Netflix: Moving Into Slo-Mo?

The rising cost of online ads blindsided the movie outfit. And rivals are looming

For Netflix (NFLX ) Inc., the online movie-rental service, its second-quarter earnings report was as ugly as Ishtar's debut. On July 15, the company reported net income that was lighter than Wall Street had expected. Worse, it said that marketing expenses were headed north because online advertising was getting pricier -- this just months after Netflix assured investors those expenses wouldn't rise this year. In the next two trading days, the shares plunged 37%, to $20.17. [The marketing cost increase] was a risk that was out there and was denied by the company," says David A. Rocker, managing partner at Rocker Partners LP, which had a short position in the stock.

The biggest challenge is just arriving. Video-rental giant Blockbuster (BBI ) Inc. just unveiled a trial DVD-by-mail service that costs only $20 a month -- a third less than analysts expected. If Blockbuster sticks with that figure, Netflix, which boosted its price from $20 to $22 in June, may have to roll back its increase. "That would have pretty broad implications," says analyst Jason Avilio of First Albany Capital (FACT ) Inc. CEO Reed Hastings vows to hold steady at $22, which Avilio estimates will mean net income of $70 million on $810 million in revenues next year. But the analyst ran estimates for the lower rate at BusinessWeek's request. The result: Profits would fall to $38 million in 2005.

One week of bad news is hardly the end of Netflix. It's still by far the leading online DVD-rental service, with 2.1 million subscribers and 80% customer growth. The company still predicts it will reach 5 million subscribers by 2006. Amid the bad news, Netflix actually raised its 2004 net income target, to between $12.6 million and $22.1 million. "We're completely on track," says Hastings.

That's not all bravado. Analysts estimate that Netflix has five times as many DVD-by-mail subscribers as Wal-Mart Stores Inc. (WMT ) and an even greater lead on Blockbuster. Netflix has proprietary software that uses factors such as customers' past rentals to help subscribers find movies they like. About half its customers rate movies. And its 24 distribution centers let it ship to 80% of American addresses overnight by U.S. mail, compared with two or three days for rivals. Says analyst Derek Brown of Pacific Growth Equities: "Competition isn't affecting the company's ability to grow."

Combine strong growth with weaker-than-expected financials, and chances rise that Netflix will be acquired. Possible buyers include online players such as (AMZN ), and telcos like Verizon Communications (VZ ). Amazon sells DVDs and, like Netflix, gets a competitive edge from customer ratings. Verizon, which is battling cable-TV companies, could use Netflix to enter the video-on-demand business. Both companies declined comment.

If Netflix doesn't get scooped up, video-on-demand looms as a long-term threat. Cable companies say film buffs will soon have little reason to trek to the video store, or the mailbox. "You can order a movie from your sofa and not be premeditated about what you want," says David Pugliese, vice-president for marketing at Cox Communications (COX ) Inc. Consultant PricewaterhouseCoopers figures 20 million U.S. households will use VOD in 2007, up from 6 million last year.

Netflix is scrambling to position itself for the competition ahead. Hastings says the company will begin delivering movies over the Net next year. Still, Netflix figures it has time before video-on-demand presents serious competition. "If Netflix isn't a major player when VOD arrives, we've screwed up," says Jay C. Hoag, a Netflix director.

To get the 5 million customers it has targeted for 2006, though, will take steady execution -- and maybe dramatic gestures. Piper Jaffray's Safa Rashtchy says Hastings, who has been selling 10,000 shares a week, should buy some Netflix stock to rebuild credibility with investors. The CEO, who owned 5.7 million shares as of March, declined the invitation. "I'm not trying to convince the market fast -- I'm trying to build a big stable business," he says. Whether he can get there may depend on rebuilding a foundation of trust the last week has done a lot to shake.

By Timothy J. Mullaney, with Tom Lowry, in New York

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