Netflix Continues Online DVD Dominance

By Davis Freeberg

Davis Freeberg is both a current shareholder and customer of Netflix. This post should not be construed as financial advice.

Netflix reported strong Q4 2005 earnings today and continued to show impressive subscriber growth for their DVD by mail business. During the 4th quarter they increased their revenue to $195 million, generated $38.1 million in income, and finished the year with 4.2 million subscribers. They expect to have almost $1 billion in revenue for 2006 and are predicting that they will hit at least 5.95 million subscribers by the end of this year. They finished the year at the top of their guidance in subscriber numbers and the .57 cents per share they reported, easily topped analysts expectations of .15 cents a share. During the conference call following their announcement, they commented on HDTV, VOD and on managing growth.

In an earlier press release Netflix stated that they planned on offering both HD-DVD and Bluray to their subscriber base. In their conference call Netflix CEO Reed Hastings went on to add, "We will offer all HDTV titles the day they launch at no extra cost." When pressed for more details about the costs of HDTV DVDs during the Q&A session, Hastings commented that as far as the short term costs go, "we don't see any, it will be the same content cost as we're planning to spend so there is no impact in this year and probably for several years out."

This is a little surprising to me. I had always assumed that the studios would use HDTV as a way to increase DVD prices, but it appears that in the short term they'd rather sacrifice price increases for consumer acceptance of the new formats. This is great news for consumers who want HDTV DVDs, but are concerned about the costs of making the digital evolution.

Last week Glen Reid, an analyst with Bear Stearns, downgraded Netflix over fears that the company will face an increasingly competitive market for VOD content. During the call, Hastings argued that the VOD market is tied up by long term exclusive agreements and directly addressed Reid's comments by arguing that the market is big enough to support both VOD and DVD rentals.

"The same studio, Fox that's being innovative and aggressive on VOD is predicting that the DVD market, rental and sale, will grow from $24 billion last year 2005 to over $30 billion by 2010 and what you have to watch out for is this sort of zero sum assumption problem. If you assume that the growth of any entertainment channel is at the expense of another, then you do get into that zero sum logic, but if you think about the 25 year history of the movie business. 25 years ago there was only the movie theater, there was no HBO, no video, no DVD and so it was about a $6 billion dollar business and it's grown as new channels have developed to be close to a $40 billion dollar business 25 years later, so while there are new channels such as VOD that have consumer interest and I think will be financially successful, that doesn't inherently take away from DVD."

With DVD being the cash cow of the movie industry, it's hard for me to imagine that the studios are going to do anything that would threaten that revenue. Sure they were forced to offer digital downloads for mp3s, but only after Napster and Kazaa forced their hand. Even today, we've yet to see a serious VOD movie service launched. The studios are instead focusing on licensing television out of fear that TiVo and other PVRs will destroy the economics of the broadcast business.

With Netflix seeing a 60% increase in subscribers over the last 12 months, it's becoming increasingly important for them to effectively manage their growth. During the conference call, they announced that during the 4th quarter, their content acquisition costs went down and that they planned on spending about 20% more on new DVD purchases then they did during Q1 of last year. This is good news for frustrated fans who have had trouble getting new releases as the service has grown. With the increase in spending during the first quarter, we should begin to see some relief from the long wait times on new releases.

The company also commented extensively on their future plans to use additional profits to help fuel subscriber acquisition costs. With SAC coming in at $40.65 some of the analysts questioned the logic of increasing spending on growth initiatives. Hastings responded with a clear message that the company wasn't interested in profits, but cared more about growth. Their logic for any price cut or increase in marketing spending would be to further drive video stores out of business.

"If in Q1 we reduced total marketing expense, which we are not thinking of, but for example hypothetically only spent $30 or $40 million dollars, you would find us hugely efficient in SAC. If we have enough gross margin that we were able to beat our earnings target or meet or beat our earnings target and spend a huge number, lets call it $100 million in marketing you would see the average SAC climb. Any of those scenarios I think make sense for the business again because we are at $40.65, so far below the total lifetime value, so think about it as the more we invest in marketing, we are pushing the market and what we're willing to do is push it hard as long as we meet our earnings target. Now why are we in such a hurry, why are we trying to push the market so hard? Because the prize that's out there is making video stores uneconomical and triggering the tipping point for mass closures of video stores."

While Hastings and Barry McCarthy both insisted that they haven't made a decision to cut prices yet, this rhetoric will not be good for Blockbuster. With 4.2 million subscribers a price cut of $1 would cost Netflix about $50 million in lost revenue. This would leave them with an additional $50 million that they could spend on advertising. With $200 million in cash, the company has the financial clout to engage in a long and heated price war, if it ultimately can cause video stores to go out of business and if it forces customers online then the price war would be worth it. In the call, Hastings said that they are running a lot of tests right now, but refused to disclose early results. He was very clear that they have not made a decision to decrease prices, but that it's a possibility if the data supports it and if they can continue to deliver $50 million in earnings with a 50% increase in earnings growth over the next several years.

With another impressive quarter of growth, Netflix continues to solidify their lead on the online dvd market. While the company may not be trying to squeeze as much money out of their subscribers in the short term, in the long term this strategy will result in destroying Blockbuster's business model and will create tremendous wealth opportunities for the company. As more customers make the transition online, the company is positioned well to benefit from Blockbuster's misfortune.

*Update - In response to yesterday's earnings, Wedbush Morgan analyst Michael Pachter updated his 12 month price target for Netflix from $6.50 to $10.00 a share. He currently rates the company as a sell, but does have a buy rating on Blockbuster with the same $10.00 target price. Blockbuster currently has about twice as many shares floating on the open market. If he is correct, we should see Blockbuster's market cap represent twice or what Netflix's market cap will be twelve months from now.