800K fewer subscribers humbles Netflix

Netflix CEO Reed Hastings wants subscribers to know he has heard them.

You don't want to order DVDs from a separate service called Qwikster? He trashed that plan.

You don't like paying more for less selection in the company's streaming-video library? He's beating the bushes to get more movies and TV shows. He has also stopped oversimplifying how hard it is to do that. For the first time, he has begun to acknowledge that Netflix faces serious obstacles in licensing content, especially films from the major studios. So, he's putting almost everything on "pause," even an important international expansion, so he can concentrate on his home audience for a while.

Netflix reported earnings today and the company was made to feel the full force of subscriber dissatisfaction. Leading up to the third quarter this year, the Web's top video-rental service had added a minimum of 1 million subscribers in each of the prior seven quarters. But for the three months ending September 30, Netflix lost 810,000 subscribers. The company reported 24.6 million subscribers in the second quarter and 23.8. million in the third.

The outlook for the next couple of quarters is even darker. For the first quarter of 2012, Netflix said it expects to report a global net loss.

Though Netflix's earnings for the third quarter met analyst expectations, the company's shares were thwacked in after-hours trading, declining 27 percent or $32 to $86.84. It was only last July that the stock pushed past $300. Since then, however, the company's shares have shed 71 percent of their value.

For most of the past two years, Netflix has been one of the great Internet success stories but now is in jeopardy of becoming a cautionary tale of hubris and collapse. "I slid into arrogance," Hastings said last month.

The trouble began in July, when Netflix announced that it would no longer offer access to the DVD-by-mail service and unlimited streaming video for $10 a month. Customers could pay $8 for streaming or $8 for discs or $16 for both. The customer cancellations and criticism from the media stunned Netflix's managers.

At first, the company downplayed the customer backlash. Netflix predicted it would finish the third quarter with 25 million subscribers and Hastings crowed that the fourth quarter could bring the company its first $1 billion quarter. Two months later, with customers still screaming about the price increase and the lack of selection in the streaming-video library, Netflix managers revised projections. Instead of 25 million subscribers, Netflix would emerge from the third quarter with 24 million.

Turns out, they didn't even get that.

Compared with what happened next though, those days might have been the quarter's halcyon period.

With customers still reeling from the price increase, Netflix announced it was breaking the company into two separate services. Hastings told subscribers a new service called Qwikster would oversee DVD rentals, and to use it they would have to create new accounts, queues, and receive a new bill. Netflix, a service much loved for its simplicity, was getting complicated.

"In hindsight it's hard to justify [the Qwikster announcement]," Hastings said during a conference call following Netflix's earnings report. "Qwikster became the symbol of Netflix not listening. We quickly changed course on that, and we're going to stick with DVDs as part of the Netflix brand."

In keeping with Hastings' new found humility, he also sounded a cautious tone in a letter to shareholders about the company's ability to acquire more streaming-video content.

Netflix leaders had said numerous times that streaming movies over the Internet is the future of home video. But in the past, the company appeared downright cocky about persuading Hollywood to license content to Los Gatos, Calif.-based Netflix. Hastings' managers would shrug and say all they needed was their pens and checkbooks.

Hastings played up his company's "virtuous cycle," where the more content Netflix acquired, the more it would attract larger numbers of subscribers, which would then pump in new money that could be used to license more films and TV shows. At the All Things Digital conference last summer, Hastings didn't blink at the possibility of paying $200 million a year to Starz, the pay TV network that owns the online rights to content from Disney and Sony Pictures.

"That [price] wouldn't be shocking," Hastings said. "We've grown a lot since [paying $30 million a year in 2008 for Starz content], and we can pay a lot more for content."

If signing Starz was such a cinch, why did negotiations break down? And what happens now? If the number of Netflix subscribers shrinks, as it did in the third quarter, then--using Netflix's logic--that means the company would have less money to pay for TV shows and films, which will mean attracting fewer subscribers and so on. In that scenario, the virtuous cycle turns into a nightmarish vortex.

In his letter to shareholders, Hastings detailed some of the challenges in acquiring content.

He wrote about how licensing deals in the TV and film sectors are typically based on exclusive deals and the rights to a lot of important content are already sewn up by others. As an example, Hastings cited the exclusive online rights that Universal Pictures has sold to HBO. What he doesn't say is that HBO has similar deals with 20th Century Fox and Warner Bros. That's content from three of the top six Hollywood film studios that Netflix can't touch.

With the Starz deal dead, Netflix is without the most-sought after content from five of the six majors.

"Given the existing licensing structure of the cable network industry," Hastings wrote to shareholders, "the total content available will likely remain carved up between Netflix, Showtime, HBO, Hulu, and others."

What he's saying is don't expect too much from us with regard to the latest films from the major studios.

This is likely one of the reasons why Netflix is playing up films obtained from "mini-major" film studios and reruns of TV series. What else does it have to entice new customers? During the conference call, Hastings was asked via e-mail whether he and his company are satisfied being a "rerun television" service.

"It's not how I would characterize it, but it's not fundamentally inaccurate," Hastings said. "We have incredible complete prior seasons of the last couple of seasons of 'Mad Men,' 'Breaking Bad,' etc., and that creates a great customer experience for episodic content."

But the question is will this kind of content be enough to bring his former subscribers back and keep Netflix growing? The next couple of quarters should give us our answer.