Why Netflix Can't Match Blockbuster's Competitive Advantage

It is with sadness and regret that I must now recommend against investing in Netflix (NFLX). I am personally a long-time customer, and former investor. Like most customers, I love the service. Like most investors, I love the management team. When Blockbuster (BBI) first announced its "me too" Total Access service, I laughed right along with all the other true believers, and largely ignored it. But when I learned more about the details of the Blockbuster service, I changed my mind.

I am a devotee of the Warren Buffett and Benjamin Graham school of investing. I like to invest in companies with unbeatable competitive advantages, preferably at a discount. I used to think that the status of Netflix as pioneer, together with its excellent brand reputation and its strong head-start amounted to such an advantage. No longer.

Why the reversal? I learned a few weeks ago about Blockbuster's feature of allowing users of its Total-Access service to swap out DVDs in its brick-and-mortar stores. All of a sudden, all of that expensive real-estate and infrastructure is no longer a liability for Blockbuster - it is an enormous advantage that Netflix simply can't match. At least not for now.

I've read comments that this feature is negligible, and "misses the whole point" of the Netflix business model. I disagree. Much as I love the Netflix service, there are times when a particular movie pops into my head, or is suggested by a friend, which I would like to see right now. Netflix customers are out of luck in this scenario. The best we can hope for is to bump the movie up in our queues and wait a day or two.

Total Access customers, by contrast, have the option to pop over to the local Blockbuster and swap out a movie they've already seen for their "must see tonight" pick. While they are t! here, chances are good they'll pick up some snacks, or may! be a use d DVD or two. In a society obsessed with instant gratification, this advantage cannot be ignored. Blockbuster's management deserves a great deal of credit for this brilliant move. I was so taken by it, in fact, that the day I heard about it I sold all of my Netflix stock (for a gain of 80%, with which I am quite satisfied). Since then, the stock has bounced around, but has yet to pass the price at which I sold it.

By the way, while I sold my Netflix shares, I have not personally switched to Total Access. Blockbuster's selection is too mainstream for me - I prefer independent and foreign films, and Netflix offers a superior selection of these, at least for now. But that's hardly encouraging. The fact is that people like me represent a very small portion of the overall market. Netflix may be guaranteed enough of a loyal following to stay in business, but the ugly but plain truth is that the mainstream is where the money is made.

This is not a recommendation to invest in Blockbuster, by the way, nor is it a recommendation to go short. Both Blockbuster and Netflix will be in big trouble when download services like Amazon's Unbox gain more steam. Download services will negate both Blockbuster's instant-gratification advantage and all the benefits of the rental-by-mail model. More importantly, however, it will all but eliminate the enormous barriers to entry that Blockbuster and Netflix both profit from now. For proof, just look at Amazon's recent announcement that it will be hosting independent movies on its service. Soon anyone will be able to reach an unlimited film audience, instantly and with almost no up-front costs. The "competitive moat" around Netflix is rapidly fading away.

But I don't believe Netflix will go bankrupt, as some doom-and-gloomers suggest. It has an excellent brand, and I'm confident it will survive as a business, and adjust to market changes, most likely better than Blockbuster and others. But I can't bring myself to believe that Netflix will maintain its market-dominating position in light of technological advances and the surge in competition. It therefore looks too expensive at 33-times earnings. There are many far better opportunities out there.

NFLX/BBI 1-yr comparison chart

Disclosure: Author has no position in the above-mentioned securities

Comments

[Blue collar...:]

Dear Mr. Brynaur,

Since you are in the "business" and I am but a lowly unconnected, unassociated amateur ....I would just like to take this opportunity to tell you that I think you are dead wrong about your view on Netflix. There is no way I can know how convenient your Blockbuster store is to you, nor...more importantly how "stocked" up they are or even more importantly than that how wide their slection and the diversity of movie "type", but i am here to tell you that my local Blockbuster which is literally just around the corner, well within walking distance stocks basically nothing but 2-3 wk and older "hits", virtually nothing except the current crop of movies which in plain language.....SUCK and requires wasting gas and energy to try and find anything appealing to a mature "user" other than someone in the 20 to 30 "hot pants" catagory.
I live in a neighborhood of older citizens and you would be amazed at the number of houses the postman regularly picks up and drops off Netflix envelopes (I have seen stacks of them in his truck as he makes his rounds and I occasionally meet him to pick up my mail b4 it goes into my box (out in the yd working am I). So.........btm. line, Netflix is a little draggy butt right now for a variety of reasons and your write up will not help that situation, but they are still far and away the best and I think the Blockbuster thing will fade away fairly quickly. Right now is the time to make the judgement in my view. Netflix is top drawer and Blockbuster with all their screaming advertising and posters is mediocre in every respect including mgt., revenues and future plans.
Sincerely, Ed Robinson Smyrna, GA

2007 Mar 27 10:39 AM

[hey4ndr3w:]

Unfortunately, BBI's "competitive advantage" costs them $2 per subscriber per month, according to the company itself. No wonder you don't recommend them as an investment.

The reason is because of their broken distribution model. They have no distribution centers, <i>per se</i>. Each individual store serves as a distribution point. Every location receives a list of films each morning to pick from store shelves and mail to TA subscribers.

This means a) BBI's aggressive program of shutting down stores means that they are also shutting down TA distribution centers; and b) TA subscribers are sharing this shrinking inventory with BBI's walk-in customers. You do not mention the recent and very public problems BBI has had fulfilling on their TA promise as a result of this gerry-rigged distribution model.

Furthermore, you fail utterly to mention NFLX's on-line offering, which seems to compete quite well with Amazon's. Your assertion that Amazon Unbox will doom them is a bit hard to take seriously, particularly in light of other significant details that seem to have escaped your notice.

2007 Mar 27 12:39 PM

[jack:]

Thanks for the comments. I have a couple of responses to offer. First, if you read my article again, you will see that I don't suggest that either company will be "doomed" by the rise in competition. In fact, in the case of Netflix, I specifically say I believe it will survive as a business. It is an excellent company with excellent management and an excellent brand. I simply believe that it is too expensive at its current earnings multiple.

Regarding Blockbuster, the fact that its service may not be particularly profitable is beside the point. The fact is that it is bound to eat into Netflix's market share. As I said, I don't recommend BBI as an investment. But it doesn't have to do well itself to damage Netflix's long-term prospects.

Lastly, I agree that I should have gone into more detail about Netflix's download service. I hinted at my issue with this: I am confident the service will be reasonably successful due to Netflix's fine brand -- my issue is that there are hardly any barriers to entry into this business. Prior to download services, Netflix had an impassable competive moat in the form of massive DVD warehouses and a streamlined distribution system.

This huge advantage evaporates entirely with download service. Netflix (an others) will have to compete based on other factors like brand, selection, etc. Again, I have no doubt it will be a modest success at doing so. But not enough of a success to pay 33-times earnings.

2007 Mar 27 03:43 PM

[jack:]

One last thing: in the long run, BBI is far more likely to be "doomed" than Netflix. Its brick-and-mortar stores provide a temporary advantage now, but when downloads take over, they will be nothing but a liability.

2007 Mar 27 03:53 PM

[andrewschroeer:]

Except that Netflix is in the process of setting up numerous deals with Hollywood studios to offer their films exclusively for download. Management at Netflix has made comments in the past that they intend the name Netflix to be even more descriptive in the future. You laud their management, but then doubt their ability to adjust. I think that's a mistake.

2007 May 13 02:43 AM