Tuesday, November 29, 2005

Reel Time: Netflix

Smart investors are always on the look out for companies that provide products or services that improve the quality of people's lives.

Enter Netflix (NFLX), which delivers movies straight to your home without the late fees.

Blockbuster (BBI) never saw them coming.

If you own NFLX in your portfolio, you'll agree with us that NFLX also knows how to deliver something else: great returns -- shares are up 120% YTD.

There are three "legs" to our Netflix investment thesis.

One: NFLX's customer base is extremely loyal.

In an environment where Walmart (WMT) and Blockbuster are all chasing the same consumer dollar, loyalty is key.

You don't need an MBA to recognize that high switching costs lead to sustained profitability.

The second thing about Netflix that astonishes us is their projected revenue-per-subscriber numbers.

NFLX has grown its subscriber base over 60% this year -- that's amidst increasing competition.

Finally, we like NFLX because its a veritable niche play.

We 've spent a good chunk of 2005 investing in and/or writing about niche companies.

No doubt about it --NFLX is right there among powerhouse niche retailers like Urban Outfitters (URBN/$38 target) and Whole Foods (WFMI).

Niche doesn't live on Wall St -- it lives on Main Street.

As such, sometimes the best way to understand Wall Street is by stepping off it altogether.

Behind NFLX is a cultural transformation that dictates why NFLX will thrive longer than most people think.

Understand: The DVD is the most fashionable medium for cinematic content.

Weekend after weekend, blockbusters are bombing left and right -- at the same time, DVD sales are generating sales two times those of the box office.

Why are DVDs squandering movie theatre revenues?

The answer is long tail.

Long tail is what's killing the box office and juicing up the $15 billion dollar a year DVD market.

Today, it's not about the hits -- it's about the misses.

Long tail says that products that are in low demand or have low sales volume can collectively make up a market share that rivals or even exceeds the relatively few current bestsellers and blockbusters, if the store or distribution channel is large enough.

The long tail equation (the theory was first propagated by Chris Anderson) says that the total volume of low popularity items is greater the volume of high popularity items.

Long tail does two things: it expresses the increasing evanescence of mass customization (one size does not fit all) and it helps us understand the relationship between sales distributions and storage space.

NFLX is giving Blockbuster an ass whooping because Blockbuster is a brick and mortar.

Blockbuster can't afford to hold assets that they may or may not rent out.

In contrast, an online retailer like NFLX specializes in catering to minority tastes and shelving just about everything.

Netflix lives on internet time.

Long tail is a dream come true for Netflix --because specialized markets are more predictable, the risk of failure is much lower, and so small-to-mid-budget movies can be very profitable.

The DVD itself is an incredibly high margin toy -- cheap to make and high in demand.

So while icon Jack Valenti pronounces "the epic viewing experience cannot be duplicated at home," we beg to differ.

Unless Hollywood all of a sudden learns how to micromarket, a mass pilgrimage back to the theatres is out of the question.

We forsee accelerated subscriber growth for NFLX in F2006; we're initiating coverage this morning with a buy rating.

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