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Walking a tightrope without a Netflix
The online DVD rental service is great but investors may be ignoring some of the stock's risks.
October 18, 2005: 12:54 PM EDT
By Paul R. La Monica, CNN/Money senior writer

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It's a happy day when an envelope bearing this logo shows up in the mailbox. But is the stock worth its current price?
It's a happy day when an envelope bearing this logo shows up in the mailbox. But is the stock worth its current price?
To DVD or not to DVD: Shares of Netflix had a rough 2004 but the stock has bounced back sharply this year.
To DVD or not to DVD: Shares of Netflix had a rough 2004 but the stock has bounced back sharply this year.

NEW YORK (CNN/Money) Box office slump, shmox office slump. Many people still love to watch movies.

But instead of expending the massive amount of energy required to get into their four miles-per-gallon SUV and schlep to the local googolplex to scarf down a $23 tub of popcorn and listen to people shout on their cell phones, consumers are just taking the short trek to their couch to watch movies.

And quite often, these sedentary cinephiles don't even have to leave their house to rent a DVD. It comes to them through the mail in a slim red envelope. And they can watch an unlimited number of movies a month for less than the price of two movie tickets.

Ahh, the magic of online DVD rental service Netflix. I'm one of the company's faithful minions and I adore the service. It's convenient, fast and relatively cheap. So it's no wonder that the company is doing so well.

Netflix announced late last month that it should end the third quarter with about 3.6 million subscribers, up from its earlier forecast of between 3.35 million and 3.5 million. The company is due to report third-quarter results on Wednesday and sales are expected to increase 24 percent from a year ago.

But investors need to keep in mind that Wall Street has had a love-hate relationship with Netflix (Research). And at its current valuation, it might be time once again for Netflix to get the investing equivalent of a Razzie award.

Competition still exists

Last year, investors gave Netflix a huge "Gigli"-like thumbs down. The stock was being held back by concerns about DVD rental competition from Blockbuster (Research) and Wal-Mart (Research) as well as the possibility that (Research) would get into the business.

Now though, Netflix is a Wall Street darling, the "Lord of the Rings" of stocks. Shares have surged nearly 140 percent this year thanks to the healthy sales and subscriber growth rates as well as diminished fears regarding competition.

Blockbuster's online business is struggling while Wal-Mart threw in the towel on its own Internet DVD rental service in May and now refers customers to Netflix.

Still, just as investors may have been overly bearish last year, they may be overly bullish now, analysts said.

Frank Gristina, an Internet analyst with Avondale Partners, said he sees little room for consensus 2006 earnings estimates, currently at 93 cents a share, to head much higher unless Netflix's cost to acquire new subscribers starts to decline.

Netflix has spent heavily on marketing and other promotional activities this year in order to attract new users. To that end, it cost Netflix $37.62 to add each new subscriber in the first half of 2005, up from $35.12 during the first six months of 2004.

And even though Netflix has so far maintained the upper hand on its rivals, it's not as if retailers pose the only challenge to the company, Gristina said.

Investors may be dismissing the rise in popularity of video-on-demand services and digital video recorders, for example, as a threat. There's also Apple's (Research) new video iPod, which could eventually lead to more online video downloads and lessen the need for DVD rentals.

"Competition from Blockbuster and Wal-Mart was overly discounted last year but competition from emerging technologies is not being discounted at all," Gristina said.

Lower prices could hit profits

As a Netflix user, I think the technology threat is a bigger concern. I would never switch from Netflix to Blockbuster. But since I signed up for a DVR through my cable service, my DVD watching has decreased substantially.

I've had the same few movies from Netflix for months and it's almost to the point where I've wondered if it's even worth subscribing to Netflix.

Now I probably wouldn't cancel my subscription entirely. But it might make sense for me to switch from my current plan, which costs me $17.99 a month and allows me to have 3 DVDs at one time, to a $14.99 plan for 2 DVDs or even a relatively new $9.99 plan for just one DVD at a time.

And that could be a problem for Netflix, said Michael Pachter, an analyst with Wedbush Morgan Securities. Even though the company may wind up adding a decent chunk of subscribers because of the one-DVD offering, too many existing subscribers may switch to it.

"The $9.99 plan has the potential to directly cannibalize the $18 customer," he said. "That will hurt profit margins because people aren't spending as much."

Pachter thinks this is already starting to happen. He pointed out that when the company raised its subscriber guidance late last month, it did not change its revenue target. It simply tightened the range from between $172.5 million and $176.5 million to a forecast of $173.5 million to $175.5 million.

"They increased subscriber guidance by more than 100,000 customers but just narrowed the revenue range. So they added customers at zero revenue," he said.

With this in mind, Netflix's stock is probably due for a breather after its action-packed run. Gristina said he still thinks the near-term fundamentals are strong but he downgraded the stock earlier this month because of its valuation. Shares now trade at about 32 times 2006 earnings estimates.

Sure, that may not seem too pricey for an Internet stock. But Pachter argues that investors shouldn't be viewing Netflix in the same manner as they do companies like Yahoo! (Research) and Google (Research).

"The average investor thinks Netflix is an Internet stock when in actuality it's just a retailer that happens to use the Internet as a mechanism," Pachter said.

For more about personal technology, click here.

For more about Apple's new video iPod, click here.

Analysts quoted in this story do not own shares of the companies mentioned and their firms have no investment banking relationships with the companies.

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Written by: Paul R. La Monica
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