SAN FRANCISCO (CNN/Money) -
It's been a blockbuster summer for Netflix. While box-office bombs have been going off all season, Netflix reported a strong second quarter last month, with net income of 11 cents a share and 1.15 million subscribers.
The company also unveiled a nifty patent that appeared, on its face, to claim exclusive rights to its "all you can eat" DVD-rental model. As a result, Netflix's (NFLX: Research, Estimates) stock has been cruising along north of $22 for most of the summer, even hitting a 52-week high of $28.60 last month.
Like the eerie, lengthening shadow of Nosferatu, however, entrenched competitors are making some serious inroads in the space.
Blockbuster (BBI: Research, Estimates) announced this week that it is expanding its in-store "Freedom Movie Pass" to two new markets, broadening the program's soft-launch to nine cities. Next year the company plans to introduce a combined online and offline Freedom program.
Wal-Mart's (WMT: Research, Estimates) DVD-rental program now stocks more than 13,000 titles, and the company says its DVD deliveries can reach 93 percent of the country within two days. Not surprisingly, Wal-Mart is also undercutting Netflix on price.
To be sure, Netflix now claims more than 90 percent of the online DVD-rental market. But a similarly named company, Netscape, once owned that much of the browser space, and we all know what happened to it when large, monied competition decided it wanted in. So how can Netflix avoid that scenario? In a word: porn.
Stick with me here, I'm serious. Both Blockbuster and Wal-Mart position themselves as family-friendly corporations and keep a strict watch on the kinds of goods they offer. Record labels often must make "Wal-Mart mixes" of popular albums, deleting offensive lyrics so the retail giant will stock them. And Blockbuster refuses to carry anything more risqué than R-rated films. This presents an enormous, if delicate, opportunity for Netflix.
The numbers behind the adult-film industry are pretty compelling. According to research conducted by Adult Video News, the leading adult-industry trade magazine, adult films constituted 29.1 percent of all video and DVD rentals and sales in 2002. The entire adult-film rental and sales market for the same year was $4.04 billion.
That's a pretty big market any way you cut it, but it's especially big compared with Netflix -- a company that recorded $63.2 million in revenue last quarter.
"In the offline world, mom-and-pop video-rental shops differentiate themselves from Blockbuster by offering adult titles," says Wayne Hentai, an editor with AVN. "It's the only way they can compete, and Netflix could do the same thing."
Of course, despite some shifts in societal attitudes regarding pornography (an X-rated film star is even running for governor of California, if that says anything), porn is still a scarlet letter for most publicly traded companies.
If Netflix announced that it was renting adult titles, "there would be backlash on Wall Street," says U.S. Bancorp Piper Jaffray analyst Safa Rashtchy. "But if Netflix did it gradually, it might not be so bad. Yahoo! (YHOO: Research, Estimates) and others have adult-advertising revenue, and it's not a problem."
Representatives from both Wal-Mart and Blockbuster confirm that their companies have no plans to carry adult titles now or in the future. Strangely, a spokeswoman for Netflix says the same thing.
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"We decided it's not a worthwhile avenue for us," she says. And for a company enjoying the market-share advantage Netflix currently commands, eschewing out-of-hand a market as sizable and profitable as porn is a privilege indeed.
But Netflix hasn't really faced the full fury of Wal-Mart or Blockbuster yet. And when it does, there's every reason to expect the company to reexamine its stance on porn. After all, it doesn't want to get Netscaped.
And investors should keep in mind that porn represents a big trump card that, if played correctly, could give Netflix a serious competitive edge against its larger competition. When the online DVD-rental competition heats up, investors should press Netflix to consider offering adult titles.
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