Will Netflix Survive iTunes Movies?

Amidst weak economic conditions, Netflix (NFLX) reported a solid 4Q '07 beating the street’s expectations. Revenues in 4Q '07 were $302.4 million, up 9% y-o-y, and gross profit margin was 33.8% compared to 38.9% a year ago. Net profit increased to $15.8 million, up 6% driven mainly by a 9% q-o-q decline in Subscriber Acquisition Cost (SAC) to $34.60, its lowest level since 4Q '03. EPS in 4Q '07 was $0.24, up 12%.

For the full year 2007, the company recorded revenues of $1.205 billion, up 21% from $996.7 million for fiscal 2006. GAAP net income in 2007 was $67.0 million, or $0.97 per diluted share. Gross margin in 2007 was at 34.8%. The company generates $45.5 million in free cash flow in 2007.

It's total subscriber base at the end of 4Q '07 was around 7.48 million, up 451,000, q-o-q. Of the total subscribers, 98% are paid subscribers. Churn was up at 4.1% in 4Q '07 from 3.9% in 4Q '06. As per Alexa’s latest quarterly data, Netflix’s page views have shown an increase of 4% vs. a fall of 6% in Blockbusters.com (BBI).

This is robust growth when you consider the revenues and the profits, but look deeper and you will find that the company is facing steep competition. Net additions of subscribers were down from 2.1 million in 2006 to 1.2 million in 2007 due increased competition. Average revenue per paying subscriber was down to $14.22 from $15.87, a year ago. Gross margins have fallen over 510 basis points in 4Q '07 from 4Q '06. Both operating and free cash flow for the quarter were down compared to 4Q '06.

However, the company is bullish on the future prospects, and expects bundled service and the delivery of TV episodes and movies over the Internet to aid long-term growth. The management guided for revenues of $1.30 - $1.35 billion, GAAP net income of $75 - $83 million, and GAAP EPS of $1.12 - $1.24 per diluted share in 2008. It expects to end 2008 with 8.4 - 8.9 million subscribers.

Meanwhile, Apple (AAPL) has launched iTunes movie rentals, which analysts expect to impact Netflix negatively, but the management feels it will only expand the market by creating awareness. Since its business model is different (based on service), the impact will be minimal. This is a weak explanation, and I have a better one. Most users still don’t have the patience to download movies online, so DVD rental is still a better option. The real competition will begin when technology gets to a point where we can download a full movie in minutes rather than hours. For now, DVDs in red envelopes are a better user experience. At least for me.

I see the embedding of Netflix in LG set-top boxes as a good experimental opportunity. The company feels it has the ability to offer online streaming and DVD rental at a low cost, and better service will aid in differentiation and future growth. The problem, however, is elsewhere. IPTV has a business model problem, and buying set top boxes, something which has traditionally come for free, will not be acceptable for consumers.

I have talked about Netflix acquiring Flixster and rolling up an online movie community that earns advertising revenues. There have been rumors about IAC/InterActiveCorp (IACI) acquiring Flixster, which today, Om Malik says is untrue. Netflix should act.

The stock is currently trading at $21.94, and has a market cap of $1.44 billion with a 52-week range of $15.62 - $29.14. Increasing competition, impending economic slowdown, falling margins and the FUD created by Apple’s iTunes Movies will hold the stock down inspite of a reasonably robust guidance for 2008. It is essential that the company rethinks its business model this year.

One final point: I like what it is doing with Red Envelope Entertainment, producing and distributing independent cinema.

Comments

[Tom B]

I have more confidence in Apple's execution than Netflix's (particularly since Netflix has yet to deliver a product). But, it's not "either/or". We COULD end up with both.

[User 142127]

The whole point man is that no one wants to download and own the movie. And Apple's rental starts the movie playing in under 30 seconds. So get your facts right pal. Didn't you watch Jobs and the Keynote. No one WANTS TO BUY a movie that you watch once. So I will repeat, you can start watching a rented movie from iTunes in less the 30 seconds. Not the hours you are trying to convince the people reading here. And you can't buy a movie from Netflix so your article is all over the place and you clearly know just enough to make an ass out of yourself.

[bradah]

"Most users still don’t have the patience to download movies online, so DVD rental is still a better option. "

They don't have to wait..........start watching in 30 sec while the rest downloads in the background.

[Realtosh]

Your analysis is spot on. It is essential that Netflix rethink their business model this year.

Netflix' greatest asset is also its' greatest weakness. Netflix has an impressive collection of DVDs accumulated over the years. As the party moves away from DVDs and onto the net, they will lose their built-in advantage. As iTunes, and possibly other online competitors, fills in their catalog, there will be shift to online distribution. Netflix’ titles will be in an older static non-HD technology, where on line downloads can adapt more easily.

iTunes will have 2 competitive advantages. These are at both ends of the movie demand curve. First, when a movie first comes out, everyone with an AppleTV can download it the very first day. No running down to Blockbuster and having all copies checked out already or waiting for Netflix to get around to sending you a copy weeks later once the new release demand for that particular title has died down.

Second, online distribution is also ideally suited to fulfill the long tail of demand for low-volume niche movies in many genres. Netflix was able to exploit this advantage against Blockbuster and other bricks and mortar DVD rental shops, who were unable to stock as many titles as Netflix’ central distribution. iTunes can use the online advantage to outflank Netflix, as can any other online distributor with the resources and resolve to assemble a collection to rival Netflix’ DVD collection. The beauty of online distribution is that as soon as a digital copy of a title is catalogued, you have unlimited copies of that title to rent or sell forever. No lost disks, no damaged disks.

I agree that the cost of set-top boxes is a barrier to consumer adoption of online services. The advantage that the AppleTV has in this overcoming this barrier is that AppleTV also ties into the iTunes/Mac ecosystem. It not only allows movies-on-demand, it does so without the $50 a month or so cable/ satellite bill. $600 a year buys or rents a lot of content.

AppleTV deals with your ease of use concern. Not only will you be able to push a virtual button and watch a movie in minutes as you suggest is important, but you’ll also have easy access to the Apple/ iTunes ecosystem. The AppleTV functions as the iPod connection for the home stereo and TV for their iTunes collection of music, music videos, TV shows, movies, podcasts, and for their photos in iPhoto and flickr, plus access to YouTube and other internet services that will be added over time.

I disagree that the entire movie needs to download in minutes. I do believe that for the movie-on-demand consumer, the movie needs to start playing in minutes and be able to play uninterrupted until end, except for any user-initiated potty break or snack run. Constant interruptions to allow for movie downloading and buffering will adversely impact the quality of the experience, and therefore reduce uptake of the service. With the increasing penetration of broadband, including fiber direct to consumer, this concern will diminish over time.

In addition, with 30 day downloads, some people will download movies in advance for viewing later after dinner, or even download overnight in advance to have movies available for weekend viewing. No need to worry if Blockbuster will have the movie available on busy Friday and Saturday nights. Also, no need to worry about the availability of the next Netflix movie in the queue, or the timing of the postal delivery of the physical DVD.


The rate of uptake of online service vs the Netflix delivery model will be affected by the cost of service and the availability of movies. At the moment, Netflix has the cost advantage vs iTunes for households who consume a large number of titles on a constant basis. They also have the long tail variety of title advantage at this moment. Both of these advantages can disappear when an online distributor, such as iTunes, builds their online catalog and offer a subscription service respectively.

Blockbuster Total Access has similar characteristics to the Netflix subscription model, plus integrates with the bricks and mortar stores to adds bonuses. This battle between the two has led to a price war which gives these subscription services the price advantage but also cuts away most of the profit.

Netflix will be around for a while, but your prediction of 5 more years of substantive growth is overly optimistic, unless as you say, they rethink their business model this year. Apple is monetizing the their community by offering additional services to their installed base. Netflix is failing to do so by not building, on top of their dead-end low-profit commodity business, a community serviced by new original content created to differentiate their brand.

Once, Netflix and Blockbuster move to online distribution, there will be a new level playing field. Each will have little or no advantage naturally arising from a consumer’s experience with the respective entity previous distribution business model. However, users of Apple technology will have an ecosystem of which AppleTV is but one part of the whole.

There is a lot more stickiness to Apple’s business model than that of either Netflix or Blockbuster. I would not own either stock right now. Tower Records had at least as good a customer experience as either of two. It is now a relic of the past because it failed to transition to the net. On the other hand, Apple is down about 35% from recent highs, even after having just announced a record quarter with historically high revenue, profit and cash flow, and with margins that are tending higher. Further, Apple has four businesses with lots of room for growth for at least the next 2-3 years: Macs, iPods/internet appliances, phones, AppleTV/media distribution.

It would be interesting to see if and when Apple gets into the content creation business to serve their much larger community, as you suggest Netflix do. There have been calls for Apple to start a record label. Jobs already did Pixar. It would not be a stretch to think that he could help Apple get into content creation.

As you can see, I agree with the market and don’t as much value in Netflix as you do unless something changes drastically. I would be looking to someone in a position to do well in the net sphere, like an Apple or an Amazon. Apple is making a lot of money, their products and business models look good, and their prospects for continued growth are solid. And as a value buyer Apple is back at a level that I can justify getting into.

[borisb]

Netflix new online ads are kickin ass.