Netflix Finds Value In Contrarian Approach

Netflix is a surprising success considering one analyst calls its business model lame and the company's spokesman calls it lucky.
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is a surprising success considering one analyst calls its business model lame and the company's spokesman calls it lucky.

Yet for competitors such as


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, the Netflix story offers lessons in well-timed innovation.

Michael Pachter, research analyst with Wedbush Morgan, says that Netflix has been incredibly serendipitous, with much of the success due to founder and CEO Reed Hastings' vision and his persistence. In fact, the company's success is even more shocking considering how unsexy the business idea was at its conception.

"There are plenty of guys that have visions that don't turn out to be right. So when I say he was lucky, I mean that Reed had an idea that sounded lame to me," Pachter said. "The vision of renting movies over the Internet is pretty simple and pretty lame. Taking that and turning it into digital delivery of their catalog and offering it as free as a substitute for the physical copy is brilliant."

While the

S&P 500

has dropped 10% this year, Netflix shares have surged 45% and the stock now sits at a new 52-week high. But even without using the share price as an indicator, it's obvious that Netflix is doing something right. The online DVD-rental company recently topped 10 million subscribers, all of which have bought into the simple business model.

No matter how the company's success is viewed, there is something everyone can learn from Netflix, a name investors have already come to adore (and not just because a DVD copy of

The Dark Knight

was delivered in the mail during the same week it was released in stores).

The recipe for Netflix's success involves an incredible amount of luck and perfect timing, evangelistic subscribers that spread the word about the company, the entrepreneurial spirit, and a laser focus on the core of the business. If any one ingredient were absent, Netflix would likely be a laggard and not the leader in the movie rental and Internet streaming space.

"The movie is the same. How you get it, the amount you pay for it, and the experience you have acquiring it is where Netflix wants to differentiate," said Netflix spokesman Steve Swasey. "Netflix wants to make it the most enjoyable experience with the greatest value and convenience at the lowest cost."

Is It Luck?

Hastings got the idea for Netflix after his startup company Pure Software was acquired by Rational Software in 1997, prompted by a late fee for a movie he had rented from a video store.

"It was six weeks late and I owed the video store $40. I had misplaced the cassette. It was all my fault. I didn't want to tell my wife about it," Hastings told

The New York Times

in late 2006. "And I said to myself, 'I'm going to compromise the integrity of my marriage over a late fee?' Later, on my way to the gym, I realized they had a much better business model. You could pay $30 or $40 a month and work out as little or as much as you wanted."

While the idea has certainly become a very profitable one in the last 12 years, Netflix spokesman Steve Swasey admits that Netflix was lucky that companies like DVD-rental giant Blockbuster were late to the DVD-by-mail game.

"Not all of this is brilliant strategy. A lot of it is luck," he said. "Netflix grew and created efficiencies into DVD-by-mail from 1999 until 2004. But if Blockbuster had taken this seriously and entered in 2001, I probably wouldn't have a job. Netflix built up both scale and efficiency by the time Blockbuster entered. Blockbuster spent $500 million trying to create the scale and efficiency that Netflix has and it didn't work."

Internet Streaming Revolution

With the global economy continuing to struggle and a recovery not on the immediate horizon, Netflix continues to offer one of the best entertainment options for cash-strapped consumers. The company is benefiting from an ideal competitive environment on two fronts, one on the DVD-rental side and the second on the Internet-streaming side.

On the physical product side, Netflix faces competition from Blockbuster and RedBox Automated Retail, a chain of self-service DVD rental vending machines owned by


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Both companies were late to the DVD-rental-by-mail party, allowing Netflix to build up a strong customer base it has maintained despite the increase in competition. Even


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faltered with its DVD-rental program, allowing Netflix to gain dominance in the sector.

However, Netflix also is facing down competition from


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iTunes store and

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"Who's going to go to Apple or Amazon and rent 'The Jerk' or 'Ghostbusters' for $2 if they're a Netflix customer?" Pachter asks. "It's a great defensive measure. It's a great hook if you can tie it in with Xbox Live, which they did. I will give him luck with his vision and absolute A+ for his execution."

Most Netflix subscribers that receive DVDs by mail also have free access to the Internet streams, whether it be to their computer or a number of supported devices, including


Xbox 360, Roku set-top box, or


Blu-ray DVD player. The free "Watch Instantly" program gives Netflix a slight advantage over paid streaming products from Apple and Amazon.

"Streaming is going to be the future," Swasey said. "But in the mean time, we have a subscriber base of 10 million that are getting DVDs from us. We revolutionized the way Americans rent movies about 10 years ago, and now we're revolutionizing again by doing the streaming. It is really exciting to watch this unfold."

Analysts Still Not Buying It

Netflix's financial highlights sparkle, as the company has doubled 2005's revenue total to $1.36 billion in 2008. Net income has also doubled over that same amount of time to $83 million, while free cash flow has jumped from $24.3 million in 2005 to $94.7 million last year.

Of course, not every analyst is sold on Netflix. While downgrading the stock to sell, Janney Montgomery Scott analyst Tony Wimble recently said Netflix could be hurt if the economy incrementally deteriorates, if streaming investments are dilutive, if kiosks like Redbox gain more momentum, and if Blockbuster is stronger than Netflix shareholders currently envision.

Meanwhile, Bank of America analyst Nat Schindler wrote in a February research note that an acceleration in subscribers has not been as profitable for Netflix, prompting him to give the stock an underperform rating. Needham analyst Charlie Wolf also downgraded shares to underperform last month, arguing that "Netflix's venture into the digital distribution of video could prove to beless profitable than its by-mail DVD distribution business."

Perhaps the best advantage Netflix has is the 10 million passionate subscribers spreading the word about the company. Netflix does all it can to enhance the customer service, the most notable feature being the algorithm it developed to deliver personalized video recommendations based on customer ratings and reviews, quite similar to the system used by Amazon.

"The biggest driver of Netflix marketing over the last 10 years has been solid, positive word of mouth," Swasey said. "People love to talk about it with their friends. They're evangelists for the service. It's an iconic brand fueled by those associated with it."

The Entrepreneurial Spirit

To maintain a competitive edge, Netflix gives its employees freedom and responsibility to maintain a sense of innovation that is lacking at bigger companies stymied by layers of rules and policies.

Following the contrarian thesis of its founder, Netflix treats every worker as an entrepreneur, which allows them unlimited vacation time and gives them some flexibility in arranging their compensation packages. In return, every employee is expected to perform at their very best.

Swasey puts Netflix on the same list as Facebook, YouTube,


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as companies that have changed the behavior pattern among consumers.

Following Southwest's Example

Swasey also said that Netflix is inspired by

Southwest Airlines

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model of staying focused strictly on the core of the business. In other words, do one thing and focus on doing it extraordinarily well.

Netflix has strayed from the core a few times before quickly refocusing. For a time, the company sold previously-viewed DVDs, advertising space on their Internet site and DVD mailers, and it even purchased rights to films through its Red Envelope Entertainment subsidiary. However, Netflix decided the time and cost involved for each did little to address whether people were watching and enjoying movies.

Believers in Netflix say it is a great example of how having a vision and being completely focused can pay huge dividends. With two million DVDs shipped per day and Internet streaming usage increasing, Netflix may teach its competitors more lessons in perseverance.

"You learn to get a vision, stick with it, and figure out how to make that vision a reality," Pachter said. "Then you have a competitive advantage."