Netflix's Best Hope: Getting Bought

The Netflix vs. Blockbuster net online DVD-rental cost comparison is more accurately $17.95 (Netflix cost per month) vs. $9.50 (Blockbuster per month, net of the coupon benefit). When Blockbuster integrates its online offering with its store network next year, expect this gulf to widen. There's no postage expense to Blockbuster, for example, when subscribers pick up and drop off DVDs at Blockbuster stores. And don't underestimate instant gratification. On impulse, consumers will be able to pick up a movie next year at Blockbuster locations. Compare that with Netflix, which uses the U.S. mail for delivery.

It is interesting to note that Blockbuster has reported that the DVD coupons given to online customers are being redeemed at a very high rate. Blockbuster tracks these redemptions, of course, and it's finding that the coupon redemptions are increasing store traffic, creating additional marginal sales and rentals.

But Blockbuster Shares Look Underpriced

While the market is overpricing Netflix's stock, it is also materially underpricing Blockbuster shares. Back out a temporary surge in expenses for store remodelings that will ramp DVD trading and video-game sales, plus expenses for the online business start-up, and the company is selling at about 6 times normalized earnings.

It's possible that Blockbuster stock is heavily discounted because of the perceived threat from video-on-demand and movie downloading via the Internet. But anyone who understands the movie studio industry knows that the distribution system is not materially going to change anytime soon. The studios will never willingly disgorge their tens of billions of dollars of profits from the sale of DVDs -- sales made to consumers and rental retailers like Blockbuster.

Not too many years ago, the advent of Betamax and VHS was supposed to be the death knell for movie theaters. And more recently, online book-buying was going to be the end of book retailers like Barnes & Noble (BKS - commentary - Cramer's Take) and Borders (BGP - commentary - Cramer's Take). Now pundits are saying that we're close to "the end" of Blockbuster's movie rental business. My assessment is quite the contrary. In a couple of years, I think we will look back and see that Blockbuster stock, selling at a normalized price-to-earnings ratio of 6 in 2004, turned out to be a real blockbuster.

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At time of publication, Alsin and/or ACM was long Blockbuster, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail].