, Netflix isn't nearly as important as it once was.

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As Wedbush analyst Michael Pachter told Reuters recently, Netflix risks being little more than an "all-you-can-eat buffet." And the same users consuming more content at the same price means the company's costs rise without revenue increasing -- a recipe for continued troubles. As customers discover that the "buffet," which once boasted high-end service, may be delivering increasingly thinned-out offerings, they might not be so happy to stick around over the long-term.

Of course, there are positive signs too. Netflix's shares are up nearly 20% so far this year. That jump had a lot to do with an early July surge resulting from Netflix's impressive usage stats. Investors responded by pushing its shares up about $15. On the year, Netflix shares are up $13.70, meaning the company was down this year before the news turned things around. Still, if the company wants build on that, it like faces a tough climb.

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