Foolish Forecast: Netflix Is Here to Stay

Monday nights are usually pretty quiet on Wall Street, even in the midst of earnings season. Online movie maven and Motley Fool Stock Advisor pick Netflix (Nasdaq: NFLX  ) breaks the early-week silence next week with a third-quarter earnings report. Check out how last quarter shaped up, then come back here for a deeper look at the company and its business.

What Fools say:
Here's how Netflix's CAPS scoring rates against some of its peers and competitors:

Market Cap (millions)

CAPS Rating

Bull Ratio

Netflix

$1,630

**

79%

Blockbuster (NYSE:BBI)

$1,030

*

47%

Amazon.com (NASDAQ:AMZN)

$37,220

**

63%

Trans World Entertainment (NASDAQ:TWMC)

$141

*

27%

Data taken from Motley Fool CAPS on 10/17/2007. Market cap data from Yahoo! Finance.

Wow. Not a lot of love going around this industry, is there? I'd include Movie Gallery too, but it just filed for bankruptcy, and got only an 8% approval rating from the CAPS crowd anyway.

So what's wrong with Netflix? Let's hear it from one Fool with a superstar-worthy 99.99 player rating: "Not enough barriers to entry. Can't win the [video on demand] wars not that it matters at all." Another player worries about "skyrocketing" subscriber acquisition costs, and others worry that consumers might prefer running down to Wal-Mart (NYSE: WMT  ) to sate their movie cravings.

Fellow Fool Rick Munarriz made clear in his summary of last quarter that he didn't like it at all. The churn rate is too high, and consumers too fickle.

What management says:
We're told to expect a flattish 6.7 million to 6.9 million subscribers at the end of the third quarter, producing revenue in the upper $280 million range and $0.11 to $0.19 of earnings per diluted share. Those numbers assumed that Blockbuster would keep its pedal to the metal with Total Access loss-leader plans, which didn't happen.

What management does:
Don't be alarmed by the razor-thin profit margins. Management has told us that it's reinvesting as much as possible into the business, adjusting marketing spending to stay fairly close to breakeven. The real story is about sales growth and highly efficient mailing operations; you can see the first item looking pretty good even during a turf war to the death, and the second point shows up as stronger gross margins.

Margins

3/06

6/06

9/06

12/06

3/07

6/07

Gross

33.3%

35.4%

36.6%

37.1%

37.5%

37.0%

Operating

3.4%

5.4%

5.9%

6.5%

6.6%

6.8%

Net

7.3%

8.0%

7.9%

4.9%

5.1%

5.5%

FCF/Revenue

19.4%

19.9%

21.2%

22.1%

21.0%

21.0%

Y-O-Y Growth

3/06

6/06

9/06

12/06

3/07

6/07

Revenue

36.4%

39.0%

45.4%

46.1%

43.0%

37.7%

Earnings

197.5%

211.7%

671.8%

16.8%

(1.3%)

(5.3%)

All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.

One Fool says:
Let's get real for a moment here. Video on demand is indeed the way to go, and we'll all be doing it eventually. But that day is still a long way off, and the only real roadblock to Netflix making tons of money right now is Blockbuster.

Amazon Unbox and the movies section in Apple's (Nasdaq: AAPL  ) iTunes Store are a nice start, but Netflix has its own equivalent puttering around under various names and just waiting for a set-top box deal of some kind. None of that matters yet, though. Technical excellence doesn't help until you can build out the movie library to an attractive size, and that won't happen for years.

The studios like their existing distribution windows too much, and this newfangled digital channel doesn't figure into their plans until the old contracts with theater chains and cable operators expire. And even then, Comcast (Nasdaq: CMCSA  ) and the gang will put up a spirited fight to protect their territories, and by then they'll have their own digital services to promote. That will be ugly. But we're not there yet.

In the meantime, Blockbuster and Netflix will continue to fight for DVD rental market share. Mom-and-pop stores and lesser rental chains will continue to suffer and die in the shadows of clashing titans. Now that Blockbuster called off the full-tilt Total Access assault, we'll see who gets the lion's share of new customers in a fair fight. I think they're going for the red envelopes.

Foolishness on Demand:


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