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Netflix Moves Up in Class

Kevin Kelleher

Netflix (NFLX Quote) vs. Blockbuster (BBI Quote) is history. Long live Netflix vs. Apple (AAPL Quote).

If a company's status can be measured by the rivals that analysts and journalists pit it against, then Netflix has just taken a big step up in the world.

In a research note on Thursday that gave Netflix's stock a brief pop, Lehman Brothers analyst Douglas Anmuth upgraded Netflix shares, saying that the company will "transform" the video rental industry.

The report sent Netflix stock up 5% to $28.49 early Thursday, its highest level in nearly three weeks (it closed at $27.67, up 2%, amid a broad decline in tech shares). Blockbuster's stock fell 2.3% to $4.61 Thursday. Netflix's market value has not only surpassed Blockbuster's $879 million capitalization, at $1.65 billion it's nearly twice as big.

Strong customer satisfaction is causing Netflix's subscriber base to grow faster than Anmuth had expected: He now says it will expand to 5.24 million at the end of the current quarter, up from his previous estimate of 5.2 million; and to 6.47 million at the end of this year, revised up from 6.4 million.

That growth is giving Netflix a critical mass of subscribers that, Anmuth said, will mean "stronger word-of-mouth advertising and driving further closures of traditional retail rental stores." In other words, the gold-and-blue blockbuster signage in your local strip mall will soon find its way on the endangered-species list. Blockbuster closed 4% of its U.S. stores last year and is poised to close more this year.

This isn't news to investors who drove up Netflix's stock above $39 in early 2004 -- a rally predicated on the belief that Netflix would become the premier provider of DVDs.

It is news, however, for naysayers who drove the stock down below $9 in March 2005. Since that time, Netflix has more than tripled.

So, while the early Netflix bulls pat themselves on the back, other investors are turning their focus to what lies ahead: digital movies streamed over the Net and into the homes of film buffs. Netflix customers and investors have been calling for this for years. Only now is that tantalizing goal starting to come within reach.

And that's where Apple comes in. In his report, Anmuth said Netflix is likely to see increased competition from Apple and Amazon.com(AMZN Quote), though he warned that consumers may be slow to leave the DVD format.

But Apple has been boldly doing its best to prove Anmuth wrong on that last point. In the same way that Netflix has been turning the video store into a historical relic, Apple is quietly laboring to turn the DVD itself into a thing of the past.

Apple is working on a new generation of iPods that many observers believe will come with enhanced video-playing abilities. Recent news reports have said that when the new iPods are unveiled this fall, the company will also introduce full-length movie features for downloads on the iTunes site for $9.99 each.

According to the trade publication Variety, Steve Jobs has been in intense talks with Hollywood studios, which are apparently freaked out about that three-digit price. But if the reports are true, Jobs is again shrewdly ahead of the game.

New DVDs can already be bought at only a small premium above that level: On Amazon, the best-selling DVD Thursday was Syriana, going for $13.87. The second-best seller was The World's Fastest Indian, selling for $12.87. Subtract out the packaging, marketing and distribution required to sell those DVDs, and $9.99 starts to sound like a reasonable price for a downloaded movie.

No stranger to tipping over apple carts, Jobs is clearly interfering with Netflix's plans to move stealthily and discreetly toward downloaded movies. To date, Netflix has been terribly bashful about when -- and what -- it may do in this new world of movie distribution.

Things took an abrupt lurch forward when Variety reported that Eric Besner, Netflix's vice president of original programming, as saying that the company is planning planning, as early as this year, "to introduce a proprietary set-top box with an Internet connection that can download movies overnight."

Besner reportedly said that the service would keep the front-end interface, where movies automatically download according to what's in a customer's queue, and that subscription fees would not be comparable to DVD rentals.

It took only a few hours for Netflix to clumsily backpedal. The blog Hacking Netflix quoted a Netflix spokesperson who said Besner's comments were taken out of context. And Netflix issued an SEC filing offering some new context regarding set-top boxes: The company "is evaluating a broad range of options," -- of which the set-top box is just one -- "and no decisions have been made regarding specific delivery options or timing."

That filing may have been an attempt to obscure Netflix's true plans. But, reading between the lines, it's actually revealing of what is really going on. The movie studios know that downloading movies is as inevitable as downloading music. But apparently there's no consensus on how to profit from it.

Most likely, the studios want to make it as expensive as the market will bear, whereas providers like Apple and Netflix are trying to keep the costs low to win customers over quickly. And most likely, Netflix wants to introduce its set-top boxes in time to beat out Apple, but doesn't want to slow things down by angering the studios unnecessarily.

So, as Apple and Netflix race to become the leading provider of downloaded movies, the first round will go to the company that does the best job of winning over the studios. Clearly, Apple is taking a more aggressive approach, and Netflix is struggling to be as diplomatic as possible.

Who will win this round? I'd put my money on Apple, for now. Studios aren't likely to budge unless they're pushed. Apple's near-term future rests on a strong holiday season. And if a holiday sales means selling movies through iTunes, count on Jobs to stop at nothing to make it happen.