Netflix (NFLX) loses its future in a game of chicken

| About: Netflix, Inc. (NFLX)
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Netflix just traded its future for $1 per month per subscriber.  After Netflix announced it was cutting the price of its monthly movie rental service from $22 to $18, Blockbuster (BBI) countered with a price cut to $17.50 (including two coupons for in-store rentals).  Netflix failed to respond, and Blockbuster is now the low-price movie rental leader.  Netflix lost the game of chicken, and threw away its future.  Here’s why.

Netflix’ choice was simple.  It could have sent a clear message to Blockbuster, Walmart and Amazon that it was committed to being the low-price leader in online movie rentals. Or it could duck out of the price war.

Had it chosen the former, Netflix would have driven Amazon and Blockbuster out of the online DVD rental market.  Netflix’ distribution centers are a sunk cost, whereas Amazon and Blockbuster haven’t invested in the infrastructure for national, overnight DVD distribution.  Because of this, Amazon would have abandoned its plans to compete with Netflix. After all, why would Amazon incur the marginal cost of building new distribution centers knowing that price competition – and a public promise from Netflix not to be under-priced - would destroy any hope of generating a positive return on its investment?

Blockbuster would also have been in a bind had Netflix continued to cut prices.  Sure, it could match Netflix’ moves in an escalating price war.  But in the process, Blockbuster would destroy its own movie rental business. (Why would you rent movies at $5 a shot and risk incurring late fees if you could get almost unlimited movies delivered to your door for, say, $15 per month?)  Blockbuster has a much higher expense base than Netflix due to its stores, and loss of foot traffic into its stores will harm it DVD sales and game rentals.  So Blockbuster would never have tolerated the resulting losses of an all-out price war for online movie rentals.  What would it have done?  Let Netflix be the online price leader, and try to differentiate itself by combining online and store-based rentals at a higher price point.  Sure, its business would whither over time.  But it could continue to generate cash.

If Netflix had chosen aggressive price leadership, it would have hammered its own revenues in 2005, and possibly forced itself to return to the capital markets for more funding.  But it would have won in the long run.  By 2007, Netflix would have at least 10 million subscribers, fabulous returns to scale, and little competition.

Instead, Netflix lost the game of pricing-chicken with Blockbuster.  Blockbuster is now the low-price leader in online movie rentals, and plans to build ten more distribution centers next year.  Sure, Netflix will have better profitability in 2005.  But in 2008 it will look back and realize that it traded millions of subscribers, significant economies of scale, and impressive long-term profitability for $1 per subscriber per month.

In A lesson in technology and Internet investing from Netflix (NASDAQ:NFLX) and Baaa baaa baaa! The sell-side analysts are coming!, I argued that investors should welcome a strong commitment to aggressive price cuts from Netflix as they would generate long-term shareholder value.  Now it turns out that Netflix CEO Reed Hastings doesn’t have the guts for a price war.  He raised prices (and churn), then cut them, then failed to cut them again.

By allowing Blockbuster to reach critical mass, Netflix will devastate its own long-term profitability. So however cheap the stock looks now, it’s not cheap enough.  I don’t own it.

Meanwhile, here are two excerpts from Blockbuster’s conference call (quotes from the CCBN StreetEvents transcript), with acerbic off-the-record comments by a sell-side analyst who wants to remain anonymous:

To date, more than half of our online subscribers have not shopped in our stores during the last 12 months, so very positive results.

Comment: “Actually, those are negative results.  Once a customer frees himself from the Blockbuster
experience [Blockbuster’s new online customers seem to be coming from Netflix], he or she isn't coming back.  So the company's $17.49 offer for 3 online rentals and 2 in-store rentals makes no sense.  Online subscribers aren't going back into the stores again and don't want those 2 in-store rentals.