Starship Netflix, You Are Cleared For Liftoff

Recently, I was looking at some of the online data that is available on GameFly and I remarked to Motley Fool contributor Daniel Rubin, that I was surprised to see that internet video game rentals hasn’t turned out to be more popular option for consumers. Online video games have been something investors and customers have been very vocal about wanting, yet Netflix CEO, Reed Hastings has stood steadfast in his commitment to stick with just DVD rentals. Rubin’s response to my comment was a true testament to how much Reed Hastings has shown an uncanny ability to understand the DVD market better then anyone in the industry.

Isn’t this yet another spectacular display of strategic leadership by Reed Hastings? The guy’s like a Starship captain flying this sucker through an asteroid storm and outmaneuvering every one and every thing.The man has thrashed Blockbuster (one of the biggest brands in busines history), beat off Wal-Mart, scared off Amazon, and now may have dodged a huge bullet by having NOT wasted time on a failed venture at this critical juncture when time is of the essence. I’ll take Red Envelope Entertainment and the value that will come from proprietary content over video games any day.

While no one doubts the importance of having a good management team, this aspect of investing, is remarkably hard to quantify, but for investors who have just witnessed Netflix report another blow out quarter, it’s clear that Captain Hastings has put Netflix Starship into orbital launch mode. A quick glance at their 3rd quarter 2006 earnings report, reveals that during the quarter Netflix achieved 493,000 net new subscriber additions, bringing their total subscriber base to almost 5.7 million customers, an increase of 58% over the last 12 months. With this stronger customer base, Netflix also reported record revenues of $258 million for the quarter and handily beat their earnings guidance by recording another $12.8 million in net income. This increase in net income was an 84% year over year improvement from their third quarter results in 2005. The company also raised guidance for the 4th quarter and for all of 2007.

These impressive results were accomplished during a quarter where Netflix spent a record $45.32 for each gross subscriber added. During the company’s conference call following the earnings announcement, Hastings not only reaffirmed their outlook on the video rental market, but also discussed how they see the video store market unfolding over the next year.

“The larger online gets the more difficult store based rental becomes economically and we think the major chains will close 5 – 10% of their stores next year. As more stores close the online market is further strengthened. Our view is the trend of online rental growth and the store rental decline will continue for many years.”

This outlook on the growth potential of the online market is shaped, in part, by the company’s experience in the San Francisco Bay Area. Not only have they seen a lower subscriber acquisition cost from Bay Area subscribers, but they’ve also see lower churn as well. In fact over the last quarter, Netflix saw their penetration in the Bay Area increase from 14.1% last quarter, to 14.9% this quarter. They also saw that in Seattle, Austin and Washington DC, their market penetration now exceeds 10%. The reason why 10% is an important number for Netflix is because this is traditionally the net margin that video stores have realized. Because of their high fixed cost structure, if 10% of a video store’s revenue disappears, it quickly pushes stores into unprofitability.

In looking ahead, Netflix put off many of the questions surrounding their upcoming download plans for another quarter, when they’ve agreed to discuss these plans in greater detail. They did however leak two important pieces of information about their downloading ambitions. The first is that the company is expecting to spend somewhere in the neighborhood of $40 million in 2007 for internet downloading services. The second piece of downloading news is that “as with all internet movie services, [Netflix] will initially have significant content availability constraints imposed by the TV network windowing system for movies.”

In other words, for those of us who are still waiting to get access to 65,000 movies and TV shows on demand, don’t hold your breath. While this won’t come as a surprise to those who have seen the studios take a cautious and skeptical approach to downloading, it is disappointing nonetheless and means that we could see the life of the DVD last much longer then what many “experts” are hoping for.

In talking about the various aspects of their business, Netflix pointed out that the only “dark cloud” that they have seen has been the stalemate over high definition DVDs. The battle for high definition DVDs has essentially come down to a battle between the Playstation 3 and the Xbox 360. With Sony having bet heavily on Blu-Ray, as a proprietary format and with Microsoft determined to not allow the PS3 to achieve that market dominance that the PS2 saw, Hastings sees little hope of a solution during the fourth quarter. He did call on the studios once again to embrace a format agnostic approach to high definition, but admitted that if any progress were to be made, it certainly wouldn’t happen until the first quarter of 07?, at the minimum.

During the question and answer session of the call, Hastings was asked if the introduction of dual layer technology had played an impact in convincing studios to release their films on both formats and sadly his reply was “We haven’t seen any move towards both technologies, the market you know is reasonably frozen pending Playstation’s arrival, so if I had to guess it would be Q1 before we start seeing some movement.”

Why the studios have been so reluctant to embrace technology will never make sense to me, but between forcing consumers to wait for the climate to thaw on movie downloads and their being frozen in regards to the HDTV format war, I am beginning to become convinced that Hollywood is looking a lot more like the arctic tundra then the palm beach paradise portrayed in the movies.

With Netflix reporting, yet another impressive quarter of growth and profitability, it’s becoming increasingly harder for the Netflix skeptics to deny that Netflix has not only made their mark in an impressive growth market, but that they can also make profits at the same time. Even the most pessimistic analyst on Netflix’s future, Michael Pacther, had to admit that “the results showed the company could be profitable even at the current level of marketing spending.”

In fact the irony of Netflix’s blow out quarter is that they were able to realize both profit and growth, despite spending record levels marketing the very $5.99 plan that Blockbuster has recently abandoned. While many in the industry may end up scratching their heads as to how Netflix has accomplished this task, Hastings has once again proven to be an impressive pilot in the asteroid field that makes up the current universe of DVD rentals.

Davis Freeberg is a technology enthusiast living in the Bay Area. He enjoys writing about movies, music & and the impact that digital technology is having on traditional media. You can read more of his coverage on technology at www.davisfreeberg.com. Davis owns shares of Netflix stock.