Netflix: Overwhelming Number of Competitors Makes For a Difficult Buy

Brian Bolan, research analyst at Jackson Securities, recently sent a note to clients initiating coverage of online video rental company Netflix (NFLX) with a 'Hold' rating. Excerpts follow:

Valuation and Recommendation

The overwhelming number and size of competitors makes an investment in Netflix a hard pill to swallow. That said, continued growth and a standard of operational excellence not only gives Netflix a fighting chance against numerous competitors, it puts them in a great position to capture more of a growing market. We initiate coverage of Netflix with a HOLD.

Introduction to Netflix

Netflix is the largest online movie rental subscription service providing more than 6.3M subscribers access to a library of more than 70,000 movie, television and other filmed entertainment titles on DVD. The company offers a variety of subscription plans, starting at $4.99 a month. There are no due dates, no late fees and no shipping fees. Subscribers select titles at the Netflix web site, receive them on DVD by U.S. mail and return them to us at their convenience using prepaid mailers. Netflix is also offering certain titles through its new instant-viewing feature.

The subscription rental service has grown rapidly since inception, and the company continues to point to the San Francisco area as a measuring stick for nationwide adoption. As of 4Q06, Netflix states that it has a customer base of 14.8% of all Bay area residents. The company also noted that they have penetrated around 10% of the homes in several other large markets.

The internet delivery of movies will be a new wrinkle for customers in 2007. This new format will come with no increase in price for consumers, so they see the service as being more valuable. Investors, however, will see additional costs and shrinking margins which could hurt the stock price.

The myriad of competitors

Competition comes from numerous sources, but mostly investors will point to Blockbuster (BBI) as the major competitor. BBI offers online rental much the same way Netflix does. However, the Blockbuster Total Access plan allows for customers to return DVD’s to most of its over 5,000 domestic stores. This eliminates the wait that Netflix customers experience when they ship the movies via the United States Postal Service (USPS).

There are other smaller DVD rental competitors as well as the Movie Gallery chain. Movie Gallery has had significant struggles but maintains its hold on the more rural market. The buyout of Hollywood Video has done little to improve the competitive position of the combined company as the stock has traded in the low single digits over the past year. With a market capitalization of less than $200M, it is hard to compare the financials of MOVI with BBI and NFLX. Recently, through a debt restructuring and purchase of MovieBeam, Movie Gallery has improved its competitive position. It has also announced plans for an online rental program of its own.

Retail chains such as Wal-Mart and Best Buy could also be considered indirect competition as their model focuses on selling DVD’s. This indirect form of competition can also be found online from numerous sites including Amazon.

Video on Demand (VOD) via cable television (Comcast) and the internet (Vongo, Movielink and CinemaNow) can also be considered indirect competition. Other competitors include Apple and their iPod as well as Google and its YouTube division as well as Yahoo! With the barrier to entry in the distribution side being as low as it is, we expect to see several other competitors emerge, but most will ultimately fail.

Key business metrics

• Churn: Churn is a monthly measure defined as customer cancellations in the quarter divided by the sum of beginning subscribers and gross subscriber additions, then divided by three months. It is reported quarterly in the earnings release.

• Subscriber Acquisition Cost: Subscriber acquisition cost is defined as total marketing expense divided by total gross subscriber additions. This metric is also found in the earnings release and is a good measurement of how effective the ad spending has been.

• Gross Margin: Gross margin is a key metric for investors to follow as it tells how effective the underlying model is performing. The higher the gross margin, the better the model is working. From time to time, the company has opted to reduce gross margin in order to help secure more market share in hopes that over time the customers will become more valuable to them.

Industry Outlook

One of the toughest questions that would come up when considering an investment in Netflix is whether the current business model will survive what will be a game changing event. That event is the onset of Internet2. Internet2 is a much faster version of the internet as most people know it, and it will make downloading a movie an experience that will only take a few minutes. At current speeds, downloading of movies, while do- able, is not as common as the downloading of music.

Access to Internet2 is limited and will be several years away from the “retail consumer,” but it is still something that an investor needs to be aware of before making an investment decision on Netflix.

Another aspect that has to be considered is the control that the movie studios might eventually have over the distributors such as Netflix. While the studio’s currently need the distribution that companies such as Wal-Mart and Best Buy in order to fully monetize their product, there will come a day when that middle man can easily be eliminated. This could impact the rental business as well as fundamental changes in the delivery and storage of movies would affect all aspects of delivery and movie consumption.

Risks

The risks involved in purchase of shares of Netflix include, but are not limited to: consumer demand for its products, the costs associated with procuring agreements with movie studios and the costs associated with fulfillment of the DVD’s or content.

Along with other boilerplate style risks that most technology companies face (ability to stay current with technology platforms, drive customer to the website, retain qualified personal to maintain and operate the technical operations), Netflix faces some unique risks.

There exists a risk that the distribution model changes course and that studios begin to offer a digital service that effectively limits the need for a rental service and could cause a severe financial impact to Netflix and thus its shareholders. This is something that is not likely to happen over the course of the next nine months, but as delivery options continue to expand, it is an idea that must be present in an investors mind.

Other risks of investing in shares of Netflix can be found in there recently filed 10-K which can be found at www.sec.gov or through the Netflix website.

Valuation

Like any stock, we believe the primary reason an investor should purchase shares is to capture earnings growth or earnings value. Coverage of the internet sector is synonymous with earnings growth, and a high growth rate at that. Netflix is not exhibiting the type of growth necessary to support a large multiple.

A large multiple could be granted by investors should the number of subscribers increase dramatically. The more subscribers Netflix has, the more possible revenue and thus the potential for higher earnings. Following this train of thought, we believe that investors will continue to closely follow the growth of subscribers and derive a valuation from that growth. We continue to believe that Netflix (NFLX)

earnings are the most important metric for Netflix (as well as any stock investment) and believe that the company is currently priced for perfection.

A multiple of 29x fiscal year 2007 bring us to our target price of $23 per share, or just about where the stock is trading today. Over the course of the year, we will pay close attention to the growth in subscribers as well as the costs of running the business. These key items will help us determine if we should adjust our price target up or down.

Thesis

The sheer number of competitors tells us that there is money to be made in the rental business, but it also tells us that the barriers to entry are low. Down the road, the rental business may face a serious challenge from VOD and other downloading options. Its unclear at this point how Netflix will fair when that point arrives. For now, we believe a valuation based off the number of subscribers is the best way to look at shares of Netflix.

NFLX 1-yr chart:

Comments

[eljefe:]

I would be hard-pressed to say that Netflix has an overwhelming number of competitors in its current market. Blockbuster is really the only one that's been able to compete in recent years, and even while leveraging its physical stores, Netflix has been able to maintain its user base and keep churn rates at reasonable levels. Heck, Wal-mart wasn't able to compete against Netflix in the mailed movie market, that has to count for something. I think the current Netflix business model to survive for a little while longer, that is, until full-scale on-demand actually becomes viable. And by that time, I fully expect Netflix to have flexed its brand name muscle and partners with a large on-demand company to maintain its revenue stream.

Dennis
Finance-Whiz.com

2007 Mar 22 02:24 AM

[Rick Hanley:]

Dennie - So Netflix made Wal-Mart shiver in their boots? Please. Have you noticed that no one has bought Netflix?

Anyway, the competition for consumer cash and eyeballs grows ever larger. Will Netflix survive what is happenning in the market? Comcast, in partnership with C-COR, is bringing to the thousands of very small cable companies the capability to offer VOD. The millions of customers of these small cable companies have been one of the sweet spots for Netflix and the other online DVD rentailers.

In June, Wal-Mart will begin to offer, for purchase by mail order, 60,000 catalog titles, obviously covering much of the catalog films in existence. Catalog films are the bread and butter for the Netflix business model. Imagine the price points that someone like Wal-Mart can offer in this space.

Game console sales are exploding and they provide a double whammy on Netflix during this round. Not only is the number of gamers growing dramatically, the consoles allow downloding of movies, TV shows, etc.

Remember, there is a limited amount amount of time and cash to go around. Netflix's own projections are fro decidedly slower growth.

2007 Mar 26 08:26 AM

[online auction:]

thanks for the info.

Nov 16 02:17 AM