Is Netflix Doomed?

The beauty of writing for so many years -- and I've penned nearly 3,000 articles since washing ashore on the Fool's virtual beachhead in 1995 -- is that eventually you can pad your scrapbook with some amazing market calls.

Sure, that also means that I've got some awful prognostications that I would love to forget, but, hey, whose scrapbook is this anyway?

So years from now, when my grandkids sit on my lap and ask me about the one time I nailed it, I may be tempted to bring up Netflix (Nasdaq: NFLX  ) . I'll warn them to expect highs, lows, and a beauty of a cliffhanger along the way. They won't get it, so I'll move on. See, when Netflix went public back in 2002, I was quick to assault the stock as overvalued. It was, and Wall Street soon realized that.

But four months later, instead of gloating over a stock that had fallen by roughly 70%, I changed my tune. I argued that Netflix was now undervalued. It was, and Wall Street soon realized that, too.

Nailing the top -- and the bottom -- made it all sweetly gratifying. The company went on to achieve great things. Profitability. Ubiquity. Well more than two million subscribers willing to pay for unlimited DVD rentals.

The stock also proved to be a great trade for Stock Advisor readers last year, with the shares nearly tripling between the buy and sell recommendations. While some initially argued that the popular newsletter cashed out too soon, they have had to shrug and sigh as the stock has seen its price cut in half this year.

Why has the stock been stung in 2004? The numbers seem impressive on the surface. Netflix has recorded at least 70% year-over-year subscriber and revenue growth during each of the past 10 quarters. It has also produced positive free cash flow in every single quarter of its publicly traded life.

In two years, the company expects to have lined up 5 million subscribers, producing $1 billion in annual revenue and as much as $200 million in free cash flow. Those may seem like hefty goals, yet that implies market penetration of just 5%. It's already well past that mark in its Bay Area homestead.

So why is Netflix in a funk? Well, folks are concerned about how quickly Netflix will grow in the future. Cynics -- and class action litigants -- point to how the company may have signed up 583,000 new subscribers this past quarter yet also lost 422,000 users that cancelled the service.

While the defections seem like a substantial sum, those fears are overblown. Back in June, Netflix increased its monthly rates to offset costs, as its effectively widened distribution network was allowing customers the luxury of checking out more than the five average DVDs that they would go through every month in the past.

What was the worry here? This was a one-time rate hike, and the results were actually comforting. One could only hope that if Netflix were to raise its rates by at least 10% every quarter that it would still manage to land more than 160,000 new subscribers!

Critics who were pointing to the company's rising churn rate and sequential weakness in sign-ups also missed the seasonal boat. The second quarter is typically a weak one, as folks may cancel their subscriptions for the summer and there is little movement on the shelves of DVD retailers to spur new trial memberships. The 5.6% churn rate may have been higher than the March quarter's showing, but it was identical to last year's June quarter -- which, I may add, didn't feature a price hike.

Yes, the number of new trial subscribers may have shrunk by 23% during the quarter over the Netflix newbie count back in March, but last year's second quarter also featured a 22% sequential slide. In fact, year over year, Netflix is growing faster now than it was a year ago.

However, there is one underrated monster lurking beneath Netflix's bed. It's big. It's awkward. It bleeds blue and yellow.

Make it a Blockbuster fight
It's easy to dismiss Blockbuster (NYSE: BBI  ) . It is the square, clunky, late-fee-spewing vanilla beast that inspired the creation of Netflix in the first place. It also made the major mistake of ignoring Netflix for too long.

Remember when Barnes & Noble (NYSE: BKS  ) figured that it could own Amazon (Nasdaq: AMZN  ) just because it was the brick-and-mortar heavyweight? You could draw some parallels here. Analysts would ask Blockbuster during conference calls what it was planning to do to compete against Netflix, and it would swat away the questions, writing off Netflix's burgeoning popularity as a novelty pandering to a niche market.

Yes, but indoor plumbing was a niche once, too.

Perhaps it was that lackadaisical approach, pressed by investors to do something in that space, that spawned its halfhearted participation in the genre by acquiring the amateurish FilmCaddy.

That came at the same time that Wal-Mart (NYSE: WMT  ) entered the game, looking to undercut Netflix. While Wal-Mart appeared to take its effort more seriously than Blockbuster, practically aping the Netflix site, both predators had flaws bigger than their claws.

With limited disc availability and shipping out orders from a single distribution center, Blockbuster and Wal-Mart were competing against the Netflix of 1999. Wall Street may have been impressed with these beefy bookends of competition, but anyone familiar with the process and Netflix's evolution knew that its rivals were doomed to eat cyber dust.

Blockbuster and Wal-Mart had a conflict of interest. Blockbuster wanted you in their stores, scooping up impulse items or purchasing pre-played versions of overstocked titles. Wal-Mart wanted to sell you the DVD and everything else under its massive roof. So you were never going to get the e-rental service marketed effectively by any person on the sales floor that feared obsolescence. The pitch would have to be flung online, and both parties were too busy burying their efforts away from their flagship site landing pages.

"There was a time when some feared that retailing juggernauts like Wal-Mart and Blockbuster would eat Netflix's lunch," I wrote recently. "It turns out that they're still ordering from the kid's menu."

Lights! Camera! Traction!
But now Blockbuster is looking to eat at the grownup table. It's packing a heavy-duty lunch box, too. After going through the Acme catalog of inept weaponry, Blockbuster is finally armed to have a decent shot at catching the industry's roadrunner. FilmCaddy ceased operations last month. Blockbuster is now taking its online rental business seriously enough to stamp its own brand on it.

Blockbuster used to have a flawed mentality, which assumed just because 65% of the country's population lived within a 10-minute drive of a Blockbuster Video that it would choose that over waiting for a red-colored mailer from Netflix. Under that nebulous delusion, a sober Netflix tiptoed giddily -- opening more than two dozen distribution centers before its competition noticed that Netflix could now serve 80% of the population with what amounted to overnight delivery using standard postal rates.

What Blockbuster failed to recognize at the time (and, heck, maybe it still doesn't get it exactly) is that a 10-minute drive is not a 10-minute experience. Last I checked, Blockbuster doesn't let you watch a rented disc in the store. You need to drive that same distance back home. So that's 20 minutes now. Sandwiched between your keyed ignitions, you have to park. You have to stroll through the aisles for available flicks. You have to stand in line to process that rental -- if they even have lines at Blockbuster these days as in-store rental traffic has been declining steadily.

And you know why Blockbuster has drop-off chutes? It's because folks have to return the rentals when they're done, and they aren't always interested in spending money on the next rented DVD. So that 10-minute drive is now a 40-minute haul in four installments with time squandered along the way in the parking lot and in the store. Is that really more convenient than taking a few steps to your mailbox the next day?

No, no, Antioco.

Yet that stumbling, bumbling juggernaut has finally gotten it right. Blockbuster is running the new service out of 10 different distribution centers to speed the process along. Nice. Its standard plan with three flicks out is just $19.99. Running a buck more than Wal-Mart's service and two bucks a month cheaper than Netflix may not seem like much, but by promising a wider title selection than Netflix and giving its subscribers e-coupons for two free in-store rentals every month, it is ready to compete as long as the deliveries are prompt and title availability runs high.

While the in-store rentals may be a slap in the face to that third of the population that doesn't live a reasonable commute from a physical store, it's a spectacular benefit for Blockbuster because it will provide a great incentive for online users to still frequent the local store.

Kicks for Netflix
Blockbuster is going to be a much harder beast to vanquish this time. That doesn't mean that Netflix can't do it. Netflix has an aggressive online affiliate marketing program to make sure that the service is pimped throughout the Internet at a cost that's a fraction of its typical new customer acquisition expense. It also has a loyal base of subscribers who have filled rental queues and have rated enough movies on the site to the point where Netflix can tap into its database to recommend available titles that they are likely to enjoy. If Wal-Mart couldn't win them over at an $18.76 price point, Blockbuster isn't going to do it at a higher price. The in-store freebies are unlikely to sway the armchair film buffs who flocked to Netflix for its home-delivered convenience.

Blockbuster is going to do a great job converting its own in-store users into online renters, but that may eventually backfire if all it does is educate the mainstream. If Blockbuster doesn't deliver the goods, in every sense of the word, it will open the floodgates heading toward the proven Netflix. That's when that 5% market penetration threshold will no longer be a ceiling, but a catapult.

What will the future hold for the industry? It's more exciting than you think. Come back next Friday, my lovely grandchildren. This story only gets better.

Fool co-founders David and Tom Gardner duke it out every month in the pages of their Motley Fool Stock Advisor. Each picks a stock and does his best to shoot holes in his brother's pick.Subscribe today for immediate online access to their top stocks!

Longtime Fool contributor Rick Munarriz will admit that the only time he enjoyed the theatrical cliffhanger was when.... Where were we? Right. The disclaimer. Rick owns shares in Netflix. The Motley Fool is Fools writing for Fools.


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