By Davis Freeberg
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.
A year ago, I took issue with Wedbush Morgan analyst Michael Pachter’s pessimistic views on Netflix and his optimistic outlook for Blockbuster Video. Surprisingly, Pachter actually took the time out to respond with clarification on his view back then that Blockbuster would be a better investment than Netflix. The whole thing was Slashdotted under the headline The DVD Race Analyzed and since 12 month price targets, are, well, 12 month price targets, here we are one year later.
A year ago Pachter had placed a 12 month price target of $3 per share on Netflix’s stock and a 12 month target of $13 per share on Blockbuster’s stock. Had Pachter been correct this would have represented a 75% decline in Netflix’s market cap and a 45% increase in Blockbuster’s market cap. What happened instead was that Netflix ended up executing very well on their business and shareholders ended up achieving a 157% return compared to Blockbuster shareholder’s 52% loss.
Over the last 12 months, Pachter has raised his target price on Netflix twice. The first was on 07/26/05 when Netflix was at $19.01, he increased his 12 month price target to $6.50 per share and again on 1/25/06, with Netflix trading at $28.59, he increased his price again to $10 per share, where it stands today.
If you compare this with Blockbuster you can see that he adjusted his price target three times. The first was 11/09/05 when he brought it down from $13 to $10. At the time Blockbuster’s stock price was $4.11. On 03/10/06 he updated his target to $5.25, when Blockbuster was at $3.65 and then raised it again on 4/27/06 with the stock at $4.76 to where it stands today at $5.60.
If Pachter is correct, it would mean that we should expect to see Netflix face some pretty turbulent times over the next 12 months. While his $10 target isn’t as aggressive as last year’s dire 75% prediction, it would still represent an erosion of 65% to Netflix’s market cap. His expectations for Blockbuster on the other hand are still more moderately rosy this year. Instead of a 45% increase in Blockbuster’s stock price, he thinks shareholders should expect a more modest 17% increase in appreciation.
I think he’s wrong.
Netflix has fundamentally changed the video store rental industry forever and has shown no signs of slowing. Video on demand will be an issue for the company, but Blockbuster will not be immune to the same issues. Netflix has developed a VOD solution, but still needs to convince Hollywood to give it’s approval. Netflix management has made very few mistakes along the way and they’ve always been quick to correct them when they have come up.
Netflix’s cohesive management team has allowed them the flexibility to move very quickly in an emerging market, whereas Blockbuster is a more bulky ship for CEO John Antioco to steer. Blockbuster has proven that they can follow the market, but so far they haven’t been able to lead. Over the last year, Antioco has had to deal with quite a bit of internal issues. He slashed staff to try and create cost savings and had to survive a brutal proxy fight with Carl Icahn — meanwhile nervous bond holders have kept a tight leash on how the company operates. Only recently has Antioco been able to committ his undivided attention to running the business instead of dealing with political pressures. And perhaps most personally disappointing for Antico this past year he had his fat $7,000,000 million per year pay package cut to $1.63 million. Ouch.
Recently, Blockbuster has been in liquidation mode. Last March they sold off their Spanish operations and currently they are selling off the remainder of their Austrailian locations. In the 1st quarter alone they closed 131 stores. Over the next year store tipping will accellerate and they are going to be forced to downsize their retail prescence even more. For every store that goes out of business, it creates a big opportunity for Netflix to expand into their market. Blockbuster might be able to move some of these customers online, but the loss of the higher transaction revenue will certainly be felt as Antioco & Co. continue to dismantle the company piece by piece.
Recently, Blockbuster has been able to demonstrate some improvement in how they compete online. Specifically, they announced that they are going to redesign their website which should help them shift demand further to archived DVDs and away from new releases. This is important because it can help them start tapping into longtail economies. They have also done a good job of differentiating their online service from Netflix by offering free weekly rental coupons to their online subscribers. This has helped to bring online customers back into the store and offers Blockbuster an upsell opportunity for their online subscribers. Both of these initives will help Blockbuster further solidify their online offering and are important steps for them to take. Blockbuster Online has become an important strategy for the company, but Blockbuster is running out of time, if they closed every store it would take 30 million subscribers to replace the $6 billion and shrinking in revenue that they make each year. They may not need all 30 million to survive, but it’s going to be difficult for them to increase their subscriber base as fast as their revenues fall.
The stand alone video store is facing a similar crisis to what the cineplex faced prior to the explosion of the multi-plex. The Cineplex could only offer limited amounts of movies and had to have a staff for the whole theater. The mutli-plex on the other hand offered more choice and cost savings. Eventually the Cineplex was forced to yield to the more efficient business model. Over the next year, Blockbuster will continue to face the same pressures. Netflix offers more choices then what they could ever hope to stock in a store and because it’s all done through the mail, they don’t have to staff 9,000 locations.
The video store business model will eventually fail because of simple economics. They have a high fixed cost and Netflix and VOD has a variable cost to their business. If a video store has traditionally made 10% profit margins on their business and 20% of their customers go away, they still have to pay their fixed costs, but if Netflix sees a decline in their subscriber base business, they can more easily adapt because most of their costs are tied to usuage not infrastructure. This allows them to be more nimble in tough markets and more aggressive in emerging ones.
Since the launch of Blockbuster’s online dvd rental program in August 2004, they have added 1.3 million customers, but over the last 6 months alone, Netflix was able to add
almost as many subscribers. Each customer that Netflix acquired represents pure growth for the company, but of Blockbuster’s 1.3 million subscribers, how many of them represent former retail store customers?
According to Blockbuster’s most recent quarterly filing, revenue for the 1st quarter of 06′ declined 7.7% compared to the 1st quarter of 05′. Between the canibalization of their own customers and competition from new alternatives, Blockbuster could soon find themselves in a postion where it will be tough to make profits at many of their stores.
If you compare the balance sheets of both companies, you can see that Netflix currently has $227 million in cash on hand, $392 million in total assets and only $155 million in total liabilities. Blockbuster’s hasn’t officially filed their 10-K for the most recent quarter, but according to their 8K they had a cash position of $223 million, they had $1.03 billion in assets, but also had $1.07 billion in debt and $413 million in accounts payable. Blockbuster’s cash position was helped tremendously by an infusion of $150 million from Carl Icahn last year, but the price Blockbuster had to pay for the money was the issuance of preferred stock that they have to pay a 7.5% coupon on in cash or stock and it has a convertible feature that allows the holder to convert the bond to stock at a $5.15 stock price until November 20, 2010. At the time of it’s issuance Blockbuster’s stock price was at $4.20.
Contrast this to Netflix most recent announcement that they plan on issuing another 3.5 million shares in a secondary offering. Not only do they not have to take on debt to obtain capital, but they also don’t have to resort to conversion features in order to raise the working capital.
In his response to my article last year, Pachter pointed out two advantages that he saw Blockbuster having over Netflix. The first was that Blockbuster’s service was $3 cheaper then Netflix and the second advantage was that he saw a cost advantage once Blockbuster began shipping from the retail stores.
A year later, not only did Blockbuster get burned by the price war that they started, but they also lost all control over pricing. If Netflix wants to raise prices, Blockbuster would gladly follow, but Netflix has hinted that they might go the other direction. They’ve already begun price testing and have said that they would consider lowering prices if they could do so and still hit earnings guidance. Whether or not Netflix decides to lower prices for the next year is irrelevant though. What matters is that they get to control how and when the DVD online market becomes a cash cow. With Blockbuster unable to compete on price, Netflix’s brand name gives them a huge advantage over the negative long term image that consumers associate with Blockbuster’s brand.
Last year, Blockbuster did begin mailing DVDs from their retail stores, but Netflix also began work on their own secret weapon. In July the company announced that they were making an investment for new postal sorting machines. At the time Hastings promised to update investors on what type of cost savings to expect in 2006 and has quietly forgotten to mention the impact since then. While I don’t know the amount of savings the machines have generated, I suspect that Pitney Bowes has helped Netflix to to negate some of the cost advantage that Blockbuster might have from the retail level shipping.
Over the next year, as video store margins continue to detoriate, Blockbuster will have no choice but to continue to close their stores. Each store closing will reduce Blockbuster’s revenue and will make their debt payments more and more difficult to make. Over the last year, Blockbuster has sold off a number of assets and the loss of these stores will also contribute to a decline in overall revenues for the company. Netflix on the other hand, continues to add subscribers each quarter and are predicting that they will exceed 6 million customers by the end of this year. Netflix is also predicting $35 million in net earnings this year and 50% earnings growth for the next several years.
Despite my own pessimistic outlook on Blockbuster, I don’t think that it still too late to save the company. In a digital world innovation can always occur. One of Blockbuster’s bright spots is their ability to leverage their real estate portfolio. This allows them to be more aggressive about closing stores and gives them some flexibility in exiting unprofitable stores. The only way that I can see Blockbuster expand revenue, but increase store closings would be for them to negotiate the rights to do burn on demand DVDs at kiosk locations nationwide. Blockbuster has had some success at negotiating revenue sharing arrangements with the studios and if they could offer a business model where you could go to your favorite supermarket and burn any of 50,000 DVDs on demand or ahead of time, then the company could survive the digital transition.
Blockbuster has explored kiosk relationships in the past, but have never committed to a strategy. Movie Gallery on the other hand has developed an early kiosk strategy, but so far it doesn’t include the rights for burn on demand functionaity. Last fall Joe Malugen, the CEO of Movie Gallery said that they were planning to launch their own kiosks at an unnamed grocery store chain, but the deal failed to materialize and has been put on hold due to their debt issues. While it might not be too late for Blockbuster, unfortunately for Movie Gallery, even burn on demand kiosks might not be enough to save them. If Blockbuster could secure the rights to this technology then I would rethink my thesis on the company, but as it stands now Blockbuster hasn’t shown any signs of being innovative and Antioco is only now starting to understand how Netflix leverages the long tail to maximize profits.
Last August, Pachter said that Blockbuster had “a chance to eat Netflix’s lunch“, but I don’t think that Netflix needs to worry as much about Blockbuster as Blockbuster does about Netflix. The online DVD rental market is a growing market and Netflix will gain customers regardless of what Blockbuster tries, but Blockbuster on the other hand is sitting on a one billion dollar time bomb that will have to be dealt with further down the road. Over the course of the last year I’ve seen a lot of writers refer to Netflix as a struggling company. They paint a picture of desperation, but the truth is that Netflix can afford to run at breakeven for ten years, if that’s what it takes to turn the video store market entirely upside down.
Update: Editor’s Note: Wedbush Morgan Analyst Michael Pachter responded to Davis Freeberg’s article with the note below.
First, to be fair, I was wrong about Netflix last year, and have been wrong so far this year. To paraphrase Mark Twain, my prognosis of Netflix’s imminent demise was greatly exaggerated. I also said that I would rethink my assessment if Netflix was able to compete on price, and Netflix did indeed compete successfully on price. I have rethought my assessment, and have reached a similar conclusion, albeit over a
longer time frame.
Second, I said that if Blockbuster revenues fell, they would face a credit crisis. Their revenues have fallen, but they’ve managed the expense side well and have raised additional capital, and I do not believe that they face a credit crunch.
As to one-year price targets, you’re absolutely right, I have probably been too harsh with Netflix and have been too optimistic about Blockbuster. In the case of these two, I have a long-term thesis about the market, and it’s impossible (at least for me) to predict exactly when this will play out (see the attached note), but I have a great deal of conviction that it will play out. Regardless, my overarching thesis is that there aren’t that many people who will ultimately opt in to a Netflix-type service, and Netflix and Blockbuster are rapidly approaching full saturation of that market. I may have been naive in assuming that they would saturate by mid-2006, and may continue to be naive in thinking it will happen in mid-2007, but I continue to think it will happen inevitably.
With that said, I think many of the conclusions you reached in your blog are poorly reasoned. Netflix has a cost of delivery (postage and fulfillment), and that cost is actually quite high. Its gross margins are significantly lower than Blockbuster’s, at around 35% compared to around 60%. The difference (25% of sales) pays for a lot of overhead. Yes, I know that Blockbuster’s overhead is twice this amount, but the difference between Blockbuster’s overhead (around 50% of sales) and Netflix’s (around 35%) isn’t that great. If Blockbuster can increase store efficiency (smaller footprint), it becomes more competitive. That’s what I think will happen.
Does that mean Blockbuster will be more profitable than Netflix? No, and especially not on a per customer basis. However, if you want to compare my price targets, I have Netflix earning $45 million in net income, so my $680 million market cap target is a 15 multiple. Same as my target for Blockbuster.
One thing you don’t discuss is the role of OTHER brick and mortar in how this plays out. I think that Movie Gallery has some problems, and at a minimum will close stores. I also think that the footprint for retail will shrink, with much smaller stores lowering overhead and providing similar service. Blockbuster stands to gain a lot more from store closings than does Netflix.
Also, your rationale on VOD is way off the mark. See my attached note. In summary here, Amazon missed out on digital downloads of music, and there is no way that they miss out on digital downloads of movies and allow Netflix to dominate.
We’re going to continue to differ in our views about the size of the market,
and I might continue to be wrong. Much in the same way that I think our
President is wrong about teaching democracy to middle-easterners, and I
think he will continue to be wrong. However, I never question his
conviction nor his consistency.
Update #2 – Slashdot has weighed in on the debate between Blockbuster & Netflix and Independent Insider runs the math on what it would have cost you if you would have shorted 1,000 shares of Netflix and purchased Blockbuster instead.