At a certain level management at Netflix (NASDAQ:$NFLX) had to realize that their business model was not only flawed but replicable.  What made the company a household name and as much a staple line item in people’s budgets as cable TV itself was its value proposition. 

The streaming video business in the face of falling bandwidth prices was going to put their mail order business in jeopardy long-term.  The competition was getting creative as well.  Coinstar’s (NASDAQ:$CSTR) RedBox was taking off in a big way, making it more difficult for Netflix to attract new customers as RedBox ate away at Netflix convenience value add. 

So, the decision was made to emphasize video streaming and de-emphasize DVD mail order.  And that’s where everything began to head south.  The debacle over their changes in pricing will go down as one of the biggest blunders since New Coke (NYSE:$KO) and the company has not recovered.

Tuesday’s announcement by Amazon (NASDAQ:$AMZN) that they had signed a deal with Epix to add their catalog to their Prime streaming service sent Netflix stock tumbling after their latest earnings report had already beaten the share price with the ugly stick as it put the final nail in the coffin of Netflix having exclusivity over Epix’s content.

This deal is a two-edged sword for Netflix because it makes their service no more or less special than Amazon’s or Hulu Plus.  Anyone else with the capex to put together the server farm can now buy the content and serve it up for some monthly fee.  Speculation abounds that Amazon, already operating at razor thin margins, will be able to sell this as a further loss-leader like the Kindle Fire. 

That argument may hold true for Apple (NASDAQ:$AAPL) and Google (NASDAQ:$GOOG) who have the deep pockets and cash flow to build their TV set top brands that way, but why would they do that when they can just cut a deal with Netflix and split the take?

Amazon wants this business because it feeds sales of tie-in materials: books, DVD’s, plushies, toys, etc. It makes sense for them to sell the media in every form that it is available in.  Apple and Google don’t sell that stuff directly; they enable people like Amazon to sell that stuff by selling the hardware and the advertising. 

This deal by Amazon actually lowers Netflix customer costs by not having to maintain a $200 million per year exclusivity deal; freeing up some of that cash (anywhere from $20 to $100 million per year depending on what Amazon paid) to plough into the one area where they can control access to content; the content they produce themselves. 

Where Netflix is struggling now operationally is in expanding into new markets which is costing them most of their profits.  Their DVD rental business is still running at >84% operating margins and generating more cash than their international streaming business is costing them.  In the 2^nd quarter the DVD business generated $133.8 million in operating profit, more than offsetting the loss for building their European business. 

But what should be obvious is that their streaming revenue margins are moving in the right direction, even in a quarter where subscriber growth was muted.  Add back in the lowered costs for licensing their existing content and these numbers begin to look a lot better.  Netflix is great value at $8.99 per month when someone cannot afford both cable and internet access.

Netflix’s long-term viability stems from their ability to do what HBO and Showtime do; produce compelling original content that is worth the price of their subscription.  In essence, they are fighting fire with fire.  The biggest threat to their business is being able to bid competitively with producers for the right to stream their content. 

By becoming a content producer themselves they can cater to a precisely quantified niche audience based on their subscriber’s activity.  This gives them a comparative advantage that can be used to create content with a greater degree of profitability.   They have 4 original series in the works, the most important of which is the reboot of the cult classic Arrested Development will air in the Spring of 2013.  They have inquired into other shows with similar rabid followings, like CBS’s Jericho but no deal as yet has happened.  These are shows with ready-made audiences that can justify the cost of production. 

The roll-out of their service in Scandinavia ties in with their original series Lilllyhammer. 

Does anyone seriously think that Amazon will be getting into producing new episodes of Firefly anytime soon?  Really?  They are going to do that at a P/E of 302 and net margins running at less than 1% and the U.S. staring at a fiscal and economic cliff?  With cable and satellite subscriptions dropping by an estimated 450,000 in Q2 it is more likely that streaming services and a la carte content services will see a pickup in subs as people scale back their entertainment budgets. 

At this point the stock, however, is toxic but it bears watching for signs of contrarians seeing the potential for Netflix to become a streaming version of HBO and turning the tables on Amazon.  If it holds in the current range above $55 per share and builds a base, it may be worth a look in a few months.