• by Diane Mermigas , November 21, 2010

Netflix is a success story for many reasons; for openers, it satisfies consumer needs rather than setting itself up as a perfect alternative to pay TV.

There is a valuable lesson to be learned from CEO Reed Hastings' spry, continuing innovation of his company - and it has all of the major players on edge. Fortune lauds the Netflix story and Hastings as the most successful business person of 2010 for posting all the right measurements: Netflix is on track to more than double the revenues exclusively generated by DVD-by-mail model as recently as 2008, with nearly two-thirds of its subscribers now streaming.

But the Netflix story and Hastings' prescription for proactive leadership are instructive for anyone wanting to make money in the new mobile, e-commerce sweet spot.

Part of Netflix's success comes from providing lower-end or basic video cable, satellite ad telephones customers with less-expense, more-targeted fare. Netflix essentially charges $9 to $60 per month for unlimited streaming for all multiplatform access and mobility compared with $70 to $115 per month for cable TV until TV Everywhere becomes more widely available.

While it plays especially well with financially strapped consumers during a recession, Netflix's ubiquitous, streaming cost-efficient business model will resonate with consumers seeking to permanently downsize spending. Even Oprah Winfrey, one of the wealthiest women in the world, has made a five-year membership to streaming movies and TV (averaging $107 per year) one of her annual "Favorite Things" for 2010.

With its stock price soaring more than 200% this year and heading, per Barclays, to a new target price of $140 a share, and international expansion in its sights, Netflix is impervious to the empire building by Apple, Google, Amazon and Sony. That's because its value proposition is different-which is all about convenience and cost.

Starting at the low end, Netflix is rapidly building revenue and market share as it acquires content, improves user experience and pricing. It's moved up market,  eroding the higher margins of incumbent cable programmers stick in their bundled, walled garden services.

"Consumers are increasingly living in a time-shifted, on-demand world, but the media industry is still making decisions rooted in time-based windows," observes Credit Suisse analyst Spencer Wang. Comcast (soon to control NBC Universal) sees TV Everywhere and providing content to Netflix as forms of experimenting.                

When as little as 5% of pay TV subscribers shift to over-the-top services such as Netflix, will cable, satellite and Telco operators need to partner with or emulate Netflix to offset losses from traditional pay TV distribution? Wang asks in an enlightening new report.

"The conundrum for incumbents is that insurgents such as Netflix can survive with low margins (9% EBITDA and 3% FCF margins versus 30% and less than 20% for incumbents," Wang said. "There is an asymmetry in views of the market opportunity."

Many cable networks could potentially become marginalized should Netflix acquire content direct from studios, which own the content in most cases. The second consecutive quarter of declining pay TV subscribers, representing about 1% of subscriber loss for dominant Comcast and for Time Warner Cable, as recently reported by the companies.

Little wonder that Time Warner Cable last week announced the new low-priced program tier TV Essentials, still well above Netflix's average monthly $50.  At the other end of the spectrum, Hulu.com launched its "Plus" subscription service at a lower than expected $7.99 per month.  

Cable and other established pay TV players' sustained technologies are exceeding market demand for services, now that technology allows for more affordable, cherry-picking content options.  At some point, the growing gap between the cost and actual usage will erode cable's pay TV proposition. Its legacy infrastructure and costs will become an impediment to quickly and effectively responding to the need for change.

Wang convincingly and clearly makes the case why this scenario is not all smoke and mirrors. He points to the cost of pay TV consumption rising an annual 7%  from 1990 to 2009 when the bundle effectively met a marketplace demand now being increasingly satisfied by over the top streaming.

Little wonder that Credit Suisse projects Netflix $2.2 billion in 2010 revenues will at least double to more than $4 billion in 2015 -- even with its content costs rising an average 30% over the five years. Earnings will grow 3% to $822 million and free cash flow will grow 47% to $500 million by 2015.

In comparison, cable program networks will be loathe to sustain their 38% earnings margins and 19% free cash flow margins, as will pay TV distributors averaging 33% and 12% respectively, Wang points out.

Cord-cutting could push modest 1.5% annual cable network subscriber growth rates to a negative -1.5%, in turn, reducing advertising revenue grow to 2% annually from an anticipated 5% forcing earnings margins to flatten. Unless pay TV players ameliorate their course, they may be on a declining trajectory fueled by the more tech and economic-friendly gains of Netflix and other emergent players. 

Hastings concedes Netflix's biggest threat is Facebook and the advent of friends sharing movies and video within that social-network ecosystem, bypassing everything else. It is the kind of thornier problem of vulnerability in which Hastings exceeds and Netflix excels. By contrast, pay TV distributors and content have to worry about both. They are locked in a business model designed to defend rather than reinvent the status quo.