The Flock Around Netflix
The unraveling of
Blockbuster's
(BBI) - Get Report
bid for
Hollywood Entertainment
(HLYW)
could leave
Netflix
(NFLX) - Get Report
as the coveted white tiger in the video rental war.
The pioneering DVD-by-mail subscription service just dazzled Wall Street, reporting that it now has more than 3 million subscribers, with more than 400,000 signing up so far this year. That puts it on track to reach its target of 4 million by year-end. The unexpected milestone sent its beleaguered stock up 8% Monday and signaled to some that the company's business model might be able to withstand Blockbuster's entry into the market.
Such staying power could make it the next acquisition target in this consolidation-happy market, with Blockbuster weighing its next move and
Amazon
(AMZN) - Get Report
, the online retail leader, maybe poised to enter the fray.
Subscription-based rentals, combined with digital cable's premium movie channels and video-on-demand technology, have whittled down Blockbuster's traditional retail business. Since 2001, the movie-rental industry has shrunk by 19%, the number of stores has dwindled and trend-watchers predict the landscape has only begun to change. Since the beginning of 2004, shares of Blockbuster have shed over 20%.
Netflix has fared worse. Its stock is off 63% since the start of 2004, even with its recent gains. The major selloff began last fall, when Blockbuster started its own subscription-based, mail-delivery service, low-balling Netflix's monthly fee by several dollars. When Netflix announced its own price reduction, market watchers figured Blockbuster had its fledgling rival on the ropes and selling persisted.
While the stock still attracts an army of short-sellers, Netflix fans see its ability to add more subscribers to an already hefty base as a sign that people sold too early.
"The conventional wisdom on Netflix is that competition is going to erode their business," said Derek Brown, analyst with Pacific Growth Equities (he does not own shares in Netflix, but his firm makes a market in the stock). "But the company saw its user base grow faster in 2004 than it did in 2003 off a large base. Even in Q1, it's growing faster than 50% year-over-year off a pretty substantive number. These growth numbers suggest to us that they have tapped into something noteworthy from the U.S. consumer."
Blockbuster, which came out swinging last year by going after Hollywood and trying to muscle out Netflix, is suddenly on its heels.
Movie Gallery
(MOVI)
is poised to scoop up Hollywood, forming a quasi-national chain and a viable competitor on the retail side. With Netflix continuing to grow market share on the subscription side, Blockbuster could feel compelled to try another takeover in that direction.
"Blockbuster is probably looking to do something dramatic," said Stephen Monticelli, president of Mosaic Investments (he does not own shares in Netflix and his firm has no investment banking relationship with the company).
To be sure, any attempt to buy Netflix would meet resistance from the company's founder and chief executive, Reed Hastings, who has made it clear that he does not want to sell -- even at $30 a share, a 200% premium to its current price.
"I don't think management is open for sale," said Frank Gristina, analyst with Avondale Partners (he does not own shares in Netflix and his firm has no investment banking relationship with the company). "We're dealing with an entrepreneur. This is his company, and he's committed to it. It would have to be the right buyer, and I'm not sure that Blockbuster is a viable suitor."
Amazon, which has been flirting with the idea of a subscription rental service, could be a better fit. While Netflix has proven an ability to attract subscribers by word of mouth, its biggest obstacle remains luring new customers to sign up for its subscription.
"The big advantage Amazon has is a huge amount of traffic coming through their site every day that can be diverted into becoming a subscriber," said Dennis McAlpine, analyst with McAlpine Associates (he does not own shares in Netflix, and his firm has no investment banking arm). "They could help Netflix get bigger, while Netflix could offer Amazon a leadership position in the market ahead of Blockbuster."
Since Hastings has vowed to sacrifice short-term profits for more subscribers, any measure of the company's value would probably use sales as a yardstick. Currently, its stock trades at 1 times sales estimates, while its closest peers in the online retail sector sport an average multiple of 1.5 times sales. Just matching that level would require offering Netflix a 50% premium to today's stock price, and most analysts agree that Hastings, who owns roughly 30% of the company, would demand a price that's at least twice that amount.
Nevertheless, many observers feel the company's long-term prospects are bleak despite the intermittent success of its business model. Facing a slew of powerful players in both retailing and media, there are few barriers to entry in Netflix's space, so logic holds that it's only a matter of time before it's either swallowed up or put out of business. Despite its inability to slow down Netflix, Adams Media Research estimates that Blockbuster grabbed 15% of the online rental market in just four months after its entry. And its ability to force Netflix to lower its prices certainly wreaked havoc on its bottom line.
"Netflix is doomed as an independent company," Monticelli said. "They've got competitive risk coming from every direction. Either they need to combine with an online company, with demonstrated skills in that area, like Amazon. Or they need to combine with a Blockbuster, which has a different set of skills but has some synergies and the purchasing power that Netflix lacks."
Despite all his tough talk, Hastings did sell his first business, a software company named Pure, to its chief rival, Rational Software, in 1997 for $752 million in stock. The move may show that he has a price, but Hastings believes he is sitting on a goldmine of unrealized value with Netflix. And while he does understand the threat from competitors, he has said publicly that he believes the changing face of technology offers the most important threat to the industry. Through its partnership with the digital video recording pioneer
TiVo
(TIVO) - Get Report
, Netflix is attempting to position itself for the changes.
"TiVo is Netflix's partner for the digital world," said McAlpine. "They believe they have a digital strategy for when consumption and bandwidth is there for digital movie delivery and video-on-demand, but many of us doubt that day will come anytime soon. People have been predicting it for a while now, and it's never been a commercial reality."