Netflix had the right idea, but it wasn’t alone

The e-retailer may not have counted on all the big rivals it would face in this new frontier of entertainment.

Netflix was riding high in June 2007 when its founder and CEO, Reed Hastings, delivered a keynote address at the Internet Retailer Conference & Exhibition. But Hastings didn’t focus on the past success his company had achieved with its game-changing business model—offering a highly personalized web site where consumers could rent movies on DVD for convenient home delivery by the local letter carrier—a strategy that was in the process of driving Blockbuster and many other video stores out of business or into bankruptcy. Instead, he focused on the future, in which, he said, consumers would access movies, TV shows and other entertainment in the form of video streamed from the Internet.

Today it’s clear Hastings was right. And yet Netflix is in the news because of the disastrous fall of its stock price, which has lost three-quarters of its value in three months, costing Netflix investors a cool $12 billion. There’s a lesson in this for other online retailers, which I’ll come back to shortly.

What went wrong for Netflix? In a nutshell, the company had to shell out a lot of money to license content that it could transmit to consumers who increasingly were taking to its video-streaming service. And as the content providers began to see how popular video streaming was becoming—and how it threatened the revenue of their existing customers, from movie theaters to cable TV channels—they raised their prices.

Plus, other big players saw what Hastings saw, and they got into the game. Really big players, like Amazon.com, and the big TV networks through their Hulu online video venture. More recently Google has entered the game by offering movies on its immensely popular YouTube site. And Facebook is getting in on the action, too, testing movie rentals directly on the social network.

As competition drove prices higher, Netflix had to pay more to provide enough content to keep video streamers interested—and even with its pricey deals the streaming selection falls far short of what consumers can get on DVD. Clearly, content wasn’t going to get cheaper. Netflix initially offered video streaming as a free add-on to its DVD-by-mail service, but as the cost of streaming content soared, that became unsustainable. Netflix had to charge more for streaming content in order to be able to afford to offer more of it. That’s what led Netflix to introduce the new pricing plans this summer, setting off a customer revolt that cost the company 800,000 U.S. subscribers in the third quarter, and sending investors storming for the exits.

There’s general agreement that Netflix bungled the communication of this pricing shift, as Hastings has now admitted on several occasions. But the bigger problem is that it didn’t account for how big an opportunity this would be, and the level of competition it would attract.

There’s the lesson for other online retailers: Recognize that your success will draw new entrants. By every measure consumers are shopping more on the web. And that includes researching and sharing, as well as purchasing. Even in a tough economy, many e-retailers are growing revenue 10-30% a year. Quite a few are expanding into new categories and broadening their selection. But the Netflix experience suggests that you have to look around the corner at who else might be attracted by the same opportunities you see. Will you find yourself competing against Amazon, which is steadily expanding into new merchandise categories? Will you find a major competitor deciding to offer free shipping on all orders, as L.L. Bean did earlier this year?

As Netflix has learned, the very power of the web is making it a magnet for the biggest companies. That’s not to say smaller retailers won’t be able to complete. In fact, focused web merchants are doing very well, especially those that sell exclusively on the web. But they still would do well to assume that more competition is heading their way.