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Netflix reeling but poised for comeback scene

Online video-rental pioneer Netflix this week reported its first-ever decline in subscribers and saw its stock sink to a 52-week low. But the company has the assets to survive its epic battle with brick-and-mortar rival Blockbuster.  Analysis, by Bill Briggs of
/ Source: contributor

In Hollywood, epic dramas offer a knee-hugging ride of rises and falls, while classic comedies inject a dash of darkness into their otherwise cheery tale.

In the mysterious case of online-DVD provider Netflix, life imitates art. Investors and consumers are watching a typical big-screen story line unfold: A fast start, followed by a surprise plot twist. What many don’t see yet is the happy ending.

It’s coming.

Is the Netflix business model broken or edging past its prime? No. Not yet. Will the company survive a triple-feature of lost subscribers, stock plunges and bloody price wars with archrival Blockbuster? Absolutely. Netflix is the furthest thing from a business horror show.

The opening act was brilliant for Netflix, which launched its subscription service in 1999. The company created a nifty niche, allowing customers to select and rent, via its Web site, a stack of DVD movies that would appear in their mailboxes about one business day later. Netflix quickly lured millions of subscribers while brick-and-mortar stores like Blockbuster seemed to age overnight.

Then Act Two: Blockbuster fought back. The movie-rental giant created its own online, mail-delivered rental service in 2004 and undercut the Netflix prices by about $2 a month. Both competitors kept trimming their prices for another year.

But last November, Blockbuster increased the pressure on Netflix by introducing its “Total Access” deal. Under that program, Blockbuster customers had the option of returning online-rented DVDs to their local Blockbuster store instead of sticking them back in the mail. Each online rental could be exchanged at the store for a free, in-store rental. Tens of thousands of Netflix loyalists swapped allegiances and ran to the better value.

“I tried Total Access for a month, and you can get a boatload of movies that way,” said longtime Netflix customer and shareholder Anders Bylund. “With Blockbuster Online’s three-DVDs-out plan, you can watch, say, 15 movies a month (at $16.99 per month). But with Total Access, you can easily double it to 30 a month (at $17.99 per month).”

By March 2007, Blockbuster reported a subscriber base of about 3 million — and two straight quarters in which it beat Netflix in customer growth. This month Netflix reported its first decline in subscribers, to 6.74 million, down about 55,000 from three months earlier. The financial bloodletting was just beginning.

Netflix recently snipped prices on its two most-popular plans to undercut Blockbuster’s Total Access program and win back customers. But the move is expected to eat into revenue.

Netflix executives now project a full-year profit of between $42.4 million and $52.4 million, below their April forecast of as much as $60 million. You don’t need to peek at the script to know what happened next.

On Tuesday, Netflix stock prices touched a 52-week low, at $15.24. Making matters worse, the company’s Web site — its rental engine — crashed Monday night and was down for some 18 hours.

Was this the big death scene for Netflix? Hardly. There are two reasons, one tangible, the other subtle. Subtlety first: Netflix has a core of loyal customers who latched on in 1999 due to what they describe as its simplicity, value and customer service. It’s hard to see the Netflix subscriber base shrinking any lower.

“To me, Netflix was a beautiful design, with easy-to-use software (like iTunes), smart tools like (movie) recommendations and affinity groups, and very fast service if you live in a town like Denver where they have a big warehouse. I would hate to see them falter,” said Michael Booth, a self-described “heavy” Netflix user and a movie critic for The Denver Post.

“I love the service. I have an affection for it the same way people have an affection for iPods or Google or any other perfect technology. I'm surprised they are crashing. I know they have huge customer churn, and that's always a big problem in technology. Just ask XM Satellite or AOL. They spend a huge amount just trying to stay even on subscription numbers because so many people drop it,” Booth said.

Beyond that, there are the hard numbers. Netflix boasts a far tighter balance sheet than Blockbuster, which has lost gobs of money to prop up its Total Access program. On Thursday  Blockbuster reported a second-quarter loss of $35.3 million, or 20 cents a share, compared with net income of $68.4 million, or 31 cents a share, a year ago. Blockbuster blamed costs associated with Total Access. Blockbuster also lost $49 million in the first quarter.

Netflix, meanwhile, has earned $35.4 million during the first half of 2007.

Blockbuster, which said it is undergoing a “comprehensive review,” can’t keep gushing money to keep pace with Netflix. In coming months, the company will face two tough choices, predicted Bylund, who writes about the DVD-rental industry for the Motley Fool stock-advice Web site.

“They either have to have to stop giving away free movies or raise prices,” Bylund said.

When that happens, the value pendulum swings back to Netflix. So does the customer flow.

But you’re thinking: What about instant movie downloads? Isn’t that the new wave anyway? Sure. But it has not yet been fully embraced by enough movie watchers to make a difference. Downloading music to iPods is all the rage, but you can still find CDs in the stores, Bylund pointed out. And Netflix already offers instant movie downloads, albeit with limited (2,000) title selection.

Even here, though, Netflix could come out ahead on loyalty.

“Universal acceptance of downloaded movies or PPV (pay per view) is still a few years away,” Booth said. “And since they have the best customer service model with a lot of loyalty, why can't they cash in on that when it comes to downloads? I would trust them on downloads way ahead of Amazon, Wal-Mart or anybody else.”