Netflix's options are dwindling

October 25, 2012: 6:00 AM ET

Margins for streamed video are much thinner than those for DVD rentals. And with few barriers to entry, competition will only get tougher for Netflix.

Reed Hastings

Netflix CEO Reed Hastings.

FORTUNE -- Netflix chief Reed Hastings was right about one thing when he made his clumsy, quickly retracted announcement last year that he was going to split off the company's DVD business: the future of video rental lies in streaming. Unfortunately, that's horrible news for Netflix.

DVD rentals make up 90% of the company's profits, but DVD subscribers are bolting fast. Margins are much better for DVDs than they are for streaming. Subscriptions to Netflix's (NFLX) streaming service are growing, but not nearly fast enough to make up the difference. The company announced on Tuesday that it added 1.16 million new U.S. subscriptions in its third quarter, well below expectations (J.P. Morgan guessed it would be 1.56 million), and even further below Netflix's own goals for the year. Shares were down by more than 8% in late trading on Wednesday, despite the fact that revenues, at 905 million, were in line with expectations and that net profits, at $8 million, were better than predicted.

DVD subscriptions fell by 630,000, and Netflix said it might lose another 760,000 in the fourth quarter. It has lost 2.56 million DVD subscribers this year. Netflix now has 25.1 million low-margin streaming subscribers and 8.6 million high-margin DVD subscribers, and those numbers, as well as the profits they represent, will continue to diverge.

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For streaming video, the barriers to entry are relatively low, so the competition, already fierce, will only get fiercer. Ideally, Netflix could raise prices, at least a little, to help it with content-acquisition costs and the costs of its international expansion, which is essentially zeroing out its stateside profits. But competition from Amazon, Hulu, Apple (AAPL), cable outfits, and Verizon/Coinstar's forthcoming streaming service -- plus who knows who else -- means its hands are tied. Meanwhile, content licenses will only get more expensive.

And that's when the company is able to land or renew licenses at all. New offerings are relatively scant, as Netflix has lost some providers, such as Starz, and has made weak or restrictive deals with others, such as Warner Bros. Complaints about a lack of selection are mounting up.

Kathe Wulff, who lives near Minneapolis, recently canceled her Netflix subscription. She sums up her reasons this way: "Redbox [a DVD vending service owned by Coinstar] has the movies faster for a buck down the street and Netflix doesn't get them for another month. I can only stream on one device at a time unless I upgrade my membership," she said. "Hulu is a much better deal with streaming and it has just-run shows from the previous day."

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Netflix laid out what it considers its main competition: the "major, low-cost, globally-ambitious Internet subscription services: Hulu, Amazon (AMZN), and HBO Go." Notably missing from this list is Verizon (VZ) and Coinstar's(CSTR) streaming service, which is expected to launch toward the end of the year. Those companies announced their joint venture in February. Since then, Netflix's stock has fallen by about half.

But perhaps the most troublesome fact for Netflix is that as the streaming market spreads out among so many competitors, it will be at a distinct disadvantage as a standalone streaming service. Its biggest competitors are subsidized by other revenue streams to finance growth and acquisition costs. Netflix isn't. It has about $709 million in cash on hand, but with profits being siphoned off by its growth initiatives, particularly internationally (where profits are slim to none so far), it will have much less room to maneuver than the likes of, for example, Amazon, which has money pouring in from many different sources.

Netflix is still at the top of the heap, and few people would bet heavily against Hastings. But for the foreseeable future, things will only continue to get tougher for the company that once owned the Internet-based video-rental market.

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