FOOL ON THE HILL

Netflix: a Blockbuster?

Four months ago, Rick Munarriz took a wrecking ball to Netflix. With the stock shedding more than half of its value since then, Rick is wearing a new hat this time: shareholder. While many of his concerns have played out and continue to weigh the company down, all hope isn't lost for the online DVD rental company.

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By Rick Aristotle Munarriz (TMF Edible)
October 14, 2002

Easter Eggs. That's what Netflix (Nasdaq: NFLX) calls the hidden surprises movie studios pack into their DVD releases, such as interviews, clips, and quizzes, to reward and entice viewers.

This column is like an Easter Egg, actually: You'll be surprised to find me praising the investing merit of Netflix, and hopefully, you'll find my insights rewarding.

In June, I took swings at the online DVD pioneer in No Hooray for Netflix. I was brutal, and I meant it. With the stock closing at $16.19 that day, I saw trouble ahead. I took a great deal of heat from investors and satisfied customers alike, but I have no regrets. I think I nailed it.

Now, before I begin to toot my own horn, let me point out that I learned how to play this horn by ear. I'm a modest guy. Really. In the spirit of self-effacing accountability, I was also the one who figured Webvan and Rainforest Cafe would rule the world by now. I miss. Often. But not this time.

I feared that the business model's low barrier to entry opened the door for Blockbuster (NYSE: BBI), Wal-Mart (NYSE: WMT), and Amazon (Nasdaq: AMZN) to arrive as potential threats. I was right. Two of the three have now thrown hats into the ring. I may have been the only financial writer to publicly share my shock over Netflix's alarmingly high defection rate in June, despite the fact that it was easy to find in its prospectus. Four months later, the suddenly popular concern over the company's high churn rate has dropped the stock into single digits.

So, in a plot twist of M. Night Shyamalan proportions, I became a Netflix shareholder earlier this month. I didn't nail the bottom. I wasn't fortunate enough to nibble as the stock dipped below the $5 mark last week. However, after some deep soul searching and value trolling, I've come to realize that the only thing more unfounded than the misplaced optimism of June is the overblown pessimism of October.

Are you familiar with Netflix? For $19.95 a month, you can borrow up to three DVD releases. Netflix pays the shipping each way. You can set up your rental wish list in an online queue. Return a disc, and the next title is on its way. Various all-you-can-eat plans go as high as $39.95 for eight DVD rentals at once. It all depends on your appetite for celluloid.

Netflix has grown virally. Word of mouth. Office water-cooler envy. Like a pro bono law firm, Netflix also lives for free trials. Thanks to an aggressive affiliate program, the company pitches 14-day free trials all over cyberspace and packages them with new DVD players. With 742,000 subscribers at last month's end, it's safe to say it has arrived, in terms of achieving critical mass.

But now we come to the first fundamental roadblock -- subscriber churn. On any given month, the company loses 7.2% of its users, on average. That's pathetic. I think college algebra comes with a higher retention rate. But what no one's saying is that for every customer exiting stage left, two new subscribers enter stage right. As bad as the turnover seems, the company still grew its user base in the third quarter by 11% sequentially. Netflix customers have more than doubled over the past year. If your gas tank leaks a drop of fuel for every two drops going in, trust me, you'll go places.

Exploring the churn rate more closely, we can't ignore the impact of free trials. The company had 708,000 paying subscribers at the end of last month. The other 5% consisted of newbies on 14-day trials. So if the introductory freebies last two weeks, it's safe to assume that about 10% of the users over the course of a full month are in for the free ride. That obviously skews the results, as these customers are less likely to stick around than a converted, paying believer. So, while I would love to see the churn rate improve, the end results don't justify the cynics' remarks. Netflix is growing, even if it means one step back for every two forward.

The DVD market itself also needs some statistical lovin' right now. According to the Consumers Electronics Association, DVD player sales in the U.S. are expected to climb by 40% this year. While more than 35 million household DVD players pales in comparison to the number of VCRs, the trend is clear. Last month, Pixar's (Nasdaq: PIXR) Monsters, Inc. moved an impressive 11 million home videos in its first week. The distribution is significant. Seven million DVDs. Only four million VHS tapes.

DVDs are cool, compact, and relatively cheap to make. Netflix thrives on this, as it's able to send the disc in a thin yet efficient mailer, keeping first-class postage to a bare minimum.

It's no surprise that DVD rental chains, such as Blockbuster and Hollywood Entertainment (Nasdaq: HLYW), have been producing solid results since last year's terrorist attacks. We've rediscovered the joys of staying in. With troubling sniper incidents and our country positioning itself for war, the armchair feels like comfort food -- and with Netflix, even a hermit of Emily Dickinson proportions can enjoy the latest home video releases.

The model is so perfect that the big boys are moving in. Blockbuster, Wal-Mart, and Columbia House are looking for a piece of the action, but let's not assume Netflix is toast. For starters, remember when Walmart.com assumed it would upstage Amazon, just because of its massive bricks-and-mortar presence and retail know-how? It has yet to happen. In many cases, an offline reputation is more of an online liability than an asset. Are you really drooling in anticipation of hooking up with the Columbia House DVD buffet? Does anyone associate Wal-Mart with title variety? Sure, I remember when Wal-Mart, Target (NYSE: TGT), and Kmart (NYSE: KM) thought they could eat Amazon for breakfast. Wal-Mart and Kmart have resorted to perpetual site relaunches, and Target got smart and handed Amazon the keys to its store.

As far as operations go, don't think that size will bring might. Blockbuster is huge, but with only one distribution center in Texas. Wal-Mart's direct-mail venture will work out of its distribution center in Georgia. Netflix? It already has nine different distribution centers up and running.

Do you think someone living in San Francisco, where Netflix has proven it's strongest (a 3.5% household penetration, given its San Jose distribution hub and marketing emphasis), would choose vanilla-flavored Wal-Mart, which mails out DVDs from the East Coast, just to save a buck every month? Don't bet your cookie cutter on it.

Netflix will continue to grow. It reported $76 million in revenue last year. Wall Street is looking for that sum to double to $150 million this year, and hit $237 million come 2003. The company expects to be consistently profitable on a pro forma operating basis by the middle of next year, but it has produced free cash flow every single quarter this year. Thanks to its IPO earlier in 2002, Netflix sports a debt-free balance sheet, with roughly $4 a share in cash. The fact that the shares fell close to that green mark last week just goes to show how forgotten Netflix has become.

But I haven't forgotten. As it ramps up regional distribution centers, I can only begin to wonder what will happen when the rest of the country -- in which the company's household market penetration is just 0.6% -- catches on to Netflix.

Maybe I'm just stating the obvious, but you can connect the dots to see where Netflix will go from here. With all three video-game systems now disc-based, a game service can't be far off. What about sponsors subsidizing shipping costs in exchange for marketing inclusion rights in mailers? Impulse retail? Services?

But let's not get ahead of ourselves. Netflix has plenty going for it in its present form as, in my opinion, a Rule Breaker on training wheels. It can afford to keep all of its Easter eggs in the same basket for now.

Blockbuster announced it's looking for acquisitions, and even if it were to buy out Netflix at twice its current price, it would still run cheaper than what Blockbuster made in late fees alone last year. I don't foresee Netflix cashing out, though I can imagine the line of suitors will be long once the offline retailers stumble.

And stumble they will. See, I've seen this movie before. I know how it ends.

Rick Aristotle Munarriz once kept Tucker: The Man and His Dream out for a month. All he got out of it was late fees. Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.