Netflix's Growing Pains

• Email
• Share
• Print

I must admit, I was a bit skeptical at first. Renting movies over the Internet made me feel like George Jetson. When I joined Netflix (Nasdaq: NFLX) and clicked on movies to fill my rental queue, I expected Rosie the robot to roll into my office and spit DVDs out of her metal stomach (in reality, the company covers shipping to send the discs through the mail).

Now, people have gotten on board, and the company's customer list keeps expanding at a healthy clip. But with rapid growth comes the lofty cost to acquire new users.

Netflix appears to have paid a steep price for its 90% revenue growth in its second quarter. The company reported net earnings of $0.11 per share, $0.02 below analysts' expectations. Netflix's subscriber acquisition cost was $35.12 per new trial subscriber in the second quarter, and it expects the number to rise to $37 to $39 in the third quarter (including the cost of increased television advertising). The name of the game in the movie rental business is customer addition and retention, and the company expects its churn rate (the percentage of customers who do not renew subscriptions) in the third quarter to be between 4.8% and 5.6% (it was 5.6% in second quarter). The bottom line is that the company is adding many more subscribers than it is losing each month.

The online movie wizard also tightened its estimates for 2004 by forecasting revenue of $511 million to $525 million (from a previous estimated range of $484 million to $535 million) and net income of $12.6 million to $22.1 million (from $10.5 million to $18.5 million). So, what should investors take from the company's earnings release? Basically, customer growth has its price.

Every successful online business has gone through rough periods of growing pains. Amazon.com (Nasdaq: AMZN), eBay (Nasdaq: EBAY), and especially Time Warner's (NYSE: AOL) America Online had a growth model squarely focused on customer acquisition and retention.

Given the choice of investing between Netflix and the top three movie rental chains -- Blockbuster (NYSE: BBI), Hollywood Entertainment (Nasdaq: HLWY), and Movie Gallery (Nasdaq: MOVI) -- I would select the company with the brightest future. While there might be a few bumps in the road for Netflix, it is clearly on its way to laying a roadmap for the movie rental industry (a view shared by Daniel Hong in his Foolish commentary, The Last Word on Netflix). Therefore, I would look to buy the Netflix shares despite this recent hiccup -- the expected drop in share price presents a real buying opportunity.

Seen any good movies lately? Subscribe to the Motley Fool Stock Advisor and get a clearer picture of what stocks to buy.

Phil Wohl spent more than 12 years on Wall Street and now concentrates his writing on more fictional characters. He has no stake in any firm mentioned above.