Launching a stock newsletter -- as we have recently done with David Gardner's Rule Breakers -- usually doesn't require much in terms of explanation. Just the mere mention of some of our other newsletters, like Income Investor, Inside Value, and Rule Your Retirement, seems to convey the appropriate image. But what exactly is a Rule Breaker? Are we looking for the next Microsoft
Well, while there may be just cause in launching a newsletter to single out naughty corporate citizens ripe for shorting, Rule Breakers is actually seeking out the rebels worth buying into. It's not easy to break from the pack heading toward the familiar and proven feeding grounds. However, it is usually that type of unconventional thinking that, while obviously entailing a good chunk of risk, often results in the most rewarding returns.
Looking at Netflix
Would consumers -- raised on ordering off the a la carte menu -- come to appreciate the Netflix smorgasbord alternative? With just over 2.2 million subscribers, you know the answer to that one. For 11 consecutive quarters, the company has been able to grow its net subscriber count by at least 70% over the previous year's tally.
Respect doesn't RSVP
But breaking the rules -- and doing so with brilliant results -- is sure to draw a crowd. Tracking the renegade breadcrumbs is a breeze as the Rule Breaker becomes the new reluctant leader.
Back in June 2002, I was worried about the sector's low barrier to entry and singled out three companies that could pose a threat to Netflix. I probably should have bought a lottery ticket that day because those three companies -- Blockbuster, Wal-Mart
The price war soured the company's record third-quarter results. While the company's proactive move may be what keeps the Amazon windmill away, drives Wal-Mart out completely, and poses a dilemma for Blockbuster if it prices its offering so low that it devalues its in-store business, investors have driven the stock down because whether it's airlines or computers or loaned-out DVDs, it's the consumers and not the companies that win when a pricing war is waged.
So what is Netflix worth? We can't look to the past anymore and apply traditional gauges of value. Unfortunately, the company's new pricing strategy renders past income statements obsolete. Even the December quarter can be thrown into the bonfire because the lower rates are being applied during the billing dates throughout the month of November. So it will be an illusory first half of the period blended into the low-margin close that is likely to typify the next few income statements.
However, we can accept the company's cash-rich balance sheet. Netflix closed out its September quarter with $167.8 million, or $2.60 a share, in cash. While earnings will take a hit next year, Netflix expects to remain profitable. So even if the company's business were worthless -- and it is not -- we would at least have a bottom. But you aren't buying into the Netflix Money Market Fund, are you?
Will the $17.99 solution accelerate subscriber growth? Perhaps. If the company was able to grow its subscriber headcount by 73% over the past year at higher prices despite Wal-Mart's presence and Blockbuster's bold effort, that shouldn't be a problem. It expects to close out 2005 with more than 4 million subscribers.
Amazon's entry -- or Blockbuster doing something drastic to remain relevant -- can always trip up those numbers, but I'm inclined to bet against it. For starters, Blockbuster didn't slow Netflix any when it priced its monthly service two bucks less than Netflix. That gap will now be all of two quarters come November. Why didn't Blockbuster go even lower? It's probably because it still has its in-store business to protect. While Blockbuster can't afford to lose this fight, it can't afford to win it at the wrong price, either. If it were giving away two free in-store rentals a month and pricing its service at $15.99 a month to stay cheaper than the basic Netflix rental plan, how would that make the walk-up consumer feel who is paying $5 for a single new release that has to be rushed back?
As for Amazon, it's anyone's guess at this point if the company is committed to opening the regional distribution centers that Netflix and Blockbuster have opened to provide the vast majority of subscribers with what amounts to overnight delivery at standard postal rates. Amazon has a trusted name, it sells a ton of DVDs, and its IMDB.com movie data site is a popular bookmark, but that alone doesn't guarantee success unless it enters the market at a lower price point than Netflix and Blockbuster. Does that seem likely? Given the way the market punished shares of Netflix when it announced its pricing strategy, could Amazon expect a $16.99 foray to be well-received? I doubt it.
Earlier this year, under a kinder environment, Netflix figured that it was two years away from producing as much as $200 million in free cash flow a year on $1 billion in revenue with 5 million subscribers. The price cut obliterates the cash flow target and shaves the revenue potential while accelerating the subscriber milestone.
At $10 a share, if you back out the company's cash, you arrive at an enterprise value just shy of $500 million. With the company likely to lap the $1 billion revenue mark come 2006, is buying Netflix at half that sum a bargain? While that's similar to the multiples of companies like Blockbuster, that would be dismissing the company's growth and its online advantages. Amazon trades for a few times more than its annual revenue.
But what about the bottom line? The Netflix that was approaching 50% in gross margins and turning out aromatic double-digit net margins this past quarter? That company dies in November.
More money to be made
When a stock falls by just over 40% in a single day due to a self-inflicted wound -- as shares of Netflix did last Friday -- it begs to be addressed.
But why are we assuming that Netflix isn't capable of running leaner and growing in other areas? The company has already said that it will eventually roll out its service in the United Kingdom and next year it will spell out its plan to team up with TiVo
There is more money to be made. If it capped its "unlimited" monthly rentals -- a move that would only dissuade the hyperactive renters and DVD-burning pirates -- and started charging $2 to $3 for every additional rental, wouldn't that promote more responsible gluttony? With a growing audience, why doesn't Netflix sell advertising on its mailers or incorporate paid search ads onto its website?
Netflix can also create a sticky value proposition while stretching out the length of time that its titles are rented out by sending subscribers an email a week after a new title goes out, highlighting the various Easter Eggs, film gaffes, and trivia tidbits to watch for on repeated viewings.
Yes, it stings to see those third-quarter results crisping away into embers. If Netflix were to achieve the same 13% in net profit margins over the course of a $1 billion year, it means that you could buy the stock today for less than five times those eventual earnings. Yet somewhere between the worst-case scenario and the fluffy nostalgia lies a stock that has been marked down to the point where it is tempting Netflix to break the rules yet again. As inertia would have it, that's just what Rule Breakers do.
How do you think Netflix can make up its fiscal shortcoming with its lower rates? Does it really have to? All this and more in the Netflix discussion board. Only on Fool.com.
Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and investor -- since 2002. He is part of the Rule Breakers analytical team that will be looking to unearth the next Netflix early in its growth cycle.