Monday, February 13, 2006

Netflix Bites Its Own Customers

Talk about Netflix's mushrooming subscriber growth continues to be offset by news related to the clandestine way the online DVD rental king treats its customers:
Netflix (NFLX) typically sends about 13 movies per month to Villanueva before the company's automated system identified him as a heavy renter and began delaying his shipments to protect its profits. The same Netflix formula also shoves Villanueva to the back of the line for the most-wanted DVDs, so the service can send those popular flicks to new subscribers and infrequent renters. The little-known practice, called ''throttling'' by critics, means Netflix customers who pay the same price for the same service are often treated differently, depending on their rental patterns.

''In determining priority for shipping and inventory allocation, we give priority to those members who receive the fewest DVDs through our service,'' Netflix's revised policy now reads. The statement specifically warns that heavy renters are more likely to encounter shipping delays and less likely to immediately be sent their top choices.

Because everyone pays a flat fee, Netflix makes more money from customers who only watch four or five DVDs per month. Customers who quickly return their movies in order to get more erode the company's profit margin because each DVD sent out and returned costs 78 cents in postage alone...(Miami Herald)
Netflix added nearly 1.6 million customers last year, giving it 4.2 million subscribers through December.

We initiated coverage on the stock last year with a strong buy, and thus far, we have yet to really see investors hurdle over the many question marks that plague this nascent company.

At a decent multiple, Netflix is worth buying, for reasons we iterated last Fall:

There are three legs to our Netflix investment thesis. One, NFLX's customer base is extremely loyal... 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 a highly competitive milieu. Finally, we like NFLX because its a veritable niche play.

Netflix 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 leverages its capacity to operate shelf-free...because specialized markets are more predictable, the risk of failure is much lower, and so small-to-mid-budget movies can be very profitable -- we forsee accelerated subscriber growth for Netflix in 2006..

With the Walmart/Amazon threat seemingly ebbing, Netflix could see more upside, but wait for a pullback.

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