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Stream This: Netflix Needs a Business Model

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On Oct. 9, a post on The New York Times Bits blog stated that Netflix could become the leader in online video content. While I agree that the company has made huge strides thanks to its deals with Microsoft’s Xbox, Starz, and, of course, the Roku player, the real question involves how Netflix plans to make money from its new distribution strategy.

Each time Netflix streams a movie to your PC, Xbox, or Roku, it pays one fee to deliver the bits and another fee to the content owner for the rights to distribute the content. Right now, the streaming-movie services offered by Netflix cost the company money, but they also help it retain customers. However, over time, as subscriptions to its DVD service slow, Netflix will need to find a way to translate the online video offering into revenue. Can Netflix convert those who use the DVD service to a streaming-only service? And more importantly, will Netflix offer a streaming-only service for those who want to stream movies to the Xbox 360 and Roku but don’t want physical DVDs?

Some say that, by making the Xbox 360 capable of receiving Netflix content, the console will be more attractive to new users who are deciding whether to buy an Xbox 360 or PlayStation 3. I would agree that, for some potential game console buyers, it could tilt the scales in favor of the Xbox.

But unless Netflix is getting paid by Microsoft to help sell consoles—and I don’t believe it is—Netflix sees additional revenue only if those who buy the console are not already Netflix subscribers. The idea that the company can easily tap into the Xbox 360 community around the world is a great idea, but in reality, this causes big problems because much of the content from major studios is typically licensed on a region-by-region basis.

With Netflix still making less than 15% of its DVD inventory available for streaming, the volume of popular content continues to be a major hurdle. If Netflix can get more first-run movies online, it will help. But how long will it take to get even 50% of the company’s content online? The problem does not lie with the encoding and hosting of the video but rather with licensing deals with content owners. Netflix’s success with its streaming offering is solely dependent on the major movie studios signing distribution deals to stream more of their library over time. But the real question involves how much inventory they will allow Netflix to access and over what time period.

Netflix is smart to secure these deals, as membership will not gain value if only physical DVDs are available. But at some point, the company is going to have to make up for the huge amount of money it is spending to stream its content to devices. At the moment, the Netflix streaming service is a loss leader. That’s fine for now, but soon, the company is going to have to explain how it is going to make back money from the service. Netflix may be able to offer a streaming-only subscription down the road or maybe advertising will creep in over time, but right now, Netflix is burning through money to make its streaming service happen. Exactly how much we don’t know; the company won’t say on record how much its streaming service costs. Over time, though, I think Netflix will get so much pressure from investors that it will have to break out those numbers.

Netflix’s Xbox offering also includes HD streaming, and the company announced in late October that it would also begin streaming HD content via the Roku box by the end of 2008. Using advanced profile Windows Media encoding will allow Roku to deliver the same HD-quality video but at lower bitrates. This enables users who don't have high-end bandwidth to still be able to get HD-quality video. While interlaced video content is typically de-interlaced before encoding with the Windows Media Video codec, advanced profiles support compression of interlaced content without first converting it to progressive content. Microsoft says that maintaining interlacing in an encoded file is important if the content is ever rendered on an interlaced display, such as a television. Even with the lower bitrates, though, the HD offering will only increase Netflix’s bandwidth costs.

For Netflix, the streaming service is a big gamble, and one the company is betting everything on. Netflix must turn the service into a real business model down the road or risk having a service that is cool but unprofitable. If it was anyone else, I’d say the company had a bad chance of making it. But so far, Netflix has been very smart about how it operates, making its platform open and providing APIs. I give the company about 14 months before it has to start showing investors how it is going to turn its IP-based video offering into a sustainable business model. I’m rooting for them.

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