Netflix Killed the Video Store

Editor’s Note: Davis Freeberg is both a Netflix shareholder and customer.

by Davis Freeberg, Staff Writer

I heard you on the wireless back in Fifty Two
Lying awake intent at tuning in on you.
If I was young it didn’t stop you coming through.”

— The Buggles, Video Killed the Radio Star

Netflix killed the video store? Well, maybe this headline is still a bit premature, but how often do you get a chance to remix a Buggles song title? So while the video store’s demise may be greatly exaggerated Netflix still did surprise and delight their investors yesterday with some pretty good news. Yesterday afternoon the company announced not only record growth for their second quarter, but also a profit of .09 cents a share, surprising analysts who had called for a profit of .01 based on previous guidance. Netflix also raised guidance and announced that they expect to make a profit of $2 – $11 million for the full fiscal year. On the analyst conference call following the announcement, for obvious reasons, both Netflix CEO Reed Hastings and CFO Barry McCarthy seemed very upbeat.

Hastings emphasized that the online DVD rental market is indeed alive and well and growing and more specifically that Netflix will most likely hit four million subscribers in December 2005. Hastings announced that Netflix now offers more then 50,000 DVDs which is about 10,000 more than previously reported. Even more exciting for the indie film buff, the majority of the additional titles have been added by independent studios. During this quarter Netflix opened four more distribution centers and now have 90% of their subscriber base in a one day delivery zone. And of course then there’s the highly anticipated TiVoflix service which Hastings is now reporting will be out be the end of the year, hopefully in time for Christmas. A pretty good round up of positive news for Netflix all in all with Hastings declaring, “the potential may be greater then any of us imagined.”

During the call Hastings acknowledge that it is not 100% smooth sailing ahead. Netflix is still in the midst of a price war with Blockbuster and some suggest Amazon still could be a potential competitor. “We will continue to work to drive churn down with aggressive pricing and great service levels,” said Hastings acknowledging the competition in the online space. Hastings discounted Amazon’s UK service by pointing out that they were presently ranked 4th there and adding that “as time goes by and our competitive position strengthens — Amazon’s direct entry into the market seems both less formidable and less likely.” Hastings added, with “our volume of one millions shipments per day we can make money at price points that new entries can’t.”

Hastings then went on to address the Blockbuster issue with very strong words. ”We are clearly taking the fight to them on all fronts. We have 3.2 million subscribers, they claim to have over one million. In fact our lead is now larger then it was a year ago as we have added more net new subs then they did over the last year. We are profitable, their online business is deeply in the red. We deliver positive cash flow their free cash flow is negative. We have no long term debt, they have substantial debt. Our churn is 4.7% we believe theirs is over 7%.
In every dimension we are winning and continuing to extend our lead.”

During the Q&A; session of the call Hastings went on to say that “we have the perception that they’ve given it everything they’ve got from a balance sheet perspective and we’ve got them contained.” He later went on to almost challenge Blockbuster saying that “we’ve seen what they’ve got and it isn’t enough.”

At one point during the call Hastings went on to compare the video stores to travel agency and predicted that as more consumers adopt online delivery, it will force traditional retailers with high fixed costs to abandon their stores.

Netflix plans to spend more money in the months ahead on automation equipment. Perhaps good news if you are a shareholder, maybe not so good news if you are one of the workers stuffing DVDs into envelopes.

The biggest surprise during the Q&A; was the grilling that Hastings and McCarthy received even after beating expectation. You would have thought that they had announced a loss. During last quarter’s call they were too conservative with their Subscriber Acquisition Costs (SAC) number and the analysts had put a lot of faith in those numbers, so their estimates were off. Netflix attributed the change to lower marketing expenses and lower churn, but it was clear that more then one analyst had trouble accepting this explanation. Several analysts kept trying to figure out if the $9.99 subscribers were in fact more profitable then the $17.99 subs, but Netflix refused to disclose a breakdown of subscribers citing competitive reasons.

Back to the TiVoflix online delivery topic, Anthony DiClemente of Lehman Brother’s asked Hastings, “how are you proceeding with the studios in terms of getting digital rights for catalog titles over a set top box?” Hastings responded that “negotiations are never done until they’re done” and that “we still believe it will be a number of years before downloading is accepted by the mainstream.” Hasting pointed that it could be be 3, 5 or even 8 years before the major studios will accept a digital model leading one to assume that at least initially, TiVoflix may focus on more independent type titles.

During the call, Netflix also disclosed that they were making an $8 million investment in automation equipment. Good news if you are a shareholder, but bad news for the employees who stuff the envelopes now. They will be implementing the automation over the remainder of this year and expect to see cost savings in 2006. They couldn’t discuss a lot of the details surrounding what type of automation is planned, but promised that it would be a topic covered on next quarter’s call.

Oh, and remember our old friend Michael Pachter over at Wedbush Morgan that we last visited with on April 28th — the analyst with the $3 price target for Netflix stock? Good news, he upgraded his 12 month price target on Netflix to $6.50 (still at a sell though). Whew!