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Netflix May Have a New Direction

The online DVD rental store's shares saw some action this week on speculation of a sale to Amazon, a move that could amp its subscriber base

There may be life left in online video rentals after all. Shares of Netflix (NFLX) jumped nearly 6% to $23.93 on June 7 amid rumors that (AMZN) wants to buy the online DVD rental store. Though Netflix wouldn't comment on the speculation, the buzz alone suggests anew that reports of Netflix's impending demise have been greatly exaggerated.

It's not surprising that Amazon may see Netflix as a good buy.

So far, Netflix has successfully weathered the emergence of video-download services now vying to wrest control of the "movie night in" market. Download services such as CinemaNow, Guba, and Hollywood-supported Movielink have yet to put a dent in the company's profits. And despite last September's launch of video downloads by Apple's (AAPL) iTunes store and Amazon's own "Unbox" service, Netflix didn't hasten its own download offering in a panic, waiting instead to unveil it in January (see, 9/12/06, "Don't Nix Netflix Just Yet").

Though growing fast, consumer demand for downloaded video rentals and purchases still barely rivals the market's appetite for physical DVD rentals. In May, Forrester Research (FORR) estimated paid video downloads would actually peak this year at $279 million in sales, up from $98 million in 2006. Less than 10% of adults had ever paid to download a movie or television show, according to the study. By contrast, Netflix alone brought in $997 million in sales during 2006.

Blockbuster's Block

Surprisingly, the company giving Netflix the most trouble is the one that was supposedly doomed by the arrival of online video rentals: No doubt, Blockbuster (BBI) has suffered since Netflix began grabbing significant market share with its Web-based mail-order model. In May, Blockbuster reported a first-quarter loss of $46.4 million.

But in a bid to revive its fortunes, Blockbuster has aggressively pushed its Total Access package. Like Netflix, Blockbuster's service enables customers to order movies online, then receive and return them by mail. But the package also allows customers to return mail-delivered DVDs at its stores and to pick up new ones there at no extra cost. The service operates at a loss now, yet Blockbuster has grabbed significant market share back from Netflix. "Before Blockbuster launched its Total Access service, Netflix was coping very well," says Youssef Squali, a Jefferies & Co. senior analyst who covers Netflix. "Then Blockbuster Total Access came about and they took a big hit."

Netflix has been growing at a significantly slower rate since Blockbuster ramped up the competition. The number of new Netflix subscribers grew just 2% in the first quarter from the end of 2006, as compared with a 19% gain in the same period a year earlier. Revenue growth has similarly languished.

Lights, Camera…Amazon

Despite that slowdown, Netflix may hold some appeal for Amazon. For starters, Netflix's service is still in demand—and certainly more so than Amazon's Unbox. Blockbuster, meanwhile, may not be able to keep up the pressure with Total Access. Squali maintains that Blockbuster will likely, at some point, raise prices or limit the number of rentals. When that happens, arguably, people who tried Blockbuster's service may turn to Netflix.

Amazon could potentially address some of Netflix's subscriber-growth troubles by marketing the service to its large user base. It could also seek to improve Unbox by combining it with Netflix's download service—should that model begin gaining significant traction with consumers.

But should Amazon be in the movie business at all? Amazon's stock declined slightly on the acquisition murmurs, showing some believe the retailer should stick to selling, not rentals. At the same time, Amazon's stock has risen 40% in the past few months, giving it more valuable currency for deals. "At the end of the day, it is a matter of how badly does Amazon want to be in this space," Squali says.

Holahan is a writer for in New York.

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