Netflix Pain Isn't Blockbuster's Gain

Blockbuster still faces margin trouble and competition from on-demand and downloads.
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Netflix

(NFLX) - Get Report

said Wednesday that it is

encountering significant competition from

Blockbuster's

(BBI) - Get Report

Total Access program.

But don't think that's a green light to buy Blockbuster shares.

Not only is the movie-rental company in a tug of war with Netflix for customers' affections, but it also must compete with video on-demand and Internet services as well.

Blockbuster's Total Access is striking a chord with customers. The $17.99-a-month program offers the same DVD mailing service as Netflix, along with the added convenience and value of allowing customers to drop off movies at a local Blockbuster store and get another DVD in the process.

Customers get more movies and Blockbuster gets more customers. Everybody wins, right?

Not so fast. Blockbuster calculates the benefits of Total Access costs at $2 per subscriber per month. That's not including the $8 to $12 cost of free movies. So it is likely the company's margins will decline as it rents millions of titles for free each month.

Blockbuster realizes the Total Access segment is not as profitable as the rest of its business. However, the company may be in the process of shooting itself in the foot.

In order to make up for that $8 to $12 loss of revenue per customer, Blockbuster is considering raising prices. But the video rental business is a highly elastic market. An increase in subscription price could very well halt the market share gains Blockbuster has achieved.

After all, Total Access customers likely signed up for the service because of the perceived value, not for the opportunity to go to the store, which is an inconvenience. With eroded value due to higher prices, customers may not find the in-store part of the program as appealing.

And if all things are considered equal from a value perspective, Netflix would be the better choice for movie buffs. It has 10,000 more titles than Blockbuster and a reputation for having more obscure choices along with the mainstream films.

Eureka!

When it comes to technology, I admit I'm a bit of a Luddite. I don't own an iPod and still listen to my old records. (Nothing beats Ratt on vinyl. Nothing!)

So it was an eye-opening experience when it dawned on me that not only did I not have to drive to my local Blockbuster to rent

Borat

(yes, I was the last person in America who hadn't seen it), I also didn't have to bother with the dozen or so steps to my mailbox.

Comcast

(CMCSA) - Get Report

had

Borat

-- and many other hits -- on demand.

After that convenience, I couldn't imagine going back to Blockbuster anytime soon. Keep in mind, Blockbuster is not getting rich off of my 10 to 12 movies per year. I fully realize that there are film aficionados who may watch that many in a week. Nevertheless, there must be more time-starved parents like me who would rather order the movie on demand and not bother with getting in the car or thinking a week in advance about what they want to see next Saturday night.

A recent report by Plunkett Research cites Leichman Research Group's findings that 65% of cable subscribers watched video on demand in 2006, twice the number from the previous year. This is a trend on the move.

In December 2006, Comcast customers watched 25 million free on-demand movies, according to a company representative. Media and technology market research firm isuppli estimates $2 billion worth of on-demand was spent in 2006. Not all of the $2 billion was spent on movies. According to isuppli's Mark Kirstein, a good chunk of that was sports entertainment such as boxing and wrestling pay-per-views, though movies were also a significant portion of the figure.

Let's be conservative and assume that only a third of the $2 billion was movie revenue. And of that $667 million, only 20% cannibalized sales from Blockbuster. Let's also assume that free on-demand movies displaced $100 million in revenue (also a conservative estimate). Even without including any improvements to margin, which an additional quarter of a billion dollars in revenue would surely add, it's enough to move the needle. When you take into account the growth that video on demand is expected to achieve, that's a lot of money that Blockbuster and Netflix are missing out on.

Keep in mind, we're not even talking about downloadable technologies that will likely be readily available in the near future.

More Issues

Blockbuster investors have to deal with uncertainty in the CEO's office. After a dispute about bonus pay, CEO John Antioco will leave the company by the end of the year. No replacement has been named.

Earnings in 2007 are expected to slide to 6 cents a share from 23 cents in 2006, while revenue is expected to slip to $5.48 billion from $5.52 billion in 2006. In 2005, while the company reported a loss, revenue came in at $5.72 billion.

Blockbuster is a crowded short. More than 32% of the float has been sold short. Normally that's a bullish sign, but I believe the shorts have it right. Interestingly, Blockbuster shares actually gave up a few pennies on lower-than-normal volume Wednesday, the day that Netflix said competition from Blockbuster was eating into its sales. Apparently, the buyers were not emboldened by the news. That's a bearish sign.

Blockbuster's valuation is not excessive. On a price-to-earnings basis, at 36 times trailing earnings and 109 times forward, it's quite expensive. But on other metrics such as price-to-book, or price-to-sales, the shares could be considered cheap.

In those instances, however, you get what you pay for -- a troubled company that, while doing some things right, faces a very steep uphill battle.

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;

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