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.