Can Netflix Keep Spinning Gold?

Where will you rent your next DVD? Chances grow daily you'll get it from Netflix (NFLX ), one of the hottest spots in internet retailing. Netflix subscribers pay $19.95 monthly to order movies online. They may pick as many as three DVDs at a time and keep them as long as they like. Once they return them the same way they came, via postage-paid mail, subscribers may order more. A year ago, 560,000 people did this. By yearend, their ranks had grown to 796,000. By April, paying subscribers topped 1 million.

As you might suspect, Netflix is one hot stock. Near $20 a share, it's up by a third since its initial public offering last May. This year, it has doubled. All the heat has ignited a battle over the future of Netflix and that other place people rent lots of movies, Blockbuster. While Netflix partisans post message-board intimations of mortality for Blockbuster, the bears are all over Netflix, with short interest rising all year. Of the short-sellers, Netflix Chief Financial Officer Barry McCarthy snaps: "I wish they would all die." It's almost as if Wall Street is filming a sequel to that boffo hit from a few years back, vs. Barnes & Noble. Fans of such investment adventures can guess the ending: Both companies survive their clash, but one turns out to be a better investment.

Which one? With estimated revenue this year of up to $255 million, Netflix is far smaller than Amazon was. Yet in many ways, the Los Gatos (Calif.) company is sturdier. Netflix is free of debt, holds a $104 million reserve of cash and short-term bonds, and operations are creating cash. In 2002, Netflix saw $40 million in cash flow and nearly $16 million in free cash flow, after deducting capital spending on such items as additions to its DVD library. This year, free cash flow may top $25 million.

So why not buy in? I would be tempted, even though the stock trades at five times the value of its net assets and 18 times my estimate of this year's free cash flow. Neither multiple leaves much room for error. Yet even more sobering is what Blockbuster plans. It now runs a pilot program, called Freedom Pass, in about 500 stores, that permits subscribers, who pay $19.99 to $29.99 monthly, to rent two or three movies at a time, on DVD or VHS tape. As with Netflix, they can rent as many as they like each month and keep them as long as they like without late fees.

Blockbuster CEO John Antioco told me that by this time next year, the chain will roll out Freedom Pass to its 5,500 U.S. stores, adding the option of ordering DVDs online and exchanging them by mail, just like Netflix. "We've scoped it, we understand it, and we think it's right," Antioco said. From findings in such test markets as New York and Phoenix, he expects 10% to 15% of Blockbuster's (BBI ) 20 million active U.S. accounts to sign up. At 10%, that's 2 million accounts -- a serious dent in the 5 million subscribers Netflix aims to grab. Nor is Blockbuster the only rival. now rents DVDs by mail -- at a cut-rate $18.86 a month, naturally.

Do these hulking threats mean Netflix is doomed? Not at all. CFO McCarthy argues that a big ad campaign by Blockbuster can only expand the market and even accelerate Netflix' growth. Perhaps. But if you're attracted to the prospects for online DVD rentals, consider that while Netflix trades at 18 times my estimate of its 2003 free cash flow, Blockbuster, at $18 a share, goes for 10 times the $310 million in free cash flow it stands to take in this year. It's worth recalling, too, how the great Amazon-Barnes & Noble match ended. Since Amazon (AMZN ) CEO Jeff Bezos was named Time magazine's 1999 Person of the Year, the Standard & Poor's 500-stock index sank 41%. In that time, Amazon's investors lost 68% of their money. Barnes & Noble's (BKS ) lost 12%.

By Robert Barker

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