The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- In case you have had trouble keeping up with the on-again, off-again love-hate relationship Netflix ( NFLX) CEO Reed Hastings has with the DVD, let me recap it for you.

  • Netflix Q2 Letter to Shareholders, July 2011:
  • In addition to separating the plans, we are setting up a dedicated DVD division, led by 12-year Netflix veteran Andy Rendich, to focus on running a successful DVD by mail service in the U.S. for a long time. Andy and his team will be located nearby in San Jose, and are already planning some great improvements for the DVD service. Because we believe we can best generate profits and satisfaction by keeping DVD by mail as a division, we have no intention of selling it. In Q4, we'll also return to marketing our DVD by mail service, something we haven't done for many quarters. Our goal is to keep DVD as healthy as possible for as many years as possible.
  • UBS Global Media and Telecommunications Conference, December 2011:
  • DVD will do whatever it's going to do. We're not -- we're going to try to not hurt it, but we're not putting a lot of time and energy into doing anything particular around it . . . .

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  • Hastings and CFO David Wells, NFLX Q4 2011 Conference Call, January 2012:
  • Hastings: There are no specific retention efforts, and we don't plan on marketing the DVD service. Our primary goal is to keep it stable, very high functioning to keep our operational metrics in terms of top-of-queue fulfillment; in terms of one-day turnaround, very, very high, and not to otherwise to start -- keep it running very well.
    David Wells: And when we've tested DVD plans and putting more emphasis on DVD plans, there hasn't been a great take rate. So I think we get that question a lot and we have looked at it through AV testing. And there's not a large consumer adoption of those plans.

    Fair enough. I have to give these guys the benefit of the doubt. I love visionaries and, without doubt, Hastings qualifies as one. I never tire of the story Hastings tells: He had an overdue movie. He was heading to the gym. Then it hit him. A company should offer a video rental membership in the same way a gym sets one price for you to work out as much as you want. That's nothing short of brilliant. And that's why Reed Hastings is rich and spends time in his backyard Jacuzzi and I do not.

    Hastings and Wells run tests and the public says no, we've had enough of your high-margin, profitable DVD business, please focus on low-margin, unprofitable areas such as streaming and international expansion. I get what Hastings is trying to do. And, given my penchant for accepting near-term weakness for the promise of long-term growth and strength, I should probably step back and direct some praise Hastings way. He's doing things the ( AMZN) way. He's doing thing the Pandora ( P) way.

    As I have made clear over the last year or so, companies like Amazon and Pandora have something Netflix lacks -- workable business models. It might not seem like it now as Amazon deals with razor-thin margins and Pandora doles out more than half of its revenue to acquire content, but both companies are investing heavily to take advantage of massive growth opportunities that will pay off.

    Amazon is building a pervasive media and e-commerce ecosystem that will touch all of our lives if it does not already. Pandora is increasing the share of local, regional and national advertising it takes from terrestrial radio as it gobbles up more and more of the multiplatform ad-revenue pie.

    Netflix invests heavily -- and Hastings brags about it -- but what is his company actually investing in? While you can pinpoint and then dig into an answer to that question for Amazon and Pandora (I just did in the last paragraph), you really cannot for Netflix.

    Netflix claims that it has scale. As it builds out its business, it contends that the streaming contribution margin goes up, but the cost to service a customer does not. Wells made this case on the company's Q4 conference call:
    A marginal DVD subscriber has a number of variable costs, the postage and DVD fees in particular. So actually, it's the opposite, which is the profitability of a new streaming subscriber, the contribution margin is almost twice what it is for a DVD subscriber. So that's the way we think about it. And we're -- we'd like to have someone use both services because obviously, that's both more revenue and more profit. But if they were only going to use one, we'd much prefer them use the streaming service.

    Of course, this analysis ignores one major factor -- content costs. Netflix can claim all day that the amount it spends to license digital content is a fixed cost. That's not entirely true. While the company can go into a quarter or fiscal year and say, "We will only spend X on content acquisition," the consumer and competitive marketplace renders such an approach unrealistic.

    In practice, the content costs Netflix encounters are variable. Whereas Pandora pays a fixed amount as the number of songs it plays increases, for example, Netflix does not enjoy that type of certainty. The company can set a budget, but a content provider can throw it for a loop before the doughnuts even get served at a meeting. If a content owner wants $15 million instead of $10 million for a series of reruns, Netflix has to decide if it's willing to pay.

    Others have so much control over Netflix's costs that, at some point, it cannot have a budget if it expects to deliver a level of service that will trigger meaningful subscriber growth. That's why it lost Starz movies earlier this year and has started to chart the original programming course.

    The former refused to continue licensing premium content to a middleman that charges $8 a month for all-you-can-eat. Whether you think Hastings' plan will work or not is neither here nor there. The pressing question is where will he get the cash to execute it?

    Consider this. As Janney analyst Tony Wible reminded the other day via email: "The 4q 'recovery' may soon be seen as a false read. Remember paid stream subs were down quarter-over-quarter."

    You can see that reality for yourself on page 16 of the Q4 Letter to Shareholders. Free subscribers fueled the "recovery," the "growth" or whatever you want to call it.

    If Wible is correct -- and I think he is -- cash is not coming from a burgeoning subscriber base. Instead, it's still going out the door to ballooning and about-to-be-due content costs and expenses associated with an all-too-aggressive international expansion.

    And, of course, we all remember Netflix's recent $400 million cash grab, which the company apparently pulled off simply because "it's always nice to have more money than you need." What happens when that bit of charity runs out?

    I talked about this last year when Hastings birthed Qwikster. Sooner rather than later, Netflix will have no choice but to sell its DVD business for what will amount to a lifeline. Hastings will spin it as all part of his vision for the future. We are a streaming company. Customers are moving away from DVDs. While I can get with that, I cannot get with a crash-and-burn approach toward the revenue stream that might actually be able to fund your long-term and lofty streaming ambitions.

    One way or the other the DVD will help keep Netflix alive. The company will either need to flip-flop again and place a renewed focus on the service or sell it for what will amount to another bailout.

    Frankly, I am not sure what to expect when Netflix reports earnings on April 23. An earnings beat, complete with a truckload of smoke and mirrors, would not surprise me in the least.

    If you're going to play anticipated downside, proceed with caution, which probably means do nothing or wade carefully into deep in-the-money, long-dated puts. At this point, I need as much of a miracle for my June $40 puts to come through as Netflix does to survive without some sort of future cash infusion.

    At the time of publication, the author was short NFLX via a long position in NFLX puts. Positions may change at any time.

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