Netflix record Q1 profit disappoints Wall St.

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SAN FRANCISCO -- Netflix Inc. on Wednesday posted the highest first-quarter profit in its 8-year history, but the online DVD rental pioneer's performance flopped on Wall Street.

Investors turned their thumbs down largely because Netflix had trouble attracting and retaining subscribers amid stiffer competition from Blockbuster Inc. during the first three months of the year.

To make matters worse, Netflix management warned its service may continue to be upstaged by Blockbuster through the remainder of the year. As a result, Netflix expects to finish 2007 with 600,000 to 700,000 fewer customers than the Los Gatos-based company had projected when the year began.

Those dreary developments overshadowed Netflix's first-quarter profit of $9.9 million, or 14 cents per share, during the first three months of the year. That more than doubled from net income of $4.4 million, or 7 cents per share, at the same time last year.

Revenue rose 36% from last year to $305.3 million.

The earnings fell 2 cents below the average estimate among analysts surveyed by Thomson Financial, one of the reasons that Netflix Chief Financial Officer Barry McCarthy described the showing as the most disappointing quarter since the company went public in May 2002. McCarthy expressed his dismay during a Wednesday conference call.

The letdown punished Netflix's stock, which plunged $2.26, or 9.4%, to close Wednesday at $21.70 on the Nasdaq Stock Market. Netflix tried to bolster its shares by announcing plans to buy back $100 million worth of stock through the rest of the year.

This is hardly the first time that investors have gotten queasy about Netflix's prospects. Similar doubts arose in 2003 when Wal-Mart Stores Inc. entered the online DVD industry, a threat that evaporated last year when the world's largest retailer handed off its subscribers to Netflix.

Analysts also perpetually fret about Netflix becoming obsolescent once movie rentals become widely available for instant delivery over high-speed cable and telephone lines. Netflix is trying to address that challenge with a $40 million investment in a recently introduced service that enables its subscribers to watch movies on a Windows-based computers with broadband Internet connections.

Dallas-based Blockbuster is tormenting Netflix by linking its competing online rental service with its 5,100 U.S. stores under an aggressive marketing program called "Total Access."

Since Total Access began late last year, Blockbuster's online subscribers have had the option of returning and checking out some DVDs from the stores at no additional cost. That convenience represented a significant advantage over Netflix, where all DVD deliveries are made through the mail -- a limitation that means subscribers have to wait at least two days before receiving a new movie.

Although Netflix's service is still larger, Blockbuster is now growing faster.

Netflix signed up 487,000 subscribers during the first quarter, a 30% drop from 687,000 new customers at the same time last year. Blockbuster isn't scheduled to release its first-quarter numbers until May 2, but its management previously predicted the company's online service would lure 800,000 more customers during the first three months of the year.

Reed Hastings, Netflix's co-founder and chief executive officer, acknowledged there will likely be more ground lost to Blockbuster in the months ahead.

"Our thesis that more people would choose Netflix seems open to question, at least for now," Hastings told analysts during Wednesday's conference call.

In another acknowledgment of Blockbuster's impact, Netflix warned that it may lose as many subscribers as it attracts during the second quarter. That means Netflix may finish June with the same number of subscribers as it had at the end of March -- 6.8 million. Blockbuster is believed to have about 3 million online subscribers.

Soleil-Hudson Square Research analyst Daniel Ernst believes Netflix will bounce back. "Netflix has proven itself to be a pretty efficient and shrewd marketer so I wouldn't be surprised if they are growing faster than Blockbuster by the end of the year."

Netflix revised its subscriber growth targets Wednesday. The company now expects to have 7.3 million to 7.8 million customers at the end of this year, down from its earlier goal of 8 million to 8.4 million.

Despite that revision, Netflix reaffirmed its financial outlook for the entire year. The company expects to earn $55 million to $60 million in 2007.

Netflix doesn't believe Blockbuster will be able to continue to give away DVDs in its stores without eventually raising the prices for its online rental service. In Wednesday's conference call, McCarthy estimated Blockbuster will lose more than $200 million under its Total Access program unless the company raises its online prices.

Blockbuster spokesman Randy Hargrove declined to comment, saying the company will provide more details in May when management reviews the first-quarter results.

"Netflix obviously sees us as a formidable competitor because of our superior offering," Hargrove said.

Currently, both Blockbuster and Netflix charge $17.99 per month for the most popular rental program, which allows subscribers to hold on to as many as three DVDs at a time.

In an interview Wednesday, Hastings said Netflix isn't ruling out the possibility of lowering its prices later this year to counter Blockbuster.

As it is, Netflix is facing higher costs to for marketing and delivery costs.

As Blockbuster emerged as a more attractive alternative, Netflix spent an average $47.46 per new subscriber in the first quarter, up substantially from an average of $38.47 per new customer last year.

Like everyone else, Netflix also is facing higher mailing costs when U.S. Postal Service rates rise next month. Netflix will be among the hardest hit by the 2-cent increase for first-class postage because it mails out about 7.5 million DVDs each week, providing each subscriber with a postage-paid envelope for the return trip.
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