Netflix' Box Office Boost

As Blockbuster bails, the online DVD service sees strong third-quarter profits; but margins are slim. Will video downloads make the difference?

by Arik Hesseldahl

It never hurts when a key rival cuts back on advertising in a two-dog race like the online movie rental business. And a little price cut can do wonders for attracting new customers. Add them together, and you get a surprisingly robust quarter for Netflix (NFLX) just months after the company warned of a dismal outlook.

News of the strong third-quarter showing in customers, revenues, and profits helped boost Netflix' stock nearly 13%, up $2.98 to $25.99—just 21 cents shy of a 52-week high.

Netflix, a Web-based service offering home delivery of movies for a flat monthly fee, said its third-quarter profits totaled $15.7 million, or 23 cents a share. That was up about $3 million, or 5 cents a share, from the same period in 2006. Revenue hit $293 million, up from $255 million a year earlier. Sales for the first nine months of the year were $903 million, up from $719 million over the same period a year ago.

Reduced Rates Drew New Subscribers

Even more unexpectedly, the company's customer base grew by 286,000 subscribers during the three-month period, a striking turnaround from the first ever decline that Netflix suffered during the second quarter. Netflix closed out September with 7 million subscribers, up from 5.6 million at the end of last year's third quarter, and said it expects to add between 300,000 and 500,000 new subscriptions in the current quarter. The company also boosted its earnings outlook for the fiscal year, saying it expects to earn between 83 and 90 cents a share, up from a previous range of 62 to 76 cents a share.

Back in the summer, soon after the weak second-quarter report, Netflix cut the price on its most popular plan by $1 per month. The change, coupled with Blockbuster's (BBI) decision to cut back on advertising for its money-losing online service, has helped Netflix reverse its fortunes. "As you know, in recent quarters, our growth has been impacted by Blockbuster's online strategy of selling dollars for 85 cents," Chief Executive Officer Reed Hastings quipped in a conference call on Oct. 22. "That's not a viable long-term strategy and our competitor now appears to have de-emphasized their online business in favor of generating profits and focusing on improving their stores."

Analyst Michael Pachter of Wedbush Morgan Securities agrees that at least some of Netflix' success is being driven by Blockbuster's slowing online rental efforts as the 7,800-store chain refocuses on its core retail business. "Blockbuster and Netflix had been dividing the market for new trial subscriptions and Netflix had higher prices," he says. "Now they're no longer dividing the market and Neflix is capturing the bulk of it. Netflix can maintain this as long as Blockbuster cooperates by losing subscribers." Pachter rates Netflix' stock a buy, with a price target of $30.

But while having a lower price has certainly helped boost subscriber growth, the strategy creates a tricky problem by reducing Netflix' average revenue per subscriber, and can't help but threaten profit growth.

In Search of a Digital Download Partner

Then there's the longer-term threat of digital downloads of movie rentals directly from the Internet. During the conference call, Hastings said Netflix' strategy is to create a "hybrid service" that combines delivery of physical DVDs with the availability of some online video downloads. "If a consumer in America is into the Internet and movies, the chances are good they are going to be a Netflix DVD rental subscriber," he said. But since most movies are still available only on DVD, Hastings argued that the majority of Netflix' business will come from DVD rentals for the foreseeable future.

Netflix does have an agreement in place with TiVo (TIVO) to deliver movies to the popular TV set-top box, but that deal has yet to amount to much revenue, says Chad Bartley of Pacific Crest Securities. "Netflix' management has alluded to the fact that they'd like to work on getting downloaded content from the computer to the TV," Bartley says. "That's going to mean some kind of partnership, whether it's with TiVo or one of the game console makers out there."

Hesseldahl is a reporter for BusinessWeek.com .