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Rumors of NetFlix’s Pending Demise Are Greatly Exaggerated

One company we’ve always been impressed with is the DVD-rental-by-mail NetFlix. Various members of the BuzzSponge team have used NetFlix over the last few years, and each of them has raved about the convenience of the service. Consequently, whenever there’s an article in the business press about the company, we tend to take notice. You can imagine, then, that we read this morning’s Wall Street Journal article about NetFlix—portentously titled “DVD-Rental Firm May Be Victim Of Its Own Success”— with particular interest.

For those of you who aren’t familiar with the NetFlix business model, here’s a brief summary. NetFlix is a movie rental website that pioneered the concept of renting DVDs to customers for a flat monthly fee. Effectively, customers paid $19.95 a month to rent as many movies as they wanted, with the sole catch being that you could “check out” three movies at a time (if you paid a higher rate, you could rent more movies). You’d thus select a list of movies that you wanted to rent and place them in a “queue” of up to 10 movies, and NetFlix would subsequently mail the movies three at a time to you. When you were done with each movie, you’d simply mail it back to Netflix in a pre-paid envelope that came with the rental, and NetFlix would mail you the next movie from your queue. Customers flocked to this model, primarily because Netflix offered several things that brick-and-mortar video stores couldn’t: an astonishing selection of movies (since Netflix operates a few huge warehouses, rather than several dozen small video stores, they could stock a wider array of movies), an easy-to-use interface (searching for movies electronically beats walking through the local Blockbuster) and finally, personal recommendations a la Amazon.com (made possible by well-organized and executed customer data collection and “collaborative filtering”).

The upshot of all of this? NetFlix has been extremely successful, despite the wintry economic climate that we’ve suffered through the last few years, having managed to consistently turn a profit for over a year and a half. Perhaps more impressively, the company continues to steadily grow and gain market share, even in the face of new competition from firms like Wal-Mart and Blockbuster. As was noted in the WSJ, in its most recent 10-Q, Netflix managed to generate $72m of revenue, up to 25% from the prior quarter. Net profitability is still small—roughly $3-$5m a quarter—but steady.

The fact that Netflix is one of a small—but growing—handful of Internet businesses turning a profit has meant that its stock has skyrocketed this year (according to the WSJ, it’s up 322%; more than either Amazon [up 162.2%] or eBay [up 56.4%]), a fact that’s pushed it’s P/E ratio to stratospheric levels (95x’s this year’s estimated earnings). These facts have made Netflix a favorite target of business journalists when it’s time to write a story about the return of bubbalicious Internet stocks, and also a favorite for investment analysts eager for publicity. Today’s WSJ article was no exception to this trend, and proposed that a) Netflix is indeed proof of a bubble in Internet stocks and b) there’s no way that Netflix’s business will withstand competition from the likes of well-run businesses like Wall-Mart or badly-run businesses like Blockbuster and c) there’s no way that Netflix’s industry—DVD rental-by-mail will survive the coming consonance shock of video-on-demand. Nothing we haven’t read before.

We’ll leave the debate as to whether or not Netflix is over-valued for a later time—we’ll wait ‘til we have a few more finance classes under our belt for that baby—but we would like to take issue with the other two anti-NetFlix arguments on the table, namely those tired, old and square arguments that the firm will end at the hands of either new competition or video-on-demand.

Now that we’ve thrown down the gauntlet, let’s examine why new competitors—especially new competitors like Wal-Mart or Blockbuster— don’t pose much of a threat to Netflix. We’ve got three answers here. Most obviously, Netflix’s niche—film buffs who rent several movies a month—is vastly different than the more mainstream segment that either Wal-Mart or Blockbuster serves. Simply put, Netflix stocks a much larger array of the more obscure art house, foreign and critically-acclaimed films that its niche—film buffs—prefer than either Blockbuster or Wal-Mart, which carry more new releases and blockbusters than NetFlix does. This means that Netflix is shielded somewhat from price competition since its product isn’t really a close substitute to the product produced/rented out by a Wal-Mart. (Consequently, the fact that Wal-Mart’s decision to price its DVD rental service at a price $4.41 less than NetFlix’s probably hasn’t slowed NetFlix’s growth too much.) If Wal-Mart or Blockbuster were to try to go after the same film buff customer, they’d face the economic challenge of having a much smaller base of film buff customers to spread the cost of acquiring art house/foreign film over, since their own audience is pretty much middle American, with very few film buffs. Moreover, Wal-Mart and Blockbuster would face a huge credibility gap trying to win over the Netflix customer—after all, it’s not too likely that budding cineastes and film aesthetes would want to rent from a low-brow service like Wal-Mart, right?

Furthermore, it’s important to consider that the economics of the NetFlix model are vastly different than the Wal-Mart model. Since its customers rent several movies a month (meaning more postage costs, content, etc), NetFlix’s customers are lower-margin customers than the likely customers of Wal-Mart, who rent just a few movies a month. The fact that Netflix has figured out a way to serve these lower-margin, high-rental volume customers profitably—optimizing its service to its niche, and figuring out how to stock movies at its warehouses in a manner that enables it to meet demand most efficiently—gives it a huge competitive advantage over a Wal-Mart or a Blockbuster, who’d have to learn how to serve these customers from scratch. Finally, because the key drivers of Netflix’s costs-a national warehouse and distribution network—are already sunk, Netflix has a powerful weapon vs. Wal-Mart or Blockbuster to use should it be challenged directly in one market. Effectively, it can lower prices at a time when its total costs are low, while the challenger’s total costs are still fairly high, since the challenger is still building out and paying for its service. This means that Netflix can quickly turn Wal-Mart’s or Blockbuster’s challenge into an investment with negative returns.

We also believe that Netflix is fairly well protected against the challenge from video-on-demand. First, the content on video-on-demand—mainstream blockbusters—is probably less appealing to the Netflix customer than to the Blockbuster or Wal-Mart customer. Secondly, video-on-demand doesn’t offer quality and high-end features that the NetFlix DVD customer likely values—there are no anamorphic scan, no 6.1 channel sound, no “making of” featurettes or deleted scenes on a VOD product. Third, it’s also probable that the threat of VOD to Netflix is less imminent than the business press would like you to believe. Keep in mind that the supplier for both VOD and DVD content—film studios—has a vested interest in promoting DVD over VOD, since DVDs form the most profitable part of a studio’s revenues at present. As such, why would a studio rush to VOD when they still have the opportunity to harvest plenty of revenue from DVD?

Finally, even assuming that VOD ever matches the quality of DVD, and arrives in the market more quickly than we expect it does, there’s no reason to believe that this should be a threat to Netflix’s business model. Provided that Netflix’s management is adroit enough to anticipate when the change to VOD will occur, and assuming that they’re strong-willed enough to accept that the costs of their investment into DVD rental-by-mail at that time are sunk, and shouldn’t figure into their decisions, they’ll be well-positioned to take advantage of VOD. This is because of the fact that Netflix’s model gives it reams of data on customer preferences, tastes, and desires, and because of the fact that like Amazon, the company has done an exceptional job of mining and refining that data to understand who its customers are, and what they want. Accordingly, when VOD comes, Netflix will be in the enviable position of being able to cross-sell the VOD content its customer wants—high-end and more obscure films—far better than any of its current competitors, who are attuned to the needs of the straight-up, mainstream market (yo).

In summary, while it’s certainly true that Netflix might be overvalued at present, the arguments proposed by popular business press as to why Netflix’s success can’t continue are poor at best, and show very little grasp of either competitive strategy or economics. So don’t believe all the hype you read about Netflix. We think it owns a pretty tight little niche, and barring any stupid decisions on the part of its management, it should be able to maintain this position for quite some time to come.

Posted by Matt Percy | Permalink

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