Why I Bought Netflix (Nasdaq: NFLX) I've been a shareholder of Netflix as long as I have been a satisfied customer -- 2002 -- just a few months after the company went public. I was skeptical at first yet after trying the service firsthand and watching the stock dip to about half of its post-IPO highs it was too tempting not to dive in. You probably know how the service works. In its most popular plan members pay $17.95 a month to rent as many DVDs they want -- with three discs out at any given time. Want another one? Mail one back. Netflix pays postage both ways with its signature red paper envelope mailers. There was a time when I wasn't sure if the company would ever turn a profit. One has to keep in mind that Netflix isn't just paying for postage but also revenue sharing for each rental (which can be as little as nothing for older catalog titles and as high as $1.20 for each new release). When it started building out a distribution network with dozens of centers to provide more than 85% of the country with next-day delivery using basic postage rates I began to wonder if spoiled movie buffs would rent too many discs for the company to turn a profit. When I first signed up I would have to wait a few days for my DVD rental from Miami to make it to the company's box in California -- and then a similar chunk of time for the next release to make its way to me. Now that I'm dealing with Fort Lauderdale it's overnight there, overnight back. The average customer was originally renting 4-5 discs a month. Would this new efficiency eat into any potential profitability? It didn't. The company closed out 2004 well in the black and with churn (customer turnover rate) at a historic low. Then again, things got ugly later in 2004 when, after raising its monthly rate from $20 to $22, the company dropped down it down four bucks a month when it feared that Amazon.com (Nasdaq: AMZN) would be entering the rental market. That vision was later vindicated when Amazon turned its attention and launched a DVD rental service in the United Kingdom. Yet the price war was born and Blockbuster -- sensing that if it didn't build its presence online it wouldn't matter much offline -- was even more aggressive in dropping its price to $14.99 and offering two free in-store rentals every month. While the series of events clipped the shares of Netflix it is expecting to turn a profit through the last three quarters of 2005 and grow its base to 4 million subscribers. As I write this, in April of 2005, the market isn't convinced. A third of the stock's price is backed by the cash on its balance sheet and the enterprise value is at a significant discount to the at least $700 million in revenue that the company expects to generate in 2005. Why I would sell Netflix? Netflix has been reluctant to move into logical expansion areas. It won't rent video games. It won't stock more risqué titles. While I don't think that those are the keys to growth necessarily it will definitely test the company's position as a market leader if someone else were to become more prominent in offering a souped up version of Netflix with the necessary investment in the distribution center network (that's important, the reason why Wal-Mart has always been a dud in DVD rentals is because while Blockbuster and Netflix have gone to local distribution centers Wal-Mart chose to ship all of its titles in and out of Georgia). An aggressive entry by Amazon (which won't be easy given Blockbuster and Netflix coming on strong at low price points) would obviously hurt Netflix as well. I see the industry moving towards monthly caps -- where Amazon already is in the UK -- as a way to keep costs in check (and serial renters who cost the companies too much money at bay). Netflix losing its role as market leader, whether it is to Blockbuster or Amazon or anyone else, would also have me evaluate the company much more judiciously. Go Back UNDER

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