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Twists in Netflix' Growth Plot

By Amy Tsao In the last several years, Netflix (NFLX) has carved out a neat little business for itself. For a monthly fee, online subscribers get to rent at any one time three DVDs that are sent out by mail. Each time a disk is mailed back to Netflix, a new one can be rented. Starting with a handful of subscribers in the San Francisco Bay area in 2000, the DVD rental service now has close to 2 million users and will likely report $500 million in revenues in 2004.

The stock's performance -- up 150% in the past 12 months, to above $29 -- reflects Netflix' impressive growth trajectory. Last year, it finished its first positive earnings year. Wall Street analysts, on average, forecast earnings per share growing 86% in 2004 and 161% in 2005.

And it's still the early days, says Chairman and CEO Reed Hastings, who likens the business to a young America Online (TWX): "When they were 2 million subscribers, they couldn't tell you they would rocket to 34 million subscribers." With a huge lead on rivals, Hastings says he's "confident we can get more than 10 million" as the business becomes more well known. He predicts Netflix will have $1 billion in revenues in 2006.

ELUSIVE PROFITABILITY? The optimism may be well founded. But the Los Gatos (Calif.) concern's results recently jolted investors. On Apr. 15, Netflix reported a first-quarter loss of 11 cents a share, compared to a 5-cent loss in the same period last year, as it spent more on marketing. Increased TV advertising pushed the quarter's average cost of acquiring each new subscriber to $35.12, up from $31.67 a year ago. Netflix says it will continue to spend around $35 to gain each subscriber for the rest of 2004.

Little wonder the stock fell 21% in the days after the earnings update and has yet to bounce back. Some experts predict a rebound will be hard to come by. While few dispute that Netflix is the leader in the DVD rental biz, competition in this arena is starting to pick up. And as Netflix' costs continue to rise, profitability could remain elusive, some analysts fear.

So far, many of the competitive threats are just that -- threats. But store-based movie-rental giant Blockbuster (BBI), in particular, is getting more serious and could dampen Netflix' enviable 80%-a-year revenue growth. Wal-Mart (WMT), with 2,800 U.S. locations at which movie renters could easily drop off their disks, could rise at any moment to take a big swipe at Netflix' business. And competing technologies like movie downloading and video-on-demand are lurking.

SERVICES "CAN COEXIST." Blockbuster, which had been experimenting with an in-store subscription service, is starting an online version with DVDs in the fourth quarter. The chain, with more than 5,600 U.S. locations, doesn't want to hurt its existing in-store rental business, but it wants to slow Netflix' advance.

As for Wal-Mart, the giant discounter started online movie rentals in recent months but has said little about the effort so far. Still, it already has a distribution model that's the envy of the world and would have few barriers if it decided to make a more serious run at this market.

Netflix may ultimately have more to worry about with video-on-demand and similar technologies. So far, video-on-demand use has been soft as the cable industry has focused on getting consumers to opt for digital cable. And right now cable operators can't match Netflix' library of 18,000 titles. But Ross Rubin, analyst at market researcher NPD Techworld, figures that could change. "I'm confident that within a couple years, there'll be large enough [cable company computer network] servers to handle that kind of selection."

Analysts agree over the long term, the landscape for watching movies at home will likely include several options -- including Netflix. Various formats and services "can coexist," says Rubin. "There's an area of overlap and competition." And Netflix' Hastings has an answer to a potential shift away from DVD rentals: He plans to introduce an online movie-downloading service in 2005.

PRICE-SENSITIVE CUSTOMERS? For now, investors are nervous over a $2-a-month price hike in June for Netflix' standard service -- to a monthly rate of $21.95. Revenues are expected to rise. Netflix raised its 2004 revenue forecast to a range of $485 million to $535 million, up from $480 million to $505 million previously. But its churn could climb, too -- as could its cancellation rate.

Hastings says he expects the price increase to have an impact within the second quarter only. "We believe we can get below 4% churn [in 2005]" he says -- down from 5.8% in 2003.

Some see the price increase as a sign of confidence in the business. But there's worry that subscribers -- both existing and newcomers -- will balk. "I don't think the increase is going to have the beneficial results that management expects," says Bill Mack, analyst at Standard & Poor's.

The gamble will result in subscriber defections beyond the second and third quarters, he figures: "Customers are pretty price-sensitive. [Netflix] will lose more than they believe." Still, Mack raised his rating on the outfit to hold, from avoid, based on valuation -- after the hammering the stock took following the latest earnings update. (Mack doesn't own shares, and S&P has no banking relationship with Netflix.)

FUTURE COMPETITORS. Mack is one of the more bearish analysts following Netflix, and he sees fair value at $33, a potential gain of 10% from its current price. He expects one of the concern's biggest costs -- adding new video titles to its library -- to continue rising rapidly, pressuring margins as subscriber growth takes a hit from the recent price hike and increasing competition. Netflix will spend more than $121 million in 2004 on refreshing titles and expanding distribution, he predicts, up from $62.7 million spent in 2003. While analysts predict earnings per share of 51 cents in 2004, he sees Netflix finishing the year with 11 cents in earnings.

Netflix also has its share of bulls. Dennis McAlpine, analyst at independent researcher McAlpine Associates in Scarsdale, N.Y., recommends the stock anywhere below $30. (McAlpine doesn't own shares and doesn't do banking with Netflix.) That's just where it is now. But any investors contemplating a stake in the leader of this young and growing business should consider the serious competitive threats it could face. Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column

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