Netflix Takes Another Blockbuster Bruising

The store-based chain steps up pricing pressure in the DVD rental wars.
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In the brawl between

Blockbuster

(BBI) - Get Report

and

Netflix

(NFLX) - Get Report

over online DVD rentals, the gloves are coming off.

With its losses mounting, Blockbuster surprised Wall Street Tuesday by offering lower subscription prices on its online rental service, signaling that it's willing to endure more financial pain in return for stealing subscribers away from its rival.

Netflix has maintained that Blockbuster's pricing is unsustainable, and Wall Street was just beginning to embrace the idea that Blockbuster might not be forced to raise prices soon. News of even lower prices sent shares of both companies sliding.

Shares of Netflix were recently down $1.62, or 7.4%, to $20.31. Blockbuster was off 6 cents, or 1.5%, to $4.01.

"Blockbuster is like a caged animal right now, so it's not financially rational," says Piper Jaffray analyst Michael Olson. "Their in-store rental business is in decline, so their only option is to build out its online rental service, and they're willing to take this price war as far as they can."

Blockbuster announced the launch of its Blockbuster By Mail program, an unlimited three-DVDs-out-at-a-time plan for $16.99 a month, undercutting a competing offering from Netflix that is priced at $17.99.

Both plans allow customers to rent three DVDs at a time through a mail-order, online subscription model that was pioneered by Netflix, but Blockbuster allows customers to return DVDs at its chain of 8,000 stores instead of using the mail, which means they receive their next DVD in the mail a day earlier. That allows customers to rent more movies every month.

Unlike Blockbuster's so-called Total Access plan, which is $17.99 a month, the Blockbuster By Mail plan doesn't allow subscribers to exchange DVDs in stores for new ones.

"While we believe Blockbuster Total Access offers the best value in the marketplace, we recognize that some consumers may not live near a store or aren't interested in taking advantage of the free in-store rentals they can get through

that plan," said Blockbuster in a press release. "If this group is considering an online service or already subscribes to an online service, we're now giving them another reason to choose Blockbuster over

Netflix."

Blockbuster also rolled out a cheaper Blockbuster By Mail plan priced at $4.99 a month, matching the lowest-priced Netflix offering.

Blockbuster couldn't be reached to discuss the financial impact of its new plans. The company recorded widening losses in its latest quarter due to a weak market for in-store movie rentals and runaway promotional spending on its Total Access plan. Meanwhile, it reported 800,000 net new subscribers for the quarter, compared with the 481,000 reported by Netflix, signaling that it's gaining momentum on a market share basis.

Netflix, which has already

slashed its outlook for the year because of the ongoing competition, also did not respond to inquiries for this story.

Olson says Blockbuster's latest move could increase the level of subscribers that opt out of service at Netflix, which will eventually hurt the company's sales and earnings.

"Current forecasts on Wall Street for 2008 don't reflect the effect of this price war on Netflix," Olson says.

Pacific Crest Securities analyst Chad Bartley says Netflix has been cautious in its earnings outlook, and he gives the company "the benefit of the doubt" for 2007. Eventually, however, he expects Blockbuster to take more share of the online-DVD-rental market.

Both analysts are neutral on shares of Netflix.

Arvind Bhatia, an analyst covering Blockbuster at Stern Agee & Leach, says he still expects the company to raise prices on its Total Access plan eventually, but he believes consumers are likely to pay a higher price for the added value of access to Blockbuster stores.

In the meantime, he says Blockbuster's aggressive pricing strategy is smart, and he has a hold rating on the stock.

"This is a relatively finite market, so the end-game is to gain as much market as possible," says Bhatia. "Blockbuster is right to take some short-term pain for long-term gain."