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Netflix guidance disappoints. Why? - April 21, 2008

After a spasm of irrational exuberance pushed shares of Netflix to new highs over the past few weeks investors abruptly reversed course late Monday, hammering the shares in after-hours trading after the company's Q1 earnings report included lower-than-hoped for guidance for the rest of the year. After officially closing up almost 2% on the day, the shares plunged more than 14% in the after-hours market, losing $5.52 a piece. The company shaved 1 cent off the upper end of its projected full-year EPS to $1.29, quickly deflating a bubble of expectation that had lifted the shares by nearly 50% over the past year.

Why the change of heart over a hypothetical penny? A better question would be: what were analysts smoking before Monday?

Netflix got a boost when arch-rival Blockbuster hiked prices on its own online subscription offering in December, leading to enough defections to goose Netflix's subscriber growth in Q1. That phenomenon was unlikely to recur, however, and sure enough, Netflix said Monday that growth would slow over the next few quarters.

Many analysts  also saw nothing but good news for Netflix in Blockbuster's $1.3 billion bid for Circuit City, arguing that, even if successful, the acquisition would be a two-year distraction for Blockbuster during which time Netflix could build up an impregnable lead in distributing movies over the Internet.

What those analysts missed is that when it comes to distributing movies online Blockbuster and Netflix are very much in the same boat, and it's barely past the break-water.

Let's review:

• Netflix has a hodge-podge of online rights to some 9,000 titles, CEO Reed Hastings said on the earnings call Monday, up from the 2,000-3,000 it had when it launched its Watch Instantly feature. That's nice, but it hasn't yet translated into a meaningful digital business. How do we know? Because Netflix refuses to disclose anything about how Watch Instantly is doing. If the numbers were anything to crow about, they'd be crowing

• The company now has deals with four electronics makers to embed its digital storefront on their devices starting in Q4. Again, nice, but Hastings emphasized on the call that none of those deals will be material to Netflix's results "for the foreseeable future." Netflix, in fact, isn't even the market leader when it comes to the embedding itself in devices. CinemaNow has many more deals in place, a more favorable set of rights and, through its recently announced deal with Technicolor, the ability to reach more screens on more different kinds of devices.

• Netflix is currently paying for digital rights it can't yet exploit, which is undercutting operating margins without adding to top-line revenue. On the call, CFO Barry McCarthy attributed to the cut in EPS guidance to "increased spend" on content to secure online rights. The need to maintain margins going forward, especially as growth slows in basic mail-delivery subs, will dictate how aggressively Netflix can pursue the rights it needs for a viable digital business.

And Blockbuster?

• It has a hodge-podge or rights to about 6,000 titles dating to its acquisition of Movielink. But Movielink wasn't a business before the acquisition and Blockbuster has done little with it since.

• Like Netflix, Blockbuster sees opportunity in the convergence of entertainment and entertainment devices, but its approach is shaped by its different history. Blockbuster's bid for Circuit City was in part an attempt to leverage its legacy brick-and-mortar business to gain a retail foot-hold in the market for convergence devices. Same strategic goal, different take.

• Also like Netflix, Blockbuster is constrained in how aggressively in can invest in that strategy by the need to maintain margins in its core business as growth there slows.

Bottom line? Both Netflix and Blockbuster have very long roads to travel for their digital strategies pay off. One may be marginally farther along than the other, but relative to the distance both have to travel the gap doesn't mean much.
Both are taking reasonable steps given their circumstances, but both are also dependent on developments largely beyond their control, such as how rapidly the studios make rights available in a way that will allow retails to offer consumers the same breadth and depth of content in the digital market as they currently can with DVDs.

The day before Netflix's Q1 earnings release, to site just one recent example, Paramount, MGM and Lionsgate announced plans to make their movies available exclusively to a new pay-TV service during the pay-per-view window, essentially denying those movies to any other would-be provider--including Blockbuster and Netflix--for six months at a time.

The big challenge facing Blockbuster and Netflix is not each other, but the fact that the studios are still clinging to quaint notions like exclusivity.
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