And the Oscar Goes to…Netflix

02/12/2008 12:00 am EST

Focus:

Vahan Janjigian

Editor, Bottom Line's Money Masters Stock Report

Vahan Janjigian, editor of Forbes Growth Investor, says the online video-rental company is in the sweet spot of the home-entertainment industry.

With about 7.5 million subscribers, Netflix (NASDAQ: NFLX) is the largest provider of online movie rentals. For a monthly subscription fee, customers choose from more than 90,000 DVD titles. On the company's website, they select movies that are delivered to them through the mail in a sleeve that doubles as a prepaid return envelope.

This business model offers key advantages over traditional movie rental operations. For example, there are no per-use fees or late fees. NFLX is a subscription service, so customers can view DVDs at their leisure. The company's Web site allows users to rate and recommend movies, access reviews written by other members, view promotional trailers and set up a rental queue so that their next selection is immediately mailed as soon as the previous one is returned.

An extensive network of shipping centers expedites delivery. NFLX has grown rapidly since pioneering this model back in 1999. Blockbuster's foray into this market in 2004 presented the greatest challenge. This prompted NFLX to reduce pricing on its more popular plans. Technology poses another risk: movies can be streamed or downloaded directly over the Internet, and cable companies offer video on demand (VOD) services.

Yet Blockbuster's challenge hasn't had the impact many observers feared. And more novel delivery methods have limitations that have thus far prevented widespread acceptance. VOD requires a cable subscription, and customers must typically view the movie within a set time period-usually 24 hours. Downloading movies over the Internet can take a long time, and the customer can't watch the movie on a television set without making additional investments in hardware.

Thanks in part to such technological hurdles, NFLX's subscription base grew 18% in 2007. Despite lower pricing, revenues climbed 20.9% to $1.21 billion. But aggressive pricing and higher postage costs shrank the gross profit margin by 231 basis points to 34.78%, [although] lower marketing expenses led to improvement in the operating profit margin. Net income jumped 36.4% to $67 million or 97 cents per share, [while] fourth-quarter revenues grew 9.1% to $302.4 million. Fourth-quarter net income was flat at $15.8 million or 24 cents per share, yet ahead of expectations by a wide margin.

Technology and competition remain key risks, as does a slowing economy and its impact on consumer spending. Yet the NFLX service is a bargain compared [with] the cost of taking the entire family out to a theater. Blockbuster's recent decision to raise plan prices and reduce marketing efforts bodes well for NFLX, which issued guidance calling for 22% earnings growth in 2008 despite further gross margin compression.

The embrace of next-generation media formats such as Blu-ray and the launch of its own Internet streaming-movie service should keep NFLX on top of the movie-delivery business for some time. (The stock closed below $27 Monday-Editor.)

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