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High Noon for Netflix

Kevin Kelleher

Netflix is ending 2006 with something of a cliffhanger: Will our intrepid hero, mired in a swamp of rising costs, be slain by archrival Blockbuster ? Or will it escape to scale new heights of market cap?

Analysts have been debating the outcome like obsessed cinephiles in the chat rooms of JoBlo.com.

The plot thickened earlier this month when Bank of America analyst Brian Pitz set a $24 target on Netflix with a warning about falling operating margins. The stock, which was trading at $28.40 before the report, has lost 5.5% of its value. (Netflix shares were recently up 2.4% to $26.82.)

Pitz's dim view was a departure from the largely bullish assessments that Wall Street had for the DVD-rental company in the wake of a stronger-than-expected third quarter.

Pitz argued that higher spending on marketing (23% of revenue in 2006, up from 18% three years ago), and an anticipated $40 million the company will spend to get ready for digital downloading of movies, will pressure margins even as Blockbuster is pushing a new service that will couple its online rentals with cheap and easy access to its stores.

"We could see ... operating margins coming under more pressure than the Street anticipates," Pitz wrote. "Shares (and ultimately earnings) of other Internet companies such as Amazon , eBay , Yahoo! and GSI Commerce have declined as a result of operating margins being impacted by spending initiatives." Bank of America has no underwriting relationship with Netflix.

Another cloud that some see hanging over Netflix's head next year is the anticipated rise in postal rates, which is expected to require the company to pay another 6 cents every time one of its DVDs is mailed out and returned. The proposed postal hike is expected to take effect next summer.

Over at Cantor Fitzgerald, Derek Brown took encouragement from a little-noticed bill passed in Congress that could delay postal-rate increases beyond the one expected next summer. The measure, which shifts some retirement costs of postal workers to the Treasury's budget and could save the postal service $3 billion a year, must still be signed by President Bush.

Netflix's current guidance assumes the postal increase will occur, and Brown said he won't change his profit estimates until the proposed bill is passed. But Brown, who has a $39 price target for the stock, wrote that he is "very encouraged by this latest turn of events and [is] optimistic that guidance/forecasts could move higher in the not-too-distant future." Cantor Fitzgerald has no underwriting relationship with Netflix.

Others feel that the concerns about the potential for Netflix to increase its subscriber base are overblown. According to Youssef Squali, an analyst at Jeffries, Netflix added 493,000 new subscribers last quarter, bringing the total to 5.7 million, and topping Squali's own estimates by a good 60,000 subscribers.

Even in Netflix's more mature markets like the San Francisco Bay Area, its DVD rental service is being used in 14.9% of households, up from a 14.1% share only three months earlier and 13.6% three months before that. Churn rates -- the percentage of users who stop service -- in the area are lower than average.

"Its DVD-rental service remains in the healthy growth phase in its oldest and highest penetrated market," wrote Squali, whose firm has no underwriting relationship with Netflix, "which also bodes well for other markets throughout the U.S."

And that gets us back to the advertising budget. Is Netflix's ad spending boosting revenue growth? Given the rising market penetration in its most mature market, it seems so. And while Netflix has spent an estimated $550 million to date to build its brand, consider what it has to show for that spending.

When people order videos online, they talk about "Netflix." When they drive down to the corner video store, they say they're going to "the video store." They only mention Blockbuster if that's specifically where they're going. Blockbuster never became the generic brand name that Netflix has in less than a decade -- that tells you something about the Netflix brand.

And however much convenience customers find in Blockbuster's Total Access plan, which lets you rent a new DVD on the spot if you return a mailed DVD to one of its stores, it's a desperate move that will likely prove to be a loss leader. Not only is the program's appeal limited (Blockbuster stores aren't as ubiquitous as they used to be), it will likely drive up Blockbuster's spending without necessarily delivering Netflix-like growth.

But if Netflix is able to dodge for a while the obstacles of postal rates, marketing costs and Blockbuster, its biggest concern could very well turn out to be the company's own shortsighted policy of delaying shipments to subscribers whom it believes order too many DVDs in a month. That's punishing your most loyal customers -- a kind of slow but sure corporate suicide.

In order to stop alienating movie buffs, Netflix should consider revamping its pricing structure or -- much better -- making its operations even more efficient. A smart company would see the problem of frequent customer transactions as an invitation to innovate -- maybe overhauling the distribution structure or introducing a loyalty program like Amazon Prime.

That's the real cliffhanger for Netflix. Otherwise, it will watch its core audience drift away, and that would result in one of the unhappiest endings of all.