I looked at a few potential suitors for Netflix
Of course I'm jumping the gun here. Netflix is still a great company, blessed with a cash-rich balance sheet. Still, doesn't that make this the ideal time to punch out -- on its own terms -- before any future shortcomings take whacks at both its share price and its bargaining power?
Fellow Fool Tim Beyers disagrees with me. Like you, I imagine, he believes that the company's best bet is to remain independent.
"There's no reason for CEO Reed Hastings to sell his company right now, at the dawn of the age of video-on-demand," he writes.
I couldn't disagree more. In fact, many of the points Tim makes for sticking it out as a stand-alone company are, I find, actually even better reasons for getting out while the going is still good.
The mad dash for cash
Tim makes a convincing case of looking at the company's productive past. That's dangerous. Let me borrow his free cash flow and net income tables to prove my point.
|
Free Cash Flow |
Total |
|---|---|
|
Trailing 12 months |
$240.0 |
|
2006 |
$220.6 |
|
2005 |
$129.8 |
|
2004 |
$129.6 |
|
2003 |
$80.9 |
|
2002 |
$37.3 |
Numbers in millions.
Free cash flow is obviously an important growth metric. Some would argue that it is the only growth metric worth watching. However, something happened just after this year's second quarter came to a close. (Read more about Netflix's second quarter here.) In a move to battle back against patrons defecting to Blockbuster's
Tim also tempted you with the company's healthy bottom-line growth, again by looking back.
|
Net Income |
Total* |
|---|---|
|
Trailing 12 months |
$63.1 |
|
2006 |
$49.1 |
|
2005 |
$42.0 |
|
2004 |
$21.6 |
|
2003 |
$6.5 |
|
2002 |
($20.9) |
Numbers in millions.
We don't even have to guess on this one. The company recently talked down its near-term earnings power. It is now looking to earn between $7 million and $17 million over the final two quarters of 2007.
If we double that to get a snapshot of how the next 12 months will pan out -- and that's a generous assumption, given that the first quarter has historically been a seasonal slacker at the company -- we get to $14 million to $34 million in net income over the next 12 months. That sets the company three years back on the profitability table.
In other words, if you are clinging to free cash flow and net income growth as the biggest pompons in your Netflix cheer, you're going to be in for a world of heartbreak in the near-term.
The size of the DVD rental market
Now that Netflix suffered its first quarterly dip in subscriber growth -- closing out the second quarter with 55,00 fewer subscribers than it started with -- there's an awful lot of humility at Netflix. The company that once figured that it would close out 2007 with as many as 2.1 million additional members is now looking to tack on between 100,000 and 600,000 subscribers over the second half of the year.
That's a pretty somber number, especially since Netflix is banking on the lower prices to drive a lot of that low-margin traffic. This may lead one to consider the actual size of the DVD rental market.
Let me show you a stat that you don't see every day. And let me also see whether you can guess what it is before I spill the beans at the other end of these bullet points.
- 2003: 0.9 million
- 2004: 1.6 million
- 2005: 2.2 million
- 2006: 3.1 million
- 2007: 2.1 million (through the end of June)
These data points would make for an impressive trajectory if it were a sign of growth. Alas, it's the number of Netflix members that have cancelled their subscriptions. Clearly, the number will get larger as the established base grows, but that's the not the point that I'm trying to make. What do you make of 9.9 million subscribers -- far more than its active base of 6.7 million members -- that have walked away?
Sure, some of those people cancelled and came back later. Some migrated to Blockbuster, even though one has to believe that the bulk of 3.6 million Total Access subscribers consist of in-store customers who have converted to the mail-delivered model. Others have been burned by the throttling at Netflix or simply didn't have the time to justify the investment.
The one common variable that applies to most of the nearly 10 million people willing to walk away from Netflix has to be that Netflix did not offer a compelling enough value to continue as a member. A buck isn't going to change that. The market consisting of homes with DVD owners who rent movies numbers in the tens of millions, but too many rent too sporadically to commit to $17 or $18 for an unlimited plan. Netflix has responded by promoting lower-priced plans, but this is clearly an industry where the low-lying fruit has been picked clean already.
Watch now or later
Tim's final point is that Netflix's flick-streaming service will be a key driver in the future. Let's hope it doesn't come to that. If you think battling Blockbuster is bad, the digital-delivery market is going to be even more cutthroat.
Netflix's well-oiled engine of regional distribution centers was enough to keep Amazon.com
Where's the moat in digital delivery? Where is the competitive advantage for Netflix beyond its data-rich user base that has stalled? Wealthier companies have fatter incentives in making a splash in digital delivery. Microsoft
Why should anyone expect Netflix to be a lead player here just because it's the top dog in sending optical discs into your mailbox?
Let me take this one step further and press you to ask the one question that few of these digital-delivery upstarts seem to be asking themselves: What is to stop the movie studios from cutting out the middlemen in the future?
There are obvious reasons why studios never built out retail chains to push their movies. It's cheaper and easier to reach more people by stuffing every retail channel possible. That is not a roadblock to digital delivery. Sure, the studio will want in on every digital-distribution outlet available initially, but it's really just a matter of time before they want a direct line from content creator to connoisseur. Studios may have fumbled their first shots at digital distribution with sites such as Movielink (which Blockbuster just acquired), but they'll get it right eventually.
So why shouldn't Netflix cash out now? Why shouldn't it punch out before its financials deteriorate, subscriber acquisitions become even more difficult, and the rest of the market realizes that the digital-delivery industry driver may not ask Netflix to ride shotgun?
I'm not done. I have a few more potential Netflix suitors -- companies that will benefit by owning Netflix even if I'm right about the industry's tricky future -- that I will discuss later this week.
Previous entries in the Tim-vs.-Rick throwdown:
- Rick argued that Amazon.com would be a good suitor for Netflix.
- Then he argued that Mr. Softy would be even better.
- Tim thinks Rick is crazy.
Amazon.com and Netflix have been recommended to Stock Advisor subscribers. Wal-Mart and Microsoft are Inside Value newsletter service stock selections. Free 30-day trial subscriptions are available for both stock research offerings.
Longtime Fool contributor Rick Munarriz owns shares in Netflix. He has been a shareholder and subscriber since 2002. He is part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy, and it's a designated driver once that third drink kicks in.
