Why Wall Street is (still) wrong about Netflix

The trouble with trying to adapt a big and growing business to disruptive technologies is that the process is... well, disruptive, as Netflix has demonstrated beyond the shadow of a doubt.

But "disruptive" doesn't mean "impossible," and it's way too soon to count Netflix out--although that hasn't stopped Wall Street from trying.

Since announcing yesterday that it shed 810,000 net subscribers in the third quarter, the purveyor of DVDs-by-mail and video-by-streaming has been the goat of Wall Street. Its share price plunged 35 percent today, to $77.37, knocking a cool $2 billion or so off its market cap.

All because Netflix's attempt to distance itself from its slowly dying DVD business in favor of instant and far more scalable video streaming has been rockier than anyone expected. While the company has made more than its share of mistakes, that doesn't change the fact that it's still got the right strategy, even if its execution has so far left a lot to be desired.

Recall that in Clayton Christenson's classic formulation, technology giants are frequently topped by "disruptive" technologies that erode seemingly impregnable businesses, often with startling speed. This is partly because it's easy for incumbents to dismiss the disruptive potential of a fledgling technology--a classic hazard of linear thinking--and partly because adapting to the new world would itself disrupt existing, and usually highly profitable, business relationships.

Thus did steam-shovel firms give way to startups that had grasped the early potential of hydraulic shovels. The same thing happened to disk-drive makers, to the makers of traditional cameras and film, and even to the mainstream media. Almost invariably, the giant companies of the time found themselves unable to successfully transition to the newer, cheaper, and ultimately much bigger businesses made possible by disruption.

So Netflix CEO Reed Hastings deserves some major credit for trying to buck this trend. With the high fixed-cost DVD business on the verge of stagnation, Hastings took the almost unprecedented step of effectively blowing it up in order to speed the transition to streaming.

On Wall Street, however, you're either a hero or a goat. So long as it seemed to have the best of both worlds, Netflix was a hero, with a near-$300 stock and a growing streaming business that made it the biggest source of Internet traffic in North America. Then came the company's steep and sudden 60 percent price hike on its existing subscribers, who'd grown used to paying the same low fee for both DVDs and streaming. Soon afterward came its bizarre--and, thankfully, hastily discarded--plan to spin off the DVD business as a separate company to be called "Qwikster."

And now Netflix is such a goat investors were primed to punish it severely for losing a third more subscribers in the quarter than it had warned. Suddenly the air is thick with talk of Netflix having irreparably damaged its brand, blown its shot to lock up access to valuable Hollywood movies and TV shows, or even started a death spiral.

OK, deep breath time. Truth is, Wall Street was wrong when it thought Netflix had mastered its disruptive transition, and it's wrong now for thinking the company has biffed it but good.

Here are a few things people tend to overlook about Netflix:

• The company is still profitable, and in fact managed to beat Wall Street profit expectations yesterday despite its dismal customer numbers.
• Yes, Netflix is projecting a loss early next year, but that's largely because it's spending heavily to launch its streaming service in the U.K. and Ireland--not because of U.S. customer trends.
• Netflix launched its streaming service in Canada a year ago, and claims it already has more than 1 million members and 10 percent household penetration in the Great White North.
• DVD customers are upset with Netflix--and understandably so. But they are the past, not the future, so far as the company is concerned. All the company really needs to do is stanch the bleeding on the DVD front while its streaming future takes root.
• Netflix couldn't close a deal to continue streaming films from Starz, but that says more about Hollywood's greed and short-sightedness than it does about the opportunities for Netflix. Hollywood still needs Netflix more than the other way around, given the speed with which cord-cutting and piracy are eroding the traditional distribution of entertainment.
• More broadly--and perhaps most importantly--Netflix is surprisingly well positioned to capitalize on a basic economic fact, which is that in a perfectly competitive market, a product's price will tend to fall to the marginal cost of distribution. Entertainment is far from perfectly competitive, of course--but it's growing more so every day. And the marginal cost of distributing digital video is... zero! (Or pretty close to it; you still need bandwidth and servers, of course.)

None of which is to say that Netflix has a lock on the future of streaming entertainment. It surely faces some tough competition, particularly from Amazon's Prime video-streaming service.

But Netflix is still in the right place at the right time, with a very competitively priced service. Maybe its offerings will shift a little more toward the Long Tail side of the catalog for a while as it works to consolidate its footing in the streaming business. But there are worse fates, and it's not at all difficult to imagine things shifting back in Netflix's favor as some of these other trends play themselves out.