Netflix Earns Four Stars

If I had to rate last night's fourth-quarter report out of DVD rental giant Netflix (Nasdaq: NFLX  ) on the company's five-star grid, I'd have to award it a solid four stars. Yes, the company had a spectacular showing. Earnings more than quadrupled to $0.21 a share. That is far better than the profit of $0.05 a share it generated a year earlier before a one-time tax gain, and comfortably ahead of the $0.15 that Wall Street was expecting.

Revenues soared 44% higher to hit $277.2 million. It also closed out 2006 with more than 6.3 million subscribers, a healthy 51% advance from the 4.2 million members it watched over a year ago.

Margins are plumper. Churn is at a record low. CEO Reed Hastings cites that the company is generating higher customer satisfaction ratings than cyberspace darlings Amazon.com (Nasdaq: AMZN  ) and Apple (Nasdaq: AAPL  ) .

Am I being too picky as a reviewer? Am I cheating Netflix -- a company that I have owned and patronized as a paying subscriber since 2002 -- of that fifth star?

I don't think so.

The missing star
Why wasn't this a perfect report? My mixed critique grows out of concerns in its guidance for 2007. Netflix is looking to earn between $0.76 and $0.83 a share this year, on between $1.25 billion to $1.3 billion in revenue. Analysts are smack dab in the middle of the profit range -- perched at $0.79 a share -- yet were looking for $1.36 billion in revenue for all of 2007.

The company is also looking to close out the year with 8.0 million to 8.4 million subscribers. Few companies would scoff at adding between 1.7 million to 2.1 million new users in any given year, but that falls short of the just over 2.1 million net subscribers that the company landed in 2006.

To be fair, if we go back a year, Netflix was only looking to gain 1.7 million more subscribers in 2006. Hopefully, Netflix is being its usual conservative self, but it's worrisome if raw subscriber count growth of the service peaked last year.

This also comes at a time in which rival Blockbuster (NYSE: BBI  ) is projecting to add 1.8 million net subscribers on its way to hit 4 million by the end of 2007. In other words, if both companies hit their marks, Blockbuster will have grown from a third of the size of Netflix to nearly half in a single year.

Netflix is respectful of its "aggressive and innovative" competitor yet it is skeptical about the economics behind its lofty growth strategy. By its math, Blockbuster's goal will translate in the company posting a $150 million to $250 million loss. Antsy creditors may get in the way of Blockbuster's ambitious growth plan of its clearly popular Total Access.

Under a dream scenario, Netflix would love to see Blockbuster either scale back on its marketing expenditures or boost its subscription prices. However, Blockbuster is clearly in this to win, and that market's recent attraction to Blockbuster's stock with this kamikaze approach may make the red ink acceptable to its creditors.

Since Blockbuster's stock bottomed out back in August, it has shot up by 89%. In that time, Netflix shares have appreciated by only 14%. Yes, Blockbuster may be that crazy kid at the party who is swallowing live goldfish and spooning down Cheez Whiz on a dare, but as long as the market's excited, its watchful creditors are likely to nod along and tell it to keep chugging.

The future of Netflix
How pervasive is Netflix? It now commands 15.7% of the households in its Bay Area home market. By the end of the year, Netflix will have 50 regional distribution centers to provide next-day delivery through the ordinary mail system to 95% of the country.

The company is gradually rolling out its Watch Now service for online streaming, but it feels like a half-hearted effort. Even the company concedes that it is limited in both selection and television accessibility (since few homes have their television sets hooked up to their computers) at the moment. The available streams are mostly dated flicks and television shows. Less than a tenth of the movies in my queue have that kind of functionality, and they are all art-house films. I think Maggie Gyllenhaal is an amazing actress, but do I want to squint at my monitor for the next 96 minutes to see Sherrybaby?

In defense of Watch Now, the streams load quickly and look great. Netflix believes that the costs of offering the service will be offset by subscribers renting fewer physical DVDs, but I'll believe that when I see it. It just feels like a reluctant bookmark in a chapter that Netflix doesn't necessarily want you to read.

So am I a nervous Netflix investor at the moment? Not at all. Despite Blockbuster's Total Access onslaught this past quarter, I am impressed to see Netflix produce a historically low monthly churn rate of 3.9%.

However, this will be a year in which investors will be well-served to watch both Blockbuster and Netflix closely. Can Netflix save the goldfish and the Cheez Whiz and still keep the party going? Only Reed Hastings -- and Maggie Gyllenhaal -- know for sure.

Netflix and Amazon have both been recommended to Motley Fool Stock Advisor newsletter subscribers. To find out why they made the cut, take a free 30-day trial today.

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and shareholder -- since 2002. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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