Skip to main content



hoisted a white flag in the online video rental war Thursday and made peace with



, igniting its former rival's stock.

On its face, the move looks like a coup for Netflix in its bid to dominate another nemesis,



. Netflix shares vaulted $2.05, or 13.2%, to $17.55, while Blockbuster shed 1.2%.

Netflix played David to Wal-Mart's Goliath, vanquishing a company that grosses more in a day than Netflix does in a year. The online video rental game is probably its to lose now, analysts say, with its chief worry still a distant one: a possible Blockbuster-




With its 3 million subscribers, projected to become 4 million by the end of 2005, Netflix holds a considerable lead in the market it pioneered. Blockbuster, its most viable competitor that came late to the party, has yet to record 1 million subscribers. Meanwhile, the addition of Wal-Mart's flock will give Netflix a boost, albeit a small one.

Daniel Ernst, an analyst with Soleil-Hudson Square Research, estimated that Wal-Mart would pass along fewer than 300,000 customers, while Dennis McAlpine of McAlpine Associates puts the figure at fewer than 100,000.

"This is really a drop in the bucket in the wider context of this market, so it is a fairly immaterial event in that respect," Ernst said.

Rather than spend the money and effort to compete in online rentals, Wal-Mart appears to have concluded that the rewards didn't justify the investment. Instead, it will focus on its core business of selling DVDs. The decision to pass its online subscribers to Netflix can be viewed as a shot against its chief competitor in DVD sales, Blockbuster.

Wal-Mart's rental customers will be offered the option to become Netflix subscribers at their current Wal-Mart rate for a year, and Wal-Mart will market the Netflix service on its Web site. In turn, Netflix will advertise Wal-Mart's DVD retail offerings on its site.

While Wal-Mart's subscriber base may be small, the retailer's capitulation helps rebut a key pillar of the bear case against Netflix, which held that its $17.99-a-month service is too easily replicable by deeper-pocketed competitors. Wal-Mart charges about $13 a month.

Netflix bears already took a hit when the company showed that Blockbuster's lower price of $14.99 a month wasn't hurting its ability to grow its subscriber base. Now, Blockbuster is weighing a $3 price increase -- another clue that Netflix is tougher than previously believed.

Blockbuster was criticized when its hostile bid to acquire

Hollywood Entertainment


fell through, and its investors accused the company of being slow to follow Netflix in the online rental market. Now, Hollywood will join with

Movie Gallery


, forming a new contender in Blockbuster's core business.

The criticism reached a crescendo when activist investor Carl Icahn, Blockbuster's largest shareholder, won three seats on the company's board after a heated proxy fight in which he criticized Blockbuster's spending habits. Icahn called its "No Late Fees" campaign a "spending spree."

As a renowned value investor, Icahn is expected to push for fewer noncore investments and a focus on generating cash through Blockbuster's existing store base. But Howard Davidowitz, chairman of a retail consulting and investment banking firm called Davidowitz & Associates, questioned whether such a strategy is viable.

"The video rental business is a hard game to play for cash right now, since various technologies are eating into the business from all sides," Davidowitz said. "You're going to end up with a lot of stores in the red that drain your cash while you're committed to them on leases. The results will not be pretty."

New cable television offerings, such as video-on-demand, coupled with growth in the online rental market, have eaten into Blockbuster's core business. Meanwhile, analysts point to new technologies that will become forces in the home movie business down the road, such as online downloads of DVD files, as being a threat to Blockbuster in the future.

Netflix claims it is ahead of the curve on technology, partnering with the digital recorder pioneer



to develop new offerings.

"Netflix is a very well-run company," Ernst said. (He does not own shares in Netflix or Blockbuster, and his firm has no investment banking business.) "Just look at its third-quarter net income margin at 13%. It generated $35 million in cash last year, giving it a 7% cash-flow yield. Also, it's growing revenue by 70% every year. Those are impressive numbers for such a young company."

Both Ernst and McAlpine conceded that a partnership between Amazon and Blockbuster against NetFlix looks increasingly likely.

"Amazon could do a deal with Blockbuster, and I think that would scare the hell out of NetFlix," said McAlpine. (He does not own shares in Netflix or Blockbuster, and his firm has no investment-banking arm.)

Amazon boasts huge numbers in terms of online traffic, an asset that Blockbuster could leverage. McAlpine said such a partnership would constitute a grave, long-term threat to Netflix, which is expected to lose $5 million to $15 million this year. But as of now, the deal is far from reality.

"Netflix still looks good to me in the long term," McAlpine said. "They've shown an ability to execute while Blockbuster has stumbled. They've proven that they're not going anywhere anytime soon."