FOOL ON THE HILL
No Hooray for Netflix

Last month's stock market debut of DVD home-delivery specialist Netflix may have been well received but it is no blockbuster epic. Despite the heady growth on the surface, one Fool sees some serious flaws in the company's business model. Flick Netflix, Rick Munarriz says. He has his reasons.

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By Rick Aristotle Munarriz (TMF Edible)
June 10, 2002

Did I just wake up in 1999? A profitless dot-com went public two weeks ago with a business model that's heavy on the Swiss and the market is okay with this? I mean, no offense, Netflix (Nasdaq: NFLX), but you were pretty much the last company I expected to see come barreling down what had been a chilly Initial Public Offering gateway. But, here you are, walking down the red carpet with the paparazzi flashing away, and I'm on the other side of the velvet rope scratching my bewildered head.

For those who don't know Netflix, the company pioneered the all-you-can-eat direct-mail business model for DVD rentals through its namesake website. Subscribers pay $19.95 a month for the basic subscription plan that entitles users to order DVDs online. Netflix foots the shipping tab each way and there are never any late fees. You just have to return the movie you have to get the next one.

Founder Reed Hastings dreamed up the concept after renting Apollo 13 at his neighborhood Blockbuster (NYSE: BBI), only to be hit with $40 in late fees when he returned it a month later. Reed, bro, is this really a story you want to go around telling people? What? You didn't know how the movie was going to end? You had to brush up on the entire cast for your next Six Degrees of Kevin Bacon home party? Come on, now. This exact experience in the concept you created would still run the return slacker a hefty $20 in subscription fees. I realize that every dot-com is under pressure to come up with some crazy story to keep up with eBay's (Nasdaq: EBAY) Pez dispenser roots, but please.

Now I realize that I am probably an unlikely suspect to take swings at Netflix. Last month, I wrote about Wall Street underestimating the potential of the DVD market. Back in April, I wrote about the refreshingly unheralded revival of Internet stocks. On the surface, Netflix should be the peanut butter meeting the chocolate -- the grenadine diving into the ginger ale. But it's not. Logic is a twister, and Netflix is a trailer park.

I guess I better start explaining. It all begins with retention. Netflix has an awesome sales pitch. It's the glutton's dream: a smorgasbord that never rushes you out the door with free shuttle service to and fro. It's paradise, until the kinks pull the plug on the fa�ade. You realize that the shuttle service can run days slow in a world where instant gratification is the norm. You show up, pay up, only to find that some months you just aren't all that hungry. The novelty wears thin, and I'm not just assuming that.

On an average month, Netflix will lose 8% of its subscribers. Multiply that by 12 and the annual turnover under hypothetically constant numbers is a staggering 63%. So, how good is this service if most members are giving Netflix the heave-ho within their first year. Could Blockbuster survive with that kind of defection rate?

The juggling lessons don't come cheap. Netflix has to make sure it's paying DVD player manufacturers to stock trial-offer literature as well as tie-ins at the retail level with companies like Best Buy (NYSE: BBY) and costly online ad campaigns. To be sure, last year the company spent $21 million in marketing costs to produce what amounted to just $26 million in gross profits. It has little choice but to keep pouring new water into the bucket with a hole.

Maybe this would be an acceptable business practice if there were some semblance of a profit at the end of the day, but there isn't. The company has amassed just over $140 million in accumulated deficits in its brief tenure. If this is all Reed wanted to do, he could have simply held on to his copy of Apollo 13 for another 291,666 years.

While the financials have been improving over the past few quarters, they are still no better than your garden variety Bond flick intro. You know, a shot is fired and the red ink runs down. Is there a catalyst to land Netflix into the camp of profitability? Just call me Dr. No.

Let's take a look at the company's most recent fiscal period. In the March quarter, Netflix posted revenue of $30.5 million. Gross profits of $15.4 million marked the first time the company's gross profit margins topped the 50% mark -- obviously a good sign -- until you begin to nickel and dime the operating expenses. With $7.9 million to placate the marketing tiki god and another $4.2 million to cover fulfillment costs, you're talking some razor-thin margins even before the other line items like technology, administrative, and stock-related expenses take their whacks.

And speaking of technology, that's one expense item that has dipped over the last two quarters. Want to guess why? Well, it's because what Netflix is doing isn't rocket science. We're talking about barriers to entry about the size of knee-high hedge bushes.

DVDovernight.com was drawing a decent crowd by renting out DVDs for $4 a pop, delivered and returned. Taking a page out of the Netflix playbook, it was able to seamlessly launch its Double Feature Club. For $39.95 a year, the company would waive its late fees on its $4 rentals. So, if you plan on renting out four DVDs or less a month, DVDovernight.com comes out cheaper than Netflix. And if you plan on renting more, well, maybe you're not doing Netflix any favors.

See, the company pays for first-class shipping and sends you a pre-paid envelope for the return. Postage and packaging are not cheap. As a matter of fact, with the post office set to hike rates from $0.34 for a first-class stamp to $0.37 by the end of the month, it's only going to get more expensive for Netflix to be booking all of these roundtrip flights. And the company is in a can't-win situation given its current pricing and business model, where educated consumers can either milk Netflix's free shipping policy to the company's detriment if they're active renters or join the "8 percenters" out the door this month for cheaper, greener pastures.

With roughly 50 million shares outstanding after the IPO, the company's $750 million market cap given the $15-per-share pricing is also troubling. That is 8.6 times the company's trailing sales. Meanwhile, traditional rental chains like Blockbuster and Hollywood Entertainment (Nasdaq: HLYW) are commanding healthier gross profit margins and trading at just 0.8 their annual revenue rates.

Yes, Netflix is growing aggressively, but for how long? Making matters worse, Blockbuster will be testing its own all-you-can-eat DVD plan this summer. So, while Netflix has been able to ride the coattails of DVD growth, its own momentum is being threatened by everything from instant competition to trying to replace the growing ranks of ex-subscribers with the lower income audience that was waiting for DVD players to dip below $100 to buy into the format.

All this will crush any kind of pricing flexibility Netflix might have had, and, if I can submit past financial statements as evidence, the company's gravy days have run bone-dry as it is. The problem is that the strengths in the Netflix game plan are more sector-specific than Netflix-specific, and they aren't really tilted in the company's favor, anyway.

Yes, DVDs are an inventory dream over the bulky VHS tapes that are often in need of rewinding, but they are also more prone to get scratched being mailed all over the place than through walk-in rentals. Yes, Netflix has established revenue-sharing agreements through 80% of its titles, but it was Blockbuster that started that favorable industry trend and it is the one that commands the real bargaining power. Yes, Netflix is starting to build new distribution centers beyond its Bay Area stronghold to cut down on delivery times, but if business ever approaches profitability what's to stop the likes of Blockbuster, WalMart.com, and Amazon (Nasdaq: AMZN) from diving right in with lower overhead and a larger captive audience since they already have the infrastructure in place? There are no alternate happy endings here. Netflix will either die alone or suffer in the crowd. Los Gatos, we have a problem.

If I'm right, Reed will come to regret the day he failed to get Apollo 13 in on time.

Be kind. Rewind.

Rick Aristotle Munarriz once kept Tucker: The Man and His Dream out for a month but the only thing the late fees inspired was punctuality. Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.