Their call is based on a combination of issues that they believe could pressure margins at the DVD rental company:
- Higher than expected digital download spending: the company plans to spend $40 million in 2007, but the analysts fear the total could rise.
- Rising marketing expense: Marketing expenses have increased from 18% of revenue in 2003 to 23% this year. The company has said it will continue to invest aggressively.
- Competition from a variety of emerging media alternatives: Blockbuster (BBI) is aggressively pushing its online DVD rental service; in digital download the company faces Amazon, Apple, Fox Interactive’s IGN unit, MovieLink, CinemaNow and others, including Wal-Mart and Time Warner. Cable offering more and more video on demand.
- Potential postage price increases: USPS asking for 42 cents from 39 cents for first class letters starting May 2007.
- Spending on content acquisition and new ventures: The company has moved into the production business via its Red Envelope division.
- Pricing power: Netflix doesn’t really have much; subscribers are highly price sensitive.
“Our sell is largely based on concerns over operating expenses in 2007 and 2008,” they write. “Although we could be early in our call, we note that shares (and ultimately earnings) of other Internet companies such as Amazon, eBay, Yahoo! and GSI Commerce have declined as a result of operating margins being impacted by spending initiatives. While we do not question the company’s progress at driving subscriber growth nor their long-term decision to be a player in digital downloads, we think that the $40 million earmarked for 2007 could prove insufficient. Combine this with postage increases (first class mail proposed cost increase form 39 cents to 42 cents as of May 2007) and rising SAC driven by increased marketing expense, and what we could see is operating margins coming under more pressure than the Street anticipates.”
Netflix shares, which rose three cents in the regular session, is down 88 cents after hours to $27.52.