Netflix Battle with Blockbuster Gets Ugly

Blockbuster's new strategy, though expensive, is robbing Netflix of profits and subscribers

The fight between Netflix (NFLX) and Blockbuster (BBI) is getting uglier.

Netflix reported earnings of 37 cents per share on July 24, up from 25 cents a year ago. The online movie rental service also warned investors that its revenue, earnings and number of subscribers will be lower than predicted.

That sent Netflix stock falling, down more than 6% to $16.21 on July 24, after touching a new 52-week low of $15.24. That comes on top of a 12% drop the day before, when the company cut prices for subscribers.

The problem for Netflix is renewed competition from Blockbuster. With its store movie rental business withering away, Blockbuster has spent heavily on its Netflix competitor "Total Access" program. The service delivers movies through the mail but also allows customer to exchange videos in person at Blockbuster stores.

Blockbuster is losing money on the program, but it's succeeding in depriving Netflix of new subscribers.

"Their back is against the wall," Piper Jaffray analyst Michael Olson says of Blockbuster. Both firms are "locked in this mutually destructive competitive situation."

Netflix reported its total number of subscribers fell 1% from the first quarter, to 6.74 million. Blockbuster is gaining on its rival, though it still has less than half the subscribers.

To win back subscribers, Netflix announced on July 23 it will again cut its prices. "By lowering pricing, that's operating profit that basically evaporates," says Jim Friedland, an analyst at Cowen and Company.

To help make up for the lost revenue, Netflix said it would cut back on marketing. However, it won't stop spending on its "Watch Now" movie downloading service. It's an innovative service, Friedland says, so it makes sense to keep investing in it.

Both the price cut and the technology investments will hurt earnings over the next few years. "Netflix is positioning itself for the long term, but they're feeling the pain on profits," Friedland says.

A key question is how Blockbuster responds. Many believe Blockbuster can't keep losing money on its Total Access program for long. Friedland says Blockbuster has implied it may raise prices and cut marketing for the service.

Olson, however, believes Blockbuster, with few other growth prospects, is more likely to stick to its strategy now that it's drawing blood from Netflix.

"They both need to add subscribers as fast as possible," Olson says. "The question is how do you balance that with profitability. Blockbuster is willing to tilt the scales to less profitability and more subscriber growth. Netflix has realized that Blockbuster is not going away overnight."

To add to Netflix's troubles on Tuesday, its popular web site was down for the morning and early afternoon. A message on the site said it was "temporarily available" but expected to return in the afternoon.

There has been periodic speculation that Netflix may be a takeover target, perhaps by Amazon (AMZN).

Friedland believes Netflix makes more sense as a private equity target. With a "superior product" to Blockbuster and good long-term growth prospects, Netflix might be taken private and then taken public again in a few years at a profit. In the meantime, it may be rough sailing on the public markets as competition heats up, he says.

Another possibility is that Netflix and Blockbuster consider joining forces, Olson says. That could turn the duopoly in online rentals into a monopoly.