Will Netflix Survive iTunes Movies?

Includes: AAPL, NFLX
by: Sramana Mitra

Amidst weak economic conditions, Netflix (NASDAQ: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 (NASDAQ: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.