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Revenge of the Netflix?
Online DVD rental king Netflix's stock bombed last year -- but it could be a surprise hit in 2005.
February 25, 2005: 12:16 PM EST
By Paul R. La Monica, CNN/Money senior writer
Shares of Netflix rode dot-com enthusiasm in 2003 but fears of increased competition made shares staler than week-old popcorn last year.
Shares of Netflix rode dot-com enthusiasm in 2003 but fears of increased competition made shares staler than week-old popcorn last year.

NEW YORK (CNN/Money) Here's an award you won't see Charlize Theron handing out on Sunday's Academy Awards: and the winner of the Biggest Cinematic Stock Flop of 2004 goes to...

Netflix!

The stock of the popular online DVD rental service, a smash hit in the market in 2003, turned into the equivalent of Wall Street's "Catwoman" last year. The stock tumbled 55 percent as investors began to worry about the impact increased competition would have on profits.

Sure, Netflix (Research) is still the market leader in the online DVD rental market, and it has a lot of loyal customers -- including this writer. But being the first entrant in a new market is no guarantee of long-term success. Just ask TiVo.

Wal-Mart (Research) and Blockbuster (Research) are both trying to steal customers with their own online rental services. There's also the threat from cable companies and their video-on-demand services. And investors fear that Amazon.com (Research) may also enter the market sometime soon.

So can Netflix thrive? Or will its numerous well-heeled competitors wind up crushing it like a delicate Pinot Noir grape? (Poor Oscar-snubbed Paul Giamatti.)

The biggest problem for the company is that it's business is no longer unique. Before competitors scooped in, Netflix had pricing power. That's not the case anymore.

Netflix raised the price for its standard monthly plan last June, but the price hike, to $21.99 from $19.95 for three DVDs at once, didn't stick. Faced with stiff competition and a small consumer backlash, the company wound up cutting the price just five months later to $17.99 a month.

The company even introduced an ultra-low plan that allows consumers to rent 2 DVDs at any given time for just $11.99 a month. Price wars in tech are never a good sign. So it's no wonder that investors have bailed out of the stock faster than "Sky Captain and the World of Tomorrow" left movie theaters.

Costs aren't sideways

But some analysts think Netflix stock is close to bottoming out, and that some worries about increasing competition are overdone.

To that end, Netflix said it had 2.61 million subscribers at the end of December. What's more, churn, which measures the number of customer cancellations, hit a record low in the fourth quarter after ticking up temporarily following the price hike.

"The fourth quarter results indicate that, despite rising competition, the company is continuing to grow," said Daniel Ernst, an analyst with Hudson Square Securities-Soleil, an independent research firm.

The problem, though, is that in addition to price cuts, Netflix is stepping up promotional efforts in a bid to hold onto its lead in the business.

Because of increased expenses, the company is expected to post a loss of 20 cents a share in the first quarter, excluding charges and other items. And for the full year, analysts are predicting a profit of just 12 cents a share, down from 57 cents last year.

But Ernst argues that it's necessary for Netflix to spend on advertising to keep its lead. In addition, doing so could help Netflix take advantage of turmoil at Blockbuster, currently embroiled in a takeover fight with rival rental retailer Movie Gallery (Research) for Hollywood Video (Research).

"Blockbuster is distracted with Hollywood Entertainment and is still trying to leverage its store base. That could be good for Netflix," Ernst said.

As for other competitors, Brian Bolan, an analyst for Marquis Investment Research, said an Amazon entry into the market is starting to look less imminent.

And even if Amazon does jump in, he thinks that it could do so with a partner, which could turn out to be Netflix. He noted that an Amazon takeover attempt for Netflix is not out of the realm of possibility, either.

The looming threat from Amazon was one of the biggest fears that dragged down the stock last year. If that risk continues to dissipate, Netflix's stock could bounce back.

"There is a glimmer of hope for Netflix," said Bolan. "A big overhang on the stock was Amazon and if it doesn't enter the market soon that should bring traders back."

A cult classic?

To be sure, Netflix is not cheap by any means, trading at a whopping 87 times 2005 earnings estimates. But earnings are expected to bounce back in 2006 to 49 cents a share. And based on that projections, the stock trades at a more palatable P/E of 21.

"Rising costs and falling margins have been discounted in the stock price. 2005 is a transitional year," said Ernst.

Bolan agrees. He thinks the key challenge for Netflix will be to maintain its current pricing structure. If it can do that, it will have passed a big test.

"Let's get through the year and not see further price decreases. Come out of the year with some sort of pricing power," he said.

Investors probably should also not discount the fact that Netflix has a strong brand name and solid reputation for service. Subscribers may not be as zealous as say, iPod owners, but these cinephiles are pretty faithful and are prone to rave about how fast DVDs arrive in the mail.

Ernst said this was evident in the full year subscriber numbers for 2004. The price increase may have caused some customers to leave but subscribers didn't flee in droves. And it appears that many came back.

"It was a pleasant surprise that churn didn't go up more last year," said Ernst. "Netflix has great customer service and service quality means a lot."

So don't count out Netflix just yet. The stock could wind up making a Virginia Madsen-like comeback in 2005.

Analysts quoted in this story do not personally own shares of the companies mentioned and their firms have no investment banking ties to the companies.  Top of page

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