Netflix is dead if it listens to Wall Street

Digital distribution is coming whether investors like it or not. This is the worst time for the Web's No. 1 movie rental company to stand pat.

A correction was made to this story. See details below.

Here's hoping that Netflix managers have the confidence to carry on with a plan that isn't just necessary for growth, but is essential to the company's survival.

Netflix CEO Reed Hastings is being second guessed by Michael Pachter, an analyst with Wedbush Morgan Securities. According to a story in Portfolio (via Wired.com), Pachter "would prefer that Netflix stick to selling movie-rental subscriptions."

Like many on Wall Street, Pachter can't see past the next quarter. He crunched the numbers and argues that Netflix is spending too much on building a digital-delivery service that enables users to download movies.

Netflix may drop as much as $70 million this year on the digital service. That equals to about 70 cents per share in 2008 profits. The company had to pay Hollywood studios $40 million last year for the rights to offer 10,000 films online. Pachter, who wants Netflix to reveal more details about the online service, said that if Netflix paid $70 million to service 100,000 customers, the company would be paying $700 for each.

"I would say they're crazy; it's not worth it," Portfolio quoted Pachter as saying. He added that he only likes the deal if most of Netflix's customers switch from receiving DVDs through the mail and start getting their flicks via the Web.

But that's not going to happen overnight. What Pachter doesn't seem to get is that the online distribution of movies is coming whether investors like it or not. Hastings said last week that he expects his DVD revenue to peak within five years. Perhaps the best proof that the move-rental business is on the threshold of dramatic change is the set-top box introduced two weeks ago by none other than Netflix.

Pachter should try the Netflix Player by Roku. The $99 device enables Netflix users to watch downloadable movies on their TV sets. Most Netflix subscriptions allow for the viewing of any movie at no extra charge. Netflix streams the films, which means no extended download times. The major flaw is that there isn't enough titles to choose from. That will come in time unless Pachter gets his way and Netflix doesn't shell out for a better film library.

Regardless, the service is cheap. It's easy to hook up. The quality of video is comparable to digital TV.

But will anyone be willing to watch their Netflix movies without fussing with red envelopes or waiting for the mailman? Hastings isn't the only who thinks they might. Heavyweights such as Apple and Amazon have jumped into the Web movie-rental business. Others are sure to follow.

"Netflix is betting that during this time, we can establish ourselves as a leader in the space," said Barry McCarthy, Netflix's chief financial officer, last week at the company's investor day.

To be sure, online video is still in its infancy. It will take time before it goes mainstream. But it's hard to find anyone in entertainment or technology circles that doesn't believe consumers will eventually embrace it.

The big question is whether Netflix can afford to wait to build a digital business and possibly watch its competitors cut its grass. I don't think it can. Putting off a digital strategy is a bet against the Web, and that's the opposite tack Netflix took to build itself into a movie-rental powerhouse with 8 million subscribers.

Blockbuster and Movie Gallery are examples of companies that hesitated to embrace the Web. Now, Blockbuster continues to try to prevent Netflix from taking more of its customers. Movie Gallery went bankrupt last year.

Correction: The story erred by making it appear that Michael Pachter had said it was "crazy" that Netflix was paying Hollywood studios $40 million to obtain movie rights. He was commenting about Netflix's overall investment in digital distribution.
 

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