Description

Netflix is en route to generating 2007 FCF of $70-80 million, which puts today’s EV/FCF at no higher than 16x.  Netflix is the leader in online DVD rental, with the ability to grow from its current 6.3 million subscribers as of year-end 2006 to at least double that number over the next five years.  Over the past few years, Netflix has proven the strength of its competitive position in fending off competitors including Wal-Mart (an actual competitor) and Amazon (a much-rumored potential competitor).  This is a wide moat business that’s supported by high barriers to entry, low-cost leadership, a first-mover advantage, and a unique niche in long-tail content (comprising 2/3 of rental activity).  Netflix, like eBay, is able to tap into the demand of thousands of niche interests, which differentiates Netflix and shields it from the direct competition of video stores and video on demand. 

Recently, Blockbuster’s Total Access has caused Netflix pain in the first part of 2007, but already there are numerous signs that relief is in sight.  It’s all but inevitable that BBI will raise prices on Total Access, and when that happens Netflix will resume a higher level of subscriber growth, along with the stronger margins that such scale affords.  Also, this latest quarter brought four additional positive developments of strategic significance:  (1) news of Antioco’s departure by late ‘07, (2) Reed Hastings’ appointment to MSFT’s board, (3) the appointment of a Cisco exec to Netflix’s board, and (4) the news of a content deal extension between HBO and Universal out to 2015, which reinforces the dominance of DVD for the next decade.  All of these events set the stage for Netflix to outperform the market’s expectations going forward. 

The icing on the cake is that here amidst the current market pessimism towards Netflix, the company has taken the opportunity to announce its first-ever buyback ($100 million, sufficient to retire 6% of s/o), which it has voiced an aggressive commitment to execute on by year-end 2007.  In sum, I think we’re either at or very close to a bottom on Netflix, and I see 35% upside to a base case fair value estimate of roughly $29 per share.  

THESIS

Netflix pioneered and popularized the concept of online DVD rental, growing from scratch in 1999 to 6.3 million subscribers as of year-end 2006.  The company’s award-winning website helps subscribers dig deep into the 75,000-title DVD library and find lesser-known content which drives two-thirds of rental activity, creating a competitive advantage versus other channels (traditional video stores, VOD, etc.) which rely primarily on demand for new releases.  Netflix has 42 nationwide shipping centers, allowing it to provide next business-day delivery to 95% of its subscribers as of Q4 ’06.  The company has been FCF-positive for most of its corporate life thanks to a business model that features reliable subscription cash flows and an asset-light virtual storefront. 

Netflix is benefiting from a lollapalooza of societal factors that are driving the popularity of online DVD rental.  Here are just three big trends:  1) consumers love the DVD format, especially when paired with a big-screen HDTV which are being sold in droves; 2) online DVD rental is a compelling value considering that it costs on average 25% less than store-based DVD rental; and, 3) the proliferation of broadband internet access is allowing more and more consumers to grow comfortable with ordering their DVDs online.  For all these reasons, I think we will see Netflix double its subscriber base over the next five years, reaching more than 13 million subs (at a minimum) by 2011.

In the minds of both customers and investors alike, the Netflix brand stands for DVD rental by mail.  Consequently, the investment community has persistently worried that Netflix’s fortunes are tied to the longevity of DVD, with particular fear that internet downloading of movies will eventually displace Netflix.  As such, Netflix has long been a short sellers’ favorite, as well as a target of Herb Greenberg.  Short interest has frequently been upwards of 20% of the float, and it currently stands at 19.2% as of 3/12/07. 

I believe the investment community has three basic misunderstandings about Netflix:

First, the market lacks appreciation for the fact that Netflix’s information database is a unique and strategic asset.  This database includes 7+ years of movie ratings (over 1.7 billion and counting), subscriber-generated movie reviews, and proprietary algorithms that allow Netflix to provide personalized recommendations based on each subscriber’s specific viewing preferences.  It’s this database that allows Netflix users to effectively sort through the company’s 75,000 available titles (versus 5-10K in a typical video store) and find the movies they’ll most enjoy, whether they’re new hits, old classics, or relatively unknown independent films. 

The value of Netflix’s database is best seen in the usage mix of its subscribers:  Only one-third of Netflix’s rental activity is comprised of new releases, while the other two-thirds are comprised of lesser-known films, sometimes referred to as “long-tail” content.  According to management, this usage mix has remained fairly consistent for the past five years.  Incredibly, every three months, Netflix members rent more than 95% of the 75,000 titles in the Netflix library.  This is in stark contrast to traditional video stores and video on demand (VOD) services, both of which are heavily reliant upon a comparatively tiny selection of new releases.  In sum, the strategic value of Netflix’s information database is its unique ability to generate consumer demand for the enormous catalog of long-tail content – something no other company or distribution channel has been able to duplicate.

Second, the market lacks appreciation for the fact that Netflix’s emphasis on long-tail content shields it from competitors who focus primarily on new releases.  The market currently defines Netflix’s competition as any provider of movies – be it traditional store-based rentals at Blockbuster, DVDs for sale at Wal-Mart, digital movie downloads from Apple, or VOD by Comcast.  But in each of those cases, the movies being offered are by and large a narrow selection of new releases and mass-market pop hits.  The investment community has failed to grasp that Netflix’s title mix is fundamentally different.  Netflix is in the business of helping people find good movies, not just new releases or pop hits.  As discussed above, Netflix’s information database helps its subscribers tap into a vast number of niche interests – classics, documentaries, independent films, old television series, etc. – i.e., the long tail that comprises roughly two-thirds of Netflix’s rental activity.  This usage mix is of tremendous significance because it shields Netflix from the industry’s fiercest competition which is in new releases.  It’s on the long tail where Netflix has its edge.  Until the competition can offer convenient access to the long tail, then Netflix maintains its competitive advantage.  So far, only Blockbuster Online has come close to offering the same breadth of long tail content – and even there, Blockbuster is considered badly lagging. 

Third, Netflix’s risk of technology dislocation is overstated.  During 2006, both Apple and Amazon launched internet-based movie download initiatives, which have escalated market fears that Netflix’s DVD-by-mail approach will soon go the way of the buggy whip.  However, there are several reasons why these fears are overstated:  1) Currently only a few thousand titles are available for digital download.  It will be many years (5+) before digital downloads can offer anything close to the 75,000 titles presently available via Netflix’s DVD library.  2) Only a tiny fraction of consumers have an internet connection to their television, so the market for digital downloads is currently limited to PC viewing.  3) DVD is enormously popular with consumers, and its simplicity and reliability creates a tall hurdle for any downloading technology to overcome.  4) Consumers’ love affair with DVD is set to only intensify as high-definition DVD gains traction and provides the true high-def viewing experience which consumers covet for their big-screen HD sets.  Furthermore, high-def DVD is roughly 10x the file size of a traditional DVD, which means high-def content will be much more cumbersome for internet downloading.  5) Netflix isn’t sitting on its hands when it comes to digital downloading; in January 2007, Netflix launched a “Watch Now” feature which allows subscribers to watch downloadable titles directly inside their web browser.

When it comes to consumer technology, the stock market tends to habitually overestimate the significance of technology risk, and underestimate the durability of simple, user-friendly solutions.  During the 1990s, AOL befuddled the critics and short-sellers as it rose to 30+ million subscribers.  The naysayers were actually right in their assessment that the internet would make AOL’s closed system unnecessary, but they were completely wrong in their conclusion that this would lead to AOL’s demise because they missed the fact that consumers chose AOL not for its technology superiority, but because of its simplicity and ease of use.  (Remember the marketing slogan, “AOL makes the Internet easy!”?  Corny, but it worked.)  Even today, AOL still has 19 million paying U.S. subscribers and another 6 million in Europe – and that’s for dial-up internet access, an inferior commodity that’s offered free by some competitors (NetZero)! 

The lesson is that in the arena of consumer technology, one must never underestimate the stickiness of convenient, simple, effective solutions.  Netflix is exactly that type of solution, which is why it has resonated so strongly with consumers, and why I believe the DVD-by-mail business will prove much more resilient than critics expect.  And unlike AOL’s dial-up service, which is vastly inferior to broadband internet, DVDs are arguably the best way to watch movies – offering highest-quality audio and video (and that will be all the more true with high-def DVD), along with ultimate simplicity.  The only advantage of downloadable movies is the instant gratification factor.  There’s no reason to assume that movie downloads will utterly replace DVD anytime soon – probably not within the next 20 years, if only because DVD is so effective and simple that it will maintain a loyal consumer following even after movie downloads offer an equally convenient alternative.  As such, I expect for the next 10-20 years we’ll see a robust market for both DVDs by mail and digital downloads.  This will not be a winner-takes-all technology race. 

As broadband internet access grows ever more prevalent, the value proposition of online DVD rental will continue to attract new users.  In Q4 ’06, the combined growth of online subscribers at Netflix and Blockbuster was an incredible +18% sequentially versus Q3 ‘06.  In Netflix’s original market, the San Francisco Bay area, the Netflix household penetration is already 15.7%.  It’s conceivable that within 10 years, the online video rental market as a whole could conservatively attract 20% of U.S. households, or roughly 24 million households.  That level of penetration is consistent with Blockbuster’s current store-based membership which is estimated to be around 30 million.  And considering that online video rental is roughly 25% less expensive than store-based rental, demand should theoretically be a good deal higher.  Given Netflix’s first-mover advantage, low-cost leadership, and emphasis on long-tail content, it should be able to retain a disproportionately large share of the eventual market for online DVD rental. 

As the online DVD rental market matures, Netflix will have the potential to cut its marketing expense (as a % of revenue) and rely more on word-of-mouth advertising.  Using the Bay area as an example again, Netflix reports that its subscriber acquisition cost in that market continues to decline even as household penetration rises.  Ultimately, I expect we’ll see Netflix’s % of marketing decline from 22.6% in 2006 to something closer to 10%.  Those gains in marketing efficiency will drive strong earnings growth over the next five years.  And with high-def DVD just beginning to take off, I think it’s reasonable to expect DVD as a format will remain widely popular with consumers for the next 10 years before even beginning to stagnate relative to other alternative delivery channels.  Even after movie downloading becomes convenient, there will still remain a large number of DVD loyalists simply because of the large installed base of DVD players.  That gives Netflix a likely 15-20 year life just on its DVD delivery business alone.

In order to believe in Netflix as a worthwhile investment today, the base assumptions are as follows:

• Growth of the online DVD rental market (NFLX and BBI) to capture 20% of U.S. households
• Netflix market share in online DVD rental of 55%
• An average gross margin of 35% (vs. 37.9% today)
• Annual marketing budget of $250 million by 2011 (vs. $225.5 million in 2006), representing 10.5% of estimated 2011 revenue of $2.4 billion.
• Liquidation after 20 years (year-end 2026)

This scenario entails that Netflix achieve 2011 average subscribers of 13.2 million, revenue of $2.4 billion, and net income of $227 million ($3.13/sh).  On a DCF basis, at an 11% discount rate, this scenario comes to present value of nearly $29 per share.  This includes Netflix’s net cash today of $388 million (3/31/07), or $5.49 per share.

COMPANY DESCRIPTION

Founded in 1999, Netflix is the largest online movie rental subscription service providing more than 6 million subscribers access to a comprehensive library of more than 70,000 DVD titles of movie, television, and other filmed entertainment.  For perspective, this selection is about 7-10x larger than that of an average video store.  Netflix has revolutionized the way people "go to" the movies – by bringing the movies directly to them.

Here’s how the Netflix experience works:  Subscribers select titles at Netflix.com, where they can search by genre, sort titles based on the ratings of other Netflix members, read reviews written by other Netflix users as well as critics, and watch previews.  Once a title is selected, it appears in an online queue which the subscriber can fill with as many titles as s/he desires.  Titles are then shipped by first-class U.S. mail, with next business day delivery to 95% of subscribers as of Q4 ’06.  Returns are made easy by prepaid mailers.  Upon receipt of a returned DVD, Netflix mails the next available title in a subscriber’s queue.  This convenient process helps subscribers maintain a steady stream of DVDs – with no due dates, late fees or shipping charges.

Making this all possible is a sophisticated logistics system that includes a nationwide network of 42 Netflix shipping centers located in strategic proximity to major postal hubs.  The logistics side of the business doesn’t get a lot of attention, but anecdotal evidence suggests that Netflix has an execution advantage in its delivery operations.  Netflix utilizes proprietary technology developed internally to manage the processing and distribution of DVDs from its shipping centers.  This software automates the process of tracking and routing titles to and from each of its shipping centers and allocates order responsibilities among them.  On the recent Q4 ’06 earnings call (1/24/07), CEO Reed Hastings announced that by year-end 2007 they’ll have 50 distribution centers and an upgrade to its inventory management software, which is expected to create improved service with lower costs:

Our plan is to continue to make the best online service even better. We'll be operating over 50 distribution centers by the end of this year. We will expand our trucking network to 50 additional central post offices. Together this will extend our reach to over 100 mail entry points, providing over 95% of our subscribers with overnight delivery. We're deploying this year an entire new class of inventory management software, which builds on our experience over the last eight years and will improve service levels while reducing costs. –Reed Hastings, 1/24/07

One of the keys to Netflix’s merchandizing effort is its system of personalized recommendations.  All subscribers and site visitors are given multiple opportunities to rate titles, and Netflix has collected over 1.7 billion ratings (up from 525 million as of early 2005).  The average member has rated about 200 movies.  Netflix takes these ratings and filters them with a proprietary set of algorithms, which it then uses to determine which titles are displayed to a subscriber and in which order.  In doing so, Netflix helps subscribers quickly find titles they are most likely to enjoy.  Netflix reports that approximately 60% of subscribers select their movies based on these personalized recommendations.

The proof of Netflix’s operational excellence is seen in its very high customer satisfaction – more than 90% of subscribers say they are so satisfied with the Netflix service that they recommend it to family and friends.  Another gauge of satisfaction is that Netflix members say they rent twice as many movies per month than they did prior to joining the service. 

Netflix’ standard subscription plan allows subscribers to have up to three titles out at the same time, with unlimited usage, for $17.99 per month.  Netflix offers a variety of service plans with different price points that allow subscribers to keep either fewer or more titles at the same time.  Available plans include:

• 8 at-a-time (Unlimited) - $47.99 a month
• 7 at-a-time (Unlimited) - $41.99 a month
• 6 at-a-time (Unlimited) - $35.99 a month
• 5 at-a-time (Unlimited) - $29.99 a month
• 4 at-a-time (Unlimited) - $23.99 a month
• 3 at-a-time (Unlimited) - $17.99 a month
• 2 at-a-time (Unlimited) - $14.99 a month
• 1 at-a-time (Unlimited) - $9.99 a month
• 1 at-a-time (2 a month) - $4.99 a month

Originally, Netflix primarily pushed its $17.99 3-out plan, along with a few higher-usage plans at higher price points.  But starting in 2005, management began experimenting with lower price points to test the elasticity of the market.  The experiment proved positive, as it accelerated subscriber growth while also reducing churn.  From a competitive standpoint, Netflix’s shift to lower-price plans has helped accelerate consumers’ defection from traditional video rental stores, opting for the superior value of online DVD rental.  Here’s how CEO Reed Hastings described this dynamic on the Q3 ’05 earnings call:

One of the reasons our last year has been so successful is the market's elasticity in response to our price cuts one year ago. And to our offering of lower priced one- and two-out plans this year. So naturally we want to test this elasticity further as we continue to realize cost efficiencies in the business. As we said at our analyst conference last month, we expect to run a number of pricing tests over the next six months to determine if, at lower prices we can deliver faster subscriber growth, lower SAC, lower churn, higher competitive barriers, and still deliver on our earnings commitment. Obviously, if there's enough elasticity to make additional price cuts work, this would increase the economic pressure on video stores, and the additional store closures would further increase Netflix growth for many years ahead. This positive feedback loop between Netflix growth and video store closures is the tipping point for online rental.

While the standard $17.99 3-out/unlimited plan remains the most popular, the lower-price plans have become ever more popular with new subscribers.  For competitive reasons, Netflix does not disclose its exact plan mix, but we can get a sense for that mix by looking at Netflix’s average monthly revenue per subscriber, which was $15.87 as of Q4 ’06.  Netflix’s price points are designed to deliver a roughly equivalent amount of absolute gross profit, regardless of plan.  The company doesn’t provide financial specifics of the exact profitability by plan, but they have disclosed that lower-price plans deliver modestly lower amounts of absolute operating profit versus the higher-price plans.

Turning to the subject of competition, Netflix has four readily identifiable sources of competitive advantage:

1.      First-mover advantage – Netflix pioneered the online DVD rental model in September 1999 and faced no serious competition until August 2004, when Blockbuster launched its online DVD rental program.  That gave Netflix a five-year lead in establishing its brand and creating a first-class consumer experience.  Netflix has been rated the #1 website for customer satisfaction in the past four semi-annual surveys by ForeSee Results and FGI Research.  By way of contrast, anecdotal evidence suggests that Blockbuster Online’s website is clumsier and less intuitive.  Netflix’s early start also has provided an edge in collecting the largest number of subscriber-generated movie reviews and ratings (over 1.7 billion), which contributes to making Netflix the most user-friendly service for finding content. 

2.      Barriers to entry – Online DVD rental has become a two-pony race between Netflix and Blockbuster.  As of year-end 2006, Blockbuster had 2.2 million online subscribers versus Netflix’s 6.3 million.  That puts the current online market share at 74% Netflix, 26% Blockbuster.  As recently as two years ago Wal-Mart was a competitor, and Amazon was making rumblings about entering the online DVD rental market as well.  But in May 2005, Wal-Mart discontinued its DVD rental service and handed over its subscribers to Netflix in exchange for Netflix’s agreement to promote Wal-Mart’s DVD sales.  Similarly, Amazon never entered the market, probably in part because it saw how Blockbuster had to spend roughly $300 million during 2004 and 2005 just to scrape together a distant second place to Netflix.  The fact that Netflix successfully warded off both Wal-Mart and Amazon speaks to the significant barriers to entry that now exist in the online DVD rental business.  I estimate that today the minimum cost of entry for a new competitor would likely be north of $500 million in order to build a network of nationwide shipping centers, run a huge advertising campaign, and endure deep losses while scaling up to a level of critical mass. 

3.      Low-cost provider – This one is a bit more difficult to prove objectively because Blockbuster’s financials reflect a hybrid of online and offline operations, making it impossible to compare BBI and NFLX’s cost structures on an apples-to-apples basis.  Nevertheless, the simple fact that Blockbuster must support a costly base of physical stores, while Netflix does not, supports the rationale for believing that Netflix’s costs are structurally lower than that of Blockbuster.  Netflix’s CEO Reed Hastings has asserted, “Our scale and technology allow us to make money at price points no competitor can sustainably match” (Q3 ’05 earnings call).

4.      Long-tail economics – I’m using this label to describe the unique nature of Netflix’s emphasis on lesser-known titles and independent films, which collectively are referred to as “long-tail” content.  This term comes from a November 2005 article in Wired Magazine describing the long-tail phenomenon which is relevant to numerous internet business models.  The long tail represents the thousands of niche interests and pockets of consumer demand – each one tiny on its own and therefore too small to be a target of traditional mass-market merchandising – but the collective whole of these niches represents a large market.  For Netflix, the long-tail phenomenon is visible in its users’ viewing habits in that only about one-third of Netflix’s rentals are new releases, while the other two-thirds are older films, foreign titles, or independent content.  This is exactly the opposite of traditional video stores which are primarily reliant on the new release slate.  (Envision your typical video store where people are roaming the perimeter for new releases, while practically nobody ventures into the middle of the store.) 

Netflix’s system of personalized recommendations plays a key role in driving demand across the full breadth of its DVD library.  In fact, every three months, Netflix members rent more than 95% of the 70,000 titles in the Netflix library.  This ability to connect subscribers to long-tail content is, most significantly, a vital source of competitive differentiation.  There are many alternative channels for new release  and pop hit content – including traditional video stores, video on demand, mass market retailers, and DVD self-rental kiosks – but long-tail content is nearly impossible to access economically except by online DVD rental.  Netflix’s ability to tap into long-tail economics is a vital source of competitive differentiation that the market is clearly underrating.

FINANCIAL ANALYSIS

Allow me to summarize some of the financial advantages of Netflix’s business model:

1.      Inventory and purchasing costs are low due to large, centralized warehouses which require a lower ratio of inventory to rentals than traditional video rental stores. 

2.      Netflix subscribers’ rental queues (the wish-list of DVDs that customers maintain online for future rentals) give the company visibility into future customer rentals, helping with inventory management and purchasing. 

3.      Netflix's emphasis on long-tail content broadens the range of titles that customers rent, reduces the company’s dependence on newly-released movies, and extends the life and profitability of Netflix's inventory of older movies. 

4.      Netflix bills its service one month in advance to customers’ credit cards, which means Netflix carries no accounts receivable, and which further means Netflix is able to generate positive cash from working capital float (which will continue for as long as Netflix’s subscriber base is at least stable).  As a result, Netflix’s FCF is systematically higher than net income.

5.      Netflix’s subscription-based business model provides the benefit of consistent monthly cash flow, which has allowed the company to be OCF positive every quarter since Q2 ‘01.

For all these reasons, Netflix has been able to achieve both rapid growth and positive free cash flow in all but its first few years.  Netflix burned $60 million in FCF in its first two full years (2000 and 2001), before turning sustainably FCF positive in 2002, since which it’s generated cumulative FCF of $165 million as of year-end 2006. 

Netflix’s cash generation has been all the more impressive when you consider how much the company has spent on marketing to drive subscriber growth.  Over the seven years through 2006, Netflix has spent a cumulative $598 million on marketing, or 22% of cumulative revenue.  That’s a staggering sum, and it reflects, in part, the substantial brand equity that Netflix has built over the past seven years.  One of the key opportunities for Netflix in the years ahead will be to ease off on the marketing pedal and begin relying on the established brand awareness to support a maintenance level of revenue growth.  Cutbacks in marketing will fall straight to the bottom line, and Netflix’s profit margins will expand accordingly. 

While it’s open to debate exactly how much margin expansion is ultimately possible, the point I want to make here is that Netflix is currently spending enormous discretionary sums on marketing which at some point down the road can be reduced.  This is analogous to growth capex spending, except it’s all running through Netflix’s income statement.  This is why Netflix’s current profitability is understated versus its potential profitability at maturity.  (We’ll return to this idea in the valuation section.)

Of course, in order for Netflix to achieve this scenario of higher margins via reduced marketing, it will require one key prerequisite:  a stable competitive environment.  Fortunately, this criterion is well underway now that Netflix and Blockbuster have securely established themselves as the only players in online DVD rental.  Two-firm markets typically evolve into a duopoly in which both firms enjoy good profitability.  Right now, both NFLX and BBI are still spending aggressively on marketing as they battle for market share and to raise awareness about online DVD rental.  Over time, however, as online DVD rental grows increasingly familiar with consumers, I expect word-of-mouth will drive ongoing adoption for both NFLX and BBI, allowing both firms to shift to a lower percentage of marketing expense.  Here’s how CEO Reed Hastings described this dynamic back on the Q1 ’05 earnings call:

…how long will we be spending 17 to 20% of revenue on marketing?  Because that's very high for an e-retailer or a retailer generally.  Wal-Mart, Best Buy, Amazon, Blockbuster, they're all at 1 to 3% of revenue in marketing.  And as our brand becomes more established, as we settle into 20 and 30% secular growth rates, we should be able to make considerable progress in terms of getting our percent of revenue on marketing down.  In the near term the overall dynamic is the new Blockbuster entry, and we're looking at the DVD market seeing that DVD is going to have an incredibly long life with high-def DVD with a studio focus on that; and that now is the time to really assert that leadership, to push through to 4 million subscribers, and through that to emerge with this two-firm market for the next several years.  And I think as that market stabilizes, we'll then see a return to substantial profitability for both of the players that you typically see in a large fast-growing, long-lasting two-firm market.

One quarter later, Wal-Mart bowed out of the online DVD rental business, proving that even a well-heeled competitor could not compete successfully with Netflix.  Wal-Mart’s decision provided strong confirmation of Netflix’s moat because, incredibly, Wal-Mart was unable to compete despite having a price point nearly $5 lower per month than that of Netflix ($12.97 versus $17.99 for the 3-out unlimited plan).  CEO Hastings, on the Q2 ’05 call, discussed Wal-Mart’s decision and how it confirms the significant barriers to entry in this business:

Last quarter we said on-line rental was shaping up to be a two-player market, and that is indeed what is happening. Although it's not material to today's results, Wal-Mart's decision to exit the on-line rental business and its partnership with Netflix clearly both confirmed and reinforces our leadership position, and as time goes by and our competitive position strengthens, Amazon's direct entry into the market seems both less formidable and less likely. With our volume of one million shipments per day, we can make money at price points no new entrants can. Any new competitor can have small losses and small results, such as Amazon's UK on-line rental business, or they can suffer huge losses in an attempt to get to scale quickly.

Since 2005, it’s become all the more clear that no new competitors intend to enter online DVD rental.  At the same time, so far, marketing as a % of revenue has risen even further (from 19.6% in 2004 to 22.6% in 2006).  I don’t think this disproves the ultimate potential for reduced marketing expense.  Rather, it reflects the fact that online DVD rental is still in land-grab mode.  Over the next several years, I expect the industry will begin to mature, with NFLX and BBI reaching some kind of competitive equilibrium.  That’s when we’ll begin to see both firms reduce their discretionary marketing spend, leading to higher profit margins. 

Another reason to believe in Netflix’s ability to achieve lower marketing costs at maturity is the success of its earliest markets.  For instance, in the San Francisco Bay area, the company is already seeing household adoption of 15.7% as of year-end 2006 (more than triple the national rate of Netflix adoption) combined with lower-than-average churn and lower-than-average subscriber acquisition cost.  Netflix doesn’t provide specifics on the Bay area marketing expense, but it reports that SAC is declining even while household adoption continues to climb. 

Here’s an excerpt from CEO Hastings, on the Q4 ’06 earnings call, about the significance of the Bay area trajectory, particularly considering what a competitive, tech-savvy market it is:

In the digitally obsessed San Francisco Bay Area, our household penetration climbed to 15.7% of households subscribing to Netflix, and seems likely will be over 18% by the end of 2007.  The Bay area is important in two ways. It was our initial market and with the subsequent markets tracking the growth trajectory of the Bay Area, it is leading indicator of the potential market size nationwide. Second, the Bay Area has Comcast VOD in many homes, iPods and laptops outnumber televisions, and it is TiVo heaven. In short, the Bay Area is the most competitive entertainment delivery region in the America and Netflix's extraordinary and growing success here indicates just how much consumers continue to prefer the simplicity and selection of Netflix for movies.

Netflix management has stated that the tipping point for gaining word-of-mouth marketing efficiencies seems to kick in once they reach 10% household penetration.  At present, Netflix’s 6.3 million subs represent about 5.5% household penetration on a national level.  As such, it’s probably not until Netflix surpasses the 12 million sub mark that we’ll begin to see marketing efficiencies really take hold.  The opportunity for marketing scale is definitely a long-term one – well beyond the sight of Wall Street’s myopic viewpoint.

Later, in the valuation section, I’ll discuss my specific assumptions for just how much margin expansion I believe Netflix can eventually achieve.

MANAGEMENT QUALITY  and CAPITAL ALLOCATION

Overall, Netflix’s management shines for having outmaneuvered a host of much larger competitors – Blockbuster, Wal-Mart, and Amazon – to capture the pole position in the online DVD rental business.  The quarterly conference calls provide fantastic commentary that give an inside perspective on Netflix’s strategy and view of the competitive landscape.  CEO Hastings and CFO McCarthy have been prophet-like in their forecasts for how competitors will respond to various scenarios.  For instance, they accurately predicted in 2005 that Blockbuster would not be able to maintain its $15 price point on the 3-out unlimited plan due to risk of tripping their debt covenants.  Sure enough, later in 2005 BBI raised its price to match the Netflix pricing – and even then, BBI still faced a bankruptcy scare in autumn ’05.

About the only major room for criticism is management’s ill-fated decision to raise prices in mid-2004, lifting the price on its core 3-out unlimited plan from $19.99 to $21.99.  That opened the door wide to price competition from BBI, who soon thereafter launched its own online DVD rental plan at an introductory price of $14.99.  This put Netflix in the awkward position of suddenly facing higher churn, necessitating that it respond by lowering its price to $17.99 (where it’s remained ever since).  Upon announcement of that $5/mo price cut, the market crushed NFLX shares from around $17/sh in October 2004 to an ultimate low in April 2005 below $10/sh.  Netflix management learned its lesson, and they’ve been incredibly cautious ever since on their pricing.

As for capital allocation, Netflix thus far has done very little beyond optimizing its core operations.  There have been no dividends, share buybacks, or acquisitions.  During Q2 ‘06, Netflix raised cash from a secondary stock offering which brought in $105 million, with shares priced at $30.  On the July ’06 conference call, CFO McCarthy in his prepared remarks addressed the rationale for raising cash.  His answer is, essentially, that the cash is a defensive measure to enable Netflix in the future to compete aggressively for leadership in digital movie delivery.  He mentioned also that the company might in the future consider buying back stock, but that its core priority is raising cash to help it push successfully into digital delivery of movies in the future:

Some investors have wondered why a company with no debt, strong cash flow, and 200 million in free cash would raise additional cash. The short answer is because we are building cash reserves to help us compete in a world with Internet delivery of movies against substantially larger companies with much stronger balance sheets. From time to time you may see us issue additional stock, and from time to time you may see us buy back stock. But over time, you'll see us accumulate cash to position the Company to compete for content in a world with Internet delivery of movies.

Total inside ownership as of 3/21/06 was 27.8%.  It should be pointed out that execs like Hastings and McCarthy are regular sellers of their stock using 10b5-1 Trading Plans that are generally adopted no less than three months prior to the first date of sale under such plan.   As for cash compensation, it’s fairly reasonable.  In 2005, the top four execs took home just over $2 million in salary.  There are no cash bonuses, just stock option grants, which have been fairly modest for the past four years.

VALUATION

At today’s price of $21.35, Netflix carries a market cap of $1.51 billion.  The company has net cash of $388 million, which puts the EV at $1.12 billion.  Even amidst Netflix’s aggressive growth and heavy marketing spending, the company in 2006 generated FCF (ex interest income) of $53 million.  That puts the trailing EV/FCF at a very reasonable 21x.  For 2007, I’m expecting Netflix to generate FCF of $70-80 million, which puts the forward EV/FCF multiple at no higher than 16x.  But it gets much better than that…

I expect online DVD rental to achieve 20-25% household penetration within five years.  Certain markets, such as San Francisco, are already well on the way to this level of penetration even now.  A 20% U.S. adoption rate would mean roughly 24 million potential online DVD rental subscribers (to be split up between NFLX and BBI).  By way of comparison, in the U.S. there are roughly 60 million pay television households and roughly 30-45 million video store rental customers (both figures mentioned on Netflix’s Q4 ’06 call).  Online DVD rental, being more economical than store-based rental, should eventually attract at least the low-end 30 million customers who currently utilize traditional video stores.  But for the sake of conservatism, I’m focusing on 20% of U.S. households, being about 24 million subs by 2011.  Of this 24 million, I expect Netflix can maintain a modest market share lead over BBI, which I’m modeling as 55% share, or 13 million subs by 2011.  This level of subs, when combined with marketing efficiencies, should allow Netflix to generate 2011 after-tax profits of $227 million (vs. $49 million in 2006).  Even with only minimal growth thereafter and capping the business life at 20 years, Netflix’s DCF value based on these assumptions and an 11% discount rate comes to around $29 per share.  If you allow for an infinite-lived business, with zero growth in the out years, present value rises to $33 per share.

The following snapshot of Netflix’s growth model clarifies all the various assumptions behind this estimate of fair value:

RISK ASSESSMENT

Netflix faces two key risk factors:

The first is the short-term risk that Netflix might cut the price of its core 3-out unlimited plan as a way to counter BBI’s success with Total Access.  I estimate that the impact of reducing the $17.99 plan by just $1 would cause a 300bp reduction in Netflix’s gross margin.  As such, any price cut on the core 3-out plan (which likely comprises 65-75% of Netflix’s subscriber base) would cause the market to absolutely pummel NFLX shares.  The reason I consider this at least something of a risk is because Netflix has been vocal over the years about the strategic importance of maintaining its large lead in online DVD rental.  As recently as the latest call on 1/24/07, CFO Barry McCarthy said, “…large-scale and dominant market share ensure a sustainable competitive advantage for us.”  Looking back two years to when Netflix last faced intense competitive pressures, management said the following words (on the Jan ’05 earnings call):

A note of caution on competition. This is a big market and a big prize. It is hard to predict what Blockbuster and Amazon will do. If they increase their promotional efforts substantially or cut prices even further, we will respond as necessary to maintain our leadership. Should the competitors over invest or under price sufficiently to begin to compromise of our leadership, we would respond with lower prices, increased marketing or other measures to maintain our leadership. This would delay our return to profitability. No one should doubt our resolve to maintain our leadership in the market we invented or our financial ability to defend that market. We believe we have the highest gross margin and the lowest operating costs of any competitor in our business because of the size and nature of our subscriber base, the strength of our brand, and our experience operating this business. We do not intend to lose our leadership position. It is too valuable to the future of DVD rentals in the near-term and to the Internet delivery of movies in the long-term. –CEO Reed Hastings, 1/24/05

Total Access has for the moment compromised Netflix’s dominance in terms of new sub adds, with BBI set to add more net new subs than Netflix for the second straight quarter.  But the reason I do not expect Netflix to cut price is because of the overtures BBI is already making about its own intention to likely raise Total Access pricing.  Why should Netflix compromise its economic model if BBI is about to put an end to its cut-rate pricing? 

The second and longer-term risk is that Netflix is unable to make its downloading solution as easy and convenient as some other downloading alternative.  Clearly Netflix’s competitive advantages are in online DVD rental, and the trick will be to transfer those advantages to the arena of movie downloading.  As discussed earlier, downloading will probably not be the primary way most Americans watch movies for at least another 10 years.  Nevertheless, positioning for that market is already underway.  Netflix can offset this risk by working with the technology providers (Linksys, Netgear, and whoever else) to make sure that tomorrow’s internet-to-TV devices are made to be imminently convenient for use with Netflix.  The good news here is that Netflix management is keenly aware of this need.  Furthermore, as mentioned in the valuation section above, Netflix’s success as an investment doesn’t depend on it achieving success in the downloading world – as long as it can maintain a loyal base of DVD subscribers for 20 years.  That said, Netflix’s potential as an investment would be greatly enhanced by any progress it can make in forging a clear path for its downloading service to reach consumers’ TV sets.

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