Wedbush Morgan’s Michael Pachter – Sell Netflix, Buy Blockbuster

Update: We revisited this issue one year later. Click here to see an update on this debate.

Editor’s note: It should be disclosed that Davis Freeberg is both a current customer and shareholder of Netflix. This post should not be construed as providing financial advice.

by Davis Freeberg

If you want to get one analyst’s opinion on the current two horse DVD race between Blockbuster and Netflix you need to look no further than Wedbush Morgan’s Michael Pachter. Pachter has been pretty negative on Netflix for a while now and is about the most negative guy on the street with regards to the company. Pachter initiated coverage of Netflix after they lowered their pricing on 9-28-04 with a sell. Subsequently he has reitered this sale five times and presently has a 12 month price target on the stock of $3 per share. The stock closed today at $11.20.

What I find interesting is Pachter’s view on Blockbuster by contrast. At the end of March Pachter reaffirmed earlier guidance that he believes that Blockbuster should hit $13.00 per share over the next year. Blockbuster closed today at $9.96. If he’s correct, this would represent a return of over 45% based upon Blockbuster’s closing price of $8.92 on 03/28/05, the date Pachter made his call.

Irrespective of what Pachter thinks about the overall DVD rental business, Pachter’s seemingly obvious prediction would appear pretty dire for Netflix. Pacther updated his price target for Netflix On 4/22/05 with the new $3 price. If Pachter is right, then we should expect to see Netflix’s stock fall by approximately 75% over the next 12 months.

I think he’s wrong.

7.5% of Netflix is currently owned by Netflix Co-Founder and CEO Reed Hastings. Given that Netflix stock has already fallen by 60% over the last 12 month and that their stock is currently one of the largest short postions on Wall Street, a $3 price target seems a little aggressive.

Based upon current earnings, if Netflix dropped to $3 a share, it would mean that the company would be valued at a market cap of $152 Million with $175 Million in cash on hand, very little debt and revenue of approximately $600 Million per year.

Now, compare this to another of Pachter’s picks. Yesterday Prachter upgraded Movie Gallery’s rating to Buy from Hold and assigned a 12 month price target of $35 to their stock. If Pachter is correct, then this would represent an approximate return of 24% over the next year.

Movie Gallery presently has about $25 Million in cash and $50 million in debt and Blockbuster has about $330 Million in cash and a staggering $1.35 Billion in debt. In addition to the debt servicing and online promotions, both companies must also pay leases and salaries for their physical locations.

Over the last year, Pachter has been a strong proponent of Blockbuster. Last January, he suggested that Blockbuster would be a better fit for Amazon then Netflix. This contrasts to Lehman Brother’s analyst Anthony DiClemente view that a partnership with Blockbuster would be “less likely” due to shareholder unrest. Diclemente currently rates Netflix as neutral with a 12 month price target of $14.00. Pachter also came to the defense of the $52 Million pay package of Blockbuster’s CEO, John Antioco, by calling it fair and “comparable to pay for CEOs of other large retailers.” While this may help Antioco sleep better at night, it probably doesn’t help the 200 employees who were laid off at the same time that the compensation package was negotiated.

And here’s some more. If you know someone who is using Netflix right now ask them about the service? Do they like it? Now go into your local Blockbuster Video store and ask the clerk there how he feels about his employer. Netflix’s customers are huge evangelists for the service and they view the service as fun, innovative and exciting — not bad for a growing company with very little debt. Blockbuster on the other hand is a bloated company, with tons of debt, who is laying off it’s employees, cutting back their hours, fending off a shareholder proxy fight with Carl Icahn, who has had their CEO recently announce that if he was not re-elected he would resign from the company.

Oh and by the way, earlier today ratings company Fitch revised Blockbuster’s credit rating outlook to negative from stable — something that is not typically helpful to a company with a lot of debt.

In the long run, all three companies, Netflix, Movie Gallery and Blockbuster will face a tremendous battle to stay alive when Video on Demand becomes widely available, but in the short run, if you agree with Pachter, then you should short Netflix and use the proceeds to buy Blockbuster and Movie Gallery. But I suspect if you do, you may want to go get your head checked first.

Update: Editor’s Note: Wedbush Morgan Analyst Michael Pachter responded to Davis Freeberg’s article with the note below.

Happy to respond. First of all, thanks for the compliment on my video game coverage. I am hopeful that my coverage of other companies is an indication of my thoughtfulness and thoroughness.

I don’t hate Netflix at all. I think that they had an innovative and brilliant idea, but unfortunately chose to compete in an area where the dominant company has a lot to lose. Blockbuster loses whenever Netflix gains customers. My guess is that 1.5 million of Netflix’s customers are former Blockbuster customers. That means that if these people paid $20 per month to Blockbuster before they shifted to Netflix, Blockbuster is losing $360 million per year. It is easy to see why Blockbuster had to respond.

The amount of Blockbuster’s debt is irrelevant. They have over $6 billion in revenue, and will be able to service their debt, so long as they can maintain revenue. If Netflix continues to erode their business, they will have a serious problem.

Once Blockbuster decided to compete with Netflix head on, I decided to initiate on Netflix with a sell rating. I think that although Netflix has a fine service, and is best in class, its future growth will depend upon adding customers who don’t appreciate that it has more satisfied employees than does Blockbuster. People unfamiliar with both services are likely to choose based upon price, and Blockbuster’s service is cheaper by $3 per month.

Also, Blockbuster has a huge cost advantage over Netflix. Once Blockbuster migrates fulfillment to the store level, it will save approximately $5 per customer per month in inventory costs. That is because it is cheaper to fulfill online rental requests from a large inventory of brick and mortar movies than it is with dedicated DCs used by Netflix.

In terms of Amazon, they want the best deal that they can strike, and have a history of partnering with the best in class brick and mortar stores (Toys R Us and Target?). My understanding is that they spoke several months ago with Netflix, and couldn’t work anything out.

I have never said that Antioco’s compensation is comparable to other retail CEOs. Instead, I said that it works out to $10 million or so per year over a multi-year period, and is reasonable given that if h
e succeeds, his shareholders will benefit by $180 million for every dollar in share appreciation. The comp package was disclosed in SEC filings in September at the time of the split off. The layoffs have not yet occurred, but were announced by Blockbuster back in February or March.

My overall thesis on Netflix is that it will have difficulty competing with Blockbuster because it doesn’t make money at its current level of subscribers. Blockbuster does make money. Netflix has $140 million of cash, but if it chooses to compete with Blockbuster on price, it will see that cash erode at a rate of $9 million per month once it cuts price by $3. I’m betting that it will cut price.

IF Netflix maintains pricing and continues to grow, I will rethink my thesis.

By the way, please note that Blockbuster stock didn’t react at all to the Fitch downgrade.

Update: Slashdot picked up the story today.

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34 Comments

  1. Anonymous says:

    FIRST OF ALL, AMAZON NEVER TALKED TO NETFLIX. Netflix freaked when they thought Amazon was starting a service here in the states. They weren’t. They started that service in the UK. NO TALKS ON ADDING THE SERVICE TO AMAZON. Saying so is just stupid and betrays a complete lack of research.

    Let’s assume for a second that every potential customer does not know that:

    1. Netflix’ site is better at what these sites do.
    2. Blockbuster edits their movies.
    3. Blockbuster has a more limited selection (including no NC-17 movies, last I checked)

    …etc.

    So assuming that, some famous analysts seem to think that Blockbuster can address their debt and benefit from the bricks and mortar infrastructure. I don’t see how this is likely.

    Problem #1: Many stores are franchises!

    Problem #2: The whole point is to provide these DVD’s in the mail. So, as I read it, Pachter thinks they will somehow benefit from these bricks and mortar locations fulfilling online orders from their limited invetories??? Yeah, right. Not the stores I’ve been to.

    And to add to this, Blockbuster has no soul.

    They do have name recognition, the ability to shoot new releases out quickly, and a lower price point. But no evangelical fans to tell their friends and parents to sign-up and no pretty red envelopes (I won’t go into color psychology).

    So, there is at least, no clear f—ing winner. And why does there need to be? Are we really that friendly with the idea of monopolies? Jeez.

  2. Joefrontier says:

    Pachter is largely right about Netflix’s future. The core of the problem is cash. As Netflix spends more money to continue acquiring customers it eats into its cash reserve. To maintain this trajectory it will need to continue going to the equity (or debt) markets. This process will become more and more difficult as time progresses and Blockbuster makes more headway.

    However, Pachter seems to indicate that the migration of Blockbuster to store-based distribution is going to be a big advantage. I disagree. The advantage of Netflix is their ability to target niche markets through semi-centralized distribution. Blockbuster’s stores can’t match this breadth of content within each store without investing heavily in new infrastructure to support a large number of additional titles. I think this would erase any cost saving that he’s mentioning (at least in the short term, which is really all that matters). The fact remains, we are migrating to a digital distribution mechanism for content. Various things will cause this process to drag out, but it is happening. As this occurs, Blockbuster is going to get caught between trying to serve an existing customer base that wants physical delivery (a declining population) and those that want pure digital delivery (where their existing physical distribution mechanisms provide them with no advantage).

    So, in my opinion, they’re both sells. Blockbuster will bludgeon Netflix to death and force it into digital delivery earlier than it would like (they’ll essentially suck the margin right out of the DVD-mail business). But shortly after this occurs, Blockbuster will begin to experience the full effect of digital distribution. It won’t be pretty for either company.

  3. Darkrose says:

    Pachter’s analysis doesn’t take into account one of the primary factors that keeps people at Netflix: selection. Blockbuster simply doesn’t have the variety that Netflix does. If you want anything more than standard Hollywood fare, you’re unlikely to find it at Blockbuster. Some people may switch because of the price wars, but for the most part, I think you’re dealing with two different customer bases.

  4. Mike S says:

    Actually Blockbuster’s online rental selection is comparable to Netflix’s. They don’t have that kind of selection in each of their stores for lack of room, but their online selection is not lacking.

  5. Anonymous says:

    I’ve tried both services and NetFlix is the winner hands down. the NetFlix web site is superior for finding the latest movies, and waiting for new releases is much less with NetFlix. For instance, under both sites movies can be marked as “Short Wait” if they are in high demand. Short wait in Blockbusters world is 2 weeks, for NetFlix it’s 1-2 days.

  6. Winston says:

    What separates NetFlix from BB to me is a couple things. First, NF has been doing it longer, they were the innovator in the space, and they are probably better at it in general. Second, NF’s site upgrades over the last few months have really helped me personally. I make extensive use of their account profiles to set up queues for me, my wife, and my kids. It sure beat having to put everyone’s movies in one big queue and prioritizing everything “just right”.

    Also, how come no one has mentioned the NetFlix/Tivo partnership? NF will be the ones innovating in this area. IMO, it’ll save both their hides (NF and Tivo that is) and kill BB unless they do something similar.

  7. Kristofer Z says:

    Remeber that not only has Blockbuster been losing market share to online rental services like Netflix, but its brick-and-mortar market share has suffered from competition with the likes of Hollywood Video over the past decade or more. Why isn’t Hollywood Video scrambling to provide an online service? Becuase they don’t have to.

    Blockbuster’s customers have simply come to realize that Blockbuster provides inferior service, in general. Just recently, Blockbuster lost their second (that I know of) major class action suit to customers over rental policies. Blockbuster is simply not a customer friendly establishment. The consumers that have learned this and are learning this are not going come back to Blockbuster, even for $3 less a month.

  8. Anonymous says:

    Freeberg actually talks a lot about Tivo and VOD in last weeks article on Netflix. It doesn’t appear that VOD is going to be very lucrative or popular for awhile. I suspect that this has more to do with how lucrative DVDs are and less with how expensive, but Bill Fisher with DVD station suggested that it has more to do with the cost of zipping massive terrabytes across the internet. Either way consumers will have to wait, which could buy both Blockbuster and Netflix some time.

  9. Anonymous says:

    Davis Freeberg seems to think that Wedbush Morgan’s Michael Pachter stated that Netflix’s stock would sink to $3 per share… I believe he was referring to lowering the “monthly rental fee” by $3.

    I don’t think Netflix has to reduce it’s monthly fee… I recently switched over from both of BlockBuster’s services (in-store and online) because the “no late fees” promotion meant that no movies are available and my queue of 30+ movies were all “long wait”. Blockbuster’s online list of “new releases” is usually a week or month behind and their “this week in stores” only covers videos “for sale” in the physical stores. I’ve also had more delivery problems with Blockbuster and multiple issues with their online customer service. (I’ve had no reason to contact Netflix customer service yet.)

    Blockbuster even offered my a 30 day free period if I reconsidered not cancelling… well, I’m still unimpressed and am cancelling prior to the period ending.

    My advice? Hello Netflix, bye bye Blockbuster.

  10. Anonymous says:

    Here’s a plain old customer’s opinion. I was a Netflix customer until I saw Blockbuster’s cheaper price and what looked to be a much larger selection, I switched a few months ago. My experience is:

    – Blockbuster does seem to have a better selection of older titles, including multiple versions of the same title and explicitly listing extras CDs. Having two free in-store rentals a month is a nice perq.

    – However their online new title selection is just plain awful. They’ve gone weeks with no new online releases and then only added one or two titles. Netflix always added titles every week.

    – The Blockbuster mailer is really badly designed, maybe 1 in 10 titles arrive with the front address tearoff intact. Most have one end loose and in several cases its been torn off completely in transit and all I received was the front sheet, no disk.

    – The mailer appears to provide no protection as many disks arrive with scratches that occurred in transit (judging by the torn mailers.) Several were unplayable and had to be replaced, in one case twice.

    – Netflix’s web site is better designed and much easier to use.

    Netflix just does a better job at online rentals, not surprising since that is their core business. I’ll be leaving Blockbuster soon and odds are I’ll be back at Netflix.

  11. Anonymous says:

    I trial’d Blockbuster… Took 3 days to return/credit a movie (vs. 1 day for Netflix), took 3 days to get a movie (again, vs. Netflix:1). Even with the cheaper price for Blockbuster, I could achieve cost-effectiveness with Netflix in a couple of weeks (cost of membership vs equivalent rentals at local video store) but longer for BB (which is not for me – not as much specialty selection (anime, mostly))

  12. Anonymous says:

    Blockbu$ter sucks. Period.

  13. Anonymous says:

    I live and breathe what is being discussed here as I am a director for such an offshore company that has the same model as Netflix and Blockbuster.

    Here is my take on streaming – don’t hold your breath.

    While the notion of a streamed movie with DVD quality is attainable from a technological standpoint there is a hurdle.

    That hurdle is the studios. In many countries new DVDs are released to rental chains on a “leased” basis allowing a few months of lead on traditional retail outlets.

    These titles are leased yet often have a 1 cent purchase price, which the distributors then waive. Essentially it’s just buying the DVD, but the key to all this is the distributors are selling a window for rental stores (online or otherwise) to capitalise on.

    It’s awfully nice of them to do this, however it’s all about the bottom line – these DVDs often cost $50US a disc.

    Now put your mind into the mindset of companies and distribution arms that have been based on a tried and trusted notion of cinema then rental stores then retail sales.

    First you have the issue of change, which no one wants to do – they just do it to either make more money or avoid losing money.

    The second and most important issue is profit. Why on earth will they want to make the consumer’s dreams of streamed movies come true when they make so much on DVD sales? Humans are object oriented, we appreciate movies but want to own the DVDs, or at least rent them – denoted ownership, even if temporary, is better than borrowed data.

    If a distributor can make up to $50US per copy of a new movie, then go on to sell it in stores for nearly $20 a pop, why would it want to fit in the desired consumer dream of a streaming service that will deliver a movie you will most likely watch once or twice for something like $1-$5?

    Streaming is a pain, it doesn’t give ownership (which is a whole other issue of cognitive dissonance when wanting to watch a movie) and it would mean distributors will take a massive revenue cut.

    While I have no doubt the day will come that movies are streamable, I see that they will be downloadable and not streamed more than anything – much like Apple’s store, because then at least you own something that you don’t have to give back or pay for again.

    The advancement of the newer DVD formats are a new hurdle thrown in by all the industries involved in DVDs to make streaming harder (more data) or less attractive (lower quality), but ultimately it will be the distributors who decide to release movies, and at what price.

    Don’t hold your breath.

  14. Anonymous says:

    If Blockbuster begins to crush Netflix, they will launch their equivalent of an ICMB: PORN. Blockbuster will not retaliate and will die.

  15. Anonymous says:

    I hate Buster, their service sucks big time.

    Netflix has better service and deliver CDs real quick and they seem to have CDs available all the time. Buster put you on waiting list even for older movies.

    I trialed both Buster and Netflix, cancelled Buster after testing their service and movie availability.

    But Netflix needs to have alternatives or they will run out of cash. Maybe sign a contract w/ Amazon. Buster has money to last long time though. Cash is king.

  16. Anonymous says:

    So many of the negative comments here towards Blockbuster are based on emotion rather than fact. That emotion has been the undoing of many an investor.

  17. Anonymous says:

    In the rebuttal, Patcher did not defend/mention $3 target price he has set for Netflix. Also, in his original comments when he issued this price target, he had said that Netflix is a piece of crap run by nice people. It seems that he is being more emotional and spiteful than analysis driven. Contrary to his assertion, he does seem to hate Netflix. Also, in the rebuttal, he mentions that Blockbuster has $6B revenue, so debt/interest repayment will not be a problem. But the problem is that the revenue is not same as cash flow, meaning all that $6B is not available fot debt repayment.

    Patcher’s analysis seems really shortsighted, as he assumes that keeping the employees happy/unhappy doesn’t matter to the success of the business.

    I think Netflex should start advertising that its service is far superior to that of Blockbuster.

  18. Anonymous says:

    Looks like Patcher a crappy analyst, and you should have your head examined before you take any of his suggestions. How can migration of fulfilment at the store level help in cost? Each store will have to have large inventory which will add to cost. In his original report he had indicated a $4 cost advantage over Netflix, but, now he is mentioning a $5 cost advantage. Is it because he sees a rent decrease in near future?

  19. Anonymous says:

    Mr. Hawk maybe you could enlighten us as to the number of posts that are coming from Netflix employees. My expectations are that it would be many.

  20. billfischer says:

    Some quick thoughts.

    Blockbuster’s retail operations have very high fixed costs and their operating margins have hovered around 5%. Their subscription and inscrutable extended viewing pricing tests coupled with these high fixed costs blended with a single-digit percent household migration to online fulfillment sources turn their fixed costs into an anchor. Netflix has high variable costs, is in a very price elastic retail channel, has margin pressure from slower turning high demand new release titles and continues to have quarterly churn around 12%. My thought is that winner will be the entity that best manages to control costs (fixed for Blockbuster or variable for Netflix). I agree with Thomas Hawk that the target of $3 for Netflix doesn’t map well with the current M&A; climate or their book value.

  21. Thomas Hawk says:

    Davis Freeberg is not employed at Netflix nor does he have any affiliation with the company whatsoever beyond the disclosed fact that he is both a customer and a shareholder.

    As to the comments left by others, I cannot speak for them.

  22. Anonymous says:

    Mr. Hawk the best thing for this debate would be to forward many of the negative and false statements being made here regarding Blockbuster and ask Michael Pachter to address them with some factual data. Possibly, that might enlighten many here who are making decisions on ill gotten information.

  23. boris says:

    Pachter got 4 degrees.
    but i vainly hope he is wrong
    about netflix. Netflix magmt
    says they arent interested
    in partnering with a bricks
    and mortar retailer(holly+movie)
    because the customer experience
    wont be as good. so the 5$
    saving Pacter claims may
    be more theorical valid then
    operationally.

  24. Aron says:

    The cash concern for Netflix seems overdone. They shed 5% of their cash reserve this last quarter, but they are forecasting to be cash positive again this quarter and for the rest of the year.

    I would most like to see Pachter’s justification for the 4$ (or 5$) cost advantage. That’s an enormous figure. Broken out, Netflix spends about 7$ on content per customer per month. Can Blockbuster really do it for 2$ or 3$? It blows the mind.

    Stores face a postage challenge as well. I don’t think stores will do enough mailings to get the maximum bulk\preprocessing discounts. This is especially relevent to the return path (using BRM)

    It also seems very natural to me that Blockbuster’s proposed hybrid fulfillment system may introduce challenging quality control issues. Namely, multitasking store employees failing to perform consistently. Conversely, the pure shipping center approach is an oiled quota-driven machine.

  25. Anonymous says:

    Pachter sounds a lot like that analyst Ravi Suria who in 2000 said that Amazon will run out of money and will go bankrupt:

    http://www.newyorker.com/talk/content/?020520ta_talk_surowiecki

    Last I checked, Amazon is still around, and Suria who?

    The funny thing is, if NFLX were to turnaround and post a profit, Pachter will try to take credit for that as well.

    He has interest in BBI and he wants NFLX to fail so he and his friends can make money, hence all the FUD.

  26. Anonymous says:

    Michael Pachter has called the fall of netflix better than anyone else I know. Congrats to those analysts who are bold enough to be truthful and who are not held by the brokerage firms to tout falling stocks.

  27. Anonymous says:

    This is all meaningless unless there are some hard metrics from BBI to compare and contrast what each is spending to acquire customers. This is the part of the equation that will ultimately determine who is winning or will win the marketshare. There are rumors that BBI has a SAC charge of over $50 but there are also questions regarding NFLX’s containment of SAC spending. at the very least we know what NFLX spends on it…we do not know what BBI spends. BBI seems to be able to operate in a world where acountability is not something the financial community holds them to. They have too much debt and have the daunting task of trying to catch up to the first mover in the sector. Add the recent grandstanding by Icahn and Antioco and what you have is a recipe for taking the eye off the ball and further eroding a shrinking marketshare. BTW, equally as dumb is the call for the dividend payment by Icahn. He chides BBI for overspending but let’s take on more expense so Mr. Coroporate Raider can show a profit on his stock…..

  28. boris says:

    the word is that Blockbuster
    will have spent 400$ million
    to gather 2 million customers
    by Q1 of 2006. and may not
    get their money back.

  29. Anonymous says:

    Cost to Aquire New Customer.
    Yes thats the KEY.
    the word is that by year
    end Blockbuster will have
    spent 400$ million to gather
    up 2 million subscribers Q1 06
    even thou they tapped into
    their own active customer
    base of 20 million.
    aron?

  30. Anonymous says:

    Is Michael Patcher still around ? Does he change the $3 target for NFLX, or does he see things others cannot?

  31. Anonymous says:

    Pachter and his buddy Herb Greenberg don’t have much to say these days. NFLX is up over 100%. If you have shorted it expecting it to reach Mr. Pachter’s price targe of $3, you would be in a world of pain.

    This guy has zero credibility along with Herb Greenberg (who is being sued by Overstock for shady dealings with hedge funds who short stocks and then ask him to print negative news).

  32. Anonymous says:

    Gonna correct a few things here…

    “Blockbuster edits their movies.”

    No, that would be WalMart. Blockbuster carries more Unedited and Unrated versions of top movies than any other retailer.

    “Blockbuster has a more limited selection (including no NC-17 movies, last I checked)”

    Blockbuster has the same # of titles as Netflix. We also have more Unrated versions than they do.

    “Many stores are franchises!”

    More like 1 in 100 stores are a franchise store. Sorry. Incorrect again.

    “The whole point is to provide these DVD’s in the mail. So, as I read it, Pachter thinks they will somehow benefit from these bricks and mortar locations fulfilling online orders from their limited invetories??? Yeah, right. Not the stores I’ve been to.”

    The stores do not fill the online orders. Warehouses do. The instore exchanges are to give customers something to watch while they wait for their next online rentals to arrive.

    Nice try though.

  33. […] came out with their own rent-by-mail service and it appeared that Netflix could be in trouble. Many analysts started signing Netflix’s death sentence, saying that Netflix wouldn’t be able to compete […]

  34. […] came out with their own rent-by-mail service and it appeared that Netflix could be in trouble. Many analysts started signing Netflix’s death sentence, saying that Netflix wouldn’t be able to compete […]