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investing academy remains divided over online video-rental service

Netflix

Netflix on Tuesday posted fourth-quarter earnings of eight cents a share, up from four cents a year ago. For 2004, it posted per-share earnings of 32 cents a share, up from 10 cents a year earlier, and sales of $506.2 million, up from $272.2 million the year before. Netflix added 381,000 subscribers, to reach 2.61 million. That was ahead of consensus estimates of 300,000 to 350,000 new customers, and was up from last quarter's paltry gain of 136,000 subscribers and last year's total of 1.48 million subscribers.

Fans crowed that the command performance was a signal that Netflix has beaten back immediate threats from competitors Blockbuster and Wal-Mart Stores, which both started similar services this year and charge less per month. And they pointed to continued subscriber growth as evidence that Netflix can defend its market share against online retailing behemoth Amazon.com, which is planning to launch a comparable product in the U.S. this year and could charge as little as $13 a month.

Tuesday's strong report was something of a reversal for the Los Gatos, Calif., company, which plunged 36% on Oct. 14 after it announced it would cut its subscription price for the second time in a year, to $17.99 a month, to compete with rivals. Earlier last year, it lowered its monthly fee to $19.95 from $21.95. Shares dropped as far as 70% from the 52-week high of $39.77.

In an earnings conference call Monday, CFO Barry McCarthy said the company had "underestimated" the pressure it faced from competitors. He also noted that churn, or customer defections, had dropped to 4.4% from 4.8% in the year-ago quarter and 5.6% from the preceding three months.

Investors pounced on the report as evidence of a strong turnaround, and sent shares up 16% during morning trading. But the stock fell back almost as sharply, finishing the day up just 1.71% at $11.33, as skeptical analysts began weighing in with worries that Netflix's business model one product, one distribution channel is fundamentally flawed.

Some made the case emphatically, and colorfully. "Netflix is a worthless piece of crap with really nice people running it," says Michael Pachter, an analyst at Wedbush Morgan Securities in Los Angeles, who cut his target price to a merciless $3 a share and maintained the Sell rating with which he initiated coverage of the stock in September. "I don't mean that they're doing anything wrong. They have a wonderful idea, but it's not a sustainable business. I wish they would make it they deserve to make it. But in the Internet, all the success stories tend to be multiple channels, [offer] multiple products, or have a brick-and-mortar component. At the end of the day, there's only one line of business going on at Netflix." (Pachter doesn't own shares of Netflix; Wedbush Morgan doesn't have an investment-banking relationship with the company.)

Such bluster didn't deter the bulls, however, who counter that the company has worked this line of business well enough to inspire customer loyalty, and that its quality of service and interface features such as its rating system, user profiles and social network options will keep current subscribers and attract new ones.

Frank Gristina, vice president at Avondale Partners in Nashville, Tenn., upgraded his rating to Market Outperform, and raised his price target to $16 a share. "I felt Netflix was being oversold on the bark of its competitors," says Gristina. He says the subscriber growth took him off the fence.

"The skeptics had a leg to stand on when there was the threat of a pricing war, when the question was whether Netflix could continue at this price point," Gristina says. "I think Q4 results answered that question. The company can have a 'premium' price and control churn." For the medium term, at least, he says loyalty will have its rewards in the rapidly maturing $650 million annual online rental market. (Gristina doesn't own shares of Netflix; Avondale Partners doesn't have an investment-banking relationship with the company. It makes a market in its shares.)

"It's going to be expensive for the company to grow its subscribers," he says. "But looking forward, we think this is going to have the lion's share of the market."

Lehman Brothers small-cap entertainment analyst Anthony DiClemente was slightly more circumspect, but said the price wars of 2004 were far from a death blow.

"[Netflix] is definitely not going away," he says. "People who say they're going out of business are just wrong." DiClemente says positive cash flow, a lack of debt a point on which Netflix's McCarthy lambasted Blockbuster on Monday a subscriber base of 2.61 million customers and a year-over-year subscriber growth rate of 75% were all positive signs.

"The real hot-button question is: Can they grow those subscribers while retaining some thread of profitability, and can they generate material free cash flow from those subscribers," he says. He suggested the stock was still overpriced, and should drop between 50 cents and a dollar a share before it fit his criteria for a good buy. (DiClemente doesn't own shares of Netflix; Lehman doesn't have an investment-banking relationship with the company.)

While the online video-rental business has low barriers to entry, DiClemente and Gristina say competitors such as Wal-Mart and Amazon are reluctant to turn DVD-buying customers into DVD-renting customers, and that Netflix has withstood an initial assault by Blockbuster by curbing churn.

"The first quarter of '05 will be significant more telling than the last three months," says DiClemente. "As analysts, we haven't seen the impact of actual competition over a full quarter. That will be much more telling."