Blockbuster Bloodies Netflix

An escalation in the DVD rental wars leads Netflix to slash subscriber estimates.
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In Wall Street's DVD wars, the empire just struck back.

The rise of

Netflix

(NFLX) - Get Report

and its innovative online DVD subscription service brought

Blockbuster

(BBI) - Get Report

, the empire of movie rentals, to its knees.

But at the end of last year, Blockbuster launched its Total Access plan, using its 8,000 stores along with an advertising blitz and an online subscription service of its own to steal back customers. The first quarter was a key test for Netflix to see if it could weather the empire's reprisal -- and it failed.

Shares of Netflix were down nearly 8% Wednesday after the company posted a doubling in first-quarter earnings but slashed outlook for 2007 revenue and subscribers.

"This is quite a change in outlook for them and quite a change in tone," says Chad Bartley, an analyst with Pacific Crest Securities who holds a neutral rating on Netflix shares. "We've been concerned about the competitive landscape for Netflix and its long-term prospects as movie-watching goes online. Today's results show there is also a nearer-term threat from Blockbuster."

Netflix reported net income of $9.9 million, or 14 cents a share, for its first quarter, up from the $4.4 million, or 7 cents a share, it recorded for the same quarter last year. Excluding one-time items, it reported earnings of 16 cents a share, matching analysts' mean estimate as reported by Thomson First Call.

Revenue for the quarter rose 36% to $305.3 million from $224.1 million, beating Wall Street's expectation of $304.9 million.

Netflix ended the quarter with about 6.8 million subscribers, up 40% from a year ago. Net subscriber additions in the quarter were 481,000, compared with 687,000 for the same period of 2006 and 654,000 for the fourth quarter of 2006.

Netflix CEO Reed Hastings had warned investors that the company would likely see an uptick in subscription cancellations in the first quarter as Blockbuster rolled out its Total Access offering. Sure enough, the company's churn rate, which measures canceled subscriptions, was 4.4% as of March 31, up from 3.9% at the end of the year and 4.1% at the same time last year.

Netflix said in a press release that its results were in line with the company's estimates but at the low end of the range, "reflecting the impact of increased competition." It lowered its 2007 revenue target to a range of $1.21 billion to $1.26 billion, from its previous forecast of $1.25 billion to $1.3 billion.

The company also said it expects to have between 7.3 million and 7.8 million subscribers at the end of the year, down from a previous forecast of eight million to 8.4 million.

Battle Intensifies

Both Netflix and Blockbuster's services cost $17.99 a month for three DVDs at a time, but Blockbuster's Total Access offering allows customers of its online subscription service to either return DVDs through the mail or exchange them at stores for free movie rentals.

"The program lets customers get more movies for less money, and it adds the advantage of giving them access to their stores, which is immediate gratification as opposed to waiting for the mail to come," says John Lynch, an analyst with Needham & Company.

Blockbuster will report its quarterly results in early May. Analysts are expecting the company to report a loss, excluding one-time items, of 13 cents a share, reversing the profit of 5 cents a share it recorded on that basis in the year-ago period.

On a conference call with analysts, Hastings said Blockbuster's offering was hurting Netflix more than anticipated, but the company questions how sustainable the offering is for Blockbuster.

Netflix spokesman Steve Swasey points out that Blockbuster is essentially offering customers a $42 value for $18.

"We've been doing this for nine years, and we know the cost efficiencies and the logistics and distribution models for this business," says Swasey. "We've been making our operations more efficient and bringing our costs lower, so we just don't think Blockbuster's offering is economically viable over the long-term."

Bartley, the Pacific Crest Securities analyst, says a price hike from Blockbuster could be the next positive catalyst for shares of Netflix. It's a stock that has been highly volatile, with a large following of short-sellers.

"Blockbuster's management has alluded to the potential for an increase in pricing," says Bartley. "Of course, the effects of that will depend on the magnitude, the timing, and the details of the Total Access membership offering and what it looks like. Right now, the combination of online, mail-order service and brick-and-mortar stores is compelling to customers that live near a Blockbuster store, as so many people do."

Some observers view Blockbuster's aggressive ad spending to market Total Access as short-lived, especially since activist investor Carl Icahn has taken control of the company. Historically, Icahn has been critical of Blockbuster's capital investment strategy, calling it a waste of money for shareholders.

"I don't see any reason why Blockbuster is going to become less aggressive," says Pali Research analyst Stacey Widlitz. "Some people are expecting Icahn to install a new CEO to cut off the ad spend, but I doubt that will happen. They might cut some other things, but I don't think they're going to just turn off the faucet and milk this thing for cash, because they've made a lot of progress and they're starting to get some traction."

Shares of Netflix were recently down $1.82, or 7.6%, to $22.14. Shares of Blockbuster were up 2 cents to $6.48.