Netflix/Blockbuster: bird’s eye view

I recently started to look at Netflix (NFLX) as an investment. My summary is that it’s a really interesting story, they’re a well-run company, but in a market fraught with uncertainity.

NFLX pioneered a channel that took business away from Blockbuster BBI. Finally, in the last quarter of 2006, BBI started to fight back, undercutting NFLX, causing it problems. NFLX has a clear and simple model, but BBI is adapting theirs rapidly and NFLX may be forced to react. To figure the value of NFLX, it is becoming more imperative to understand BBI than to understand NFLX itself. While NFLX executes well, its medium-term future depends more on what BBI will do and how NFLX can counter them.

Don’t shrug off BBI’s undercutting, saying they’re losing money. Price wars can get irrational, particularly when a competitor is fighting for its existence. Areas of research:

• How much does BBI lose per TA customer? Estimates range from $2 to $42 per month; the truth is probably somewhere in between those numbers.
• Next, what can BBI do to change those numbers? BBI’s management are obviously thinking hard about how they can use their loss-leader to make profit on something other than popcorn sales.
• If BBI cannot sustain the current level of loss-leadership in TA, can they tweak it to reduce their losses, while still undercutting NFLX just enough to do real harm?
• Finally, even if BBI fails after a few years of fighting hard, might that be a few years too many for NFLX?

In the longer term, the channel is threatened by downloading.When it comes to downloading, other players like cable and ISPs will also want in on the game. One can anticipate another fight, (say) six years down the road.

Therefore, what we have is this: NFLX is a well-run company, in a market that’s in flux, with a competitor that’s desperate; and, the future, instead of ending in a winner, morphs into a different fight. In summary, from a bird’s eye view, NFLX looks like a good company, but in a business that may not be too profitable in the medium-term and has little long-term visibility.

And yet…, it’s all so interesting. It’s seductive for an investor to want to rise up to the intellectual challenge of predicting a winner. That challenge, after all, is why so many people like investing. Despite thinking that it’s unpredictable, I too am drawn to the story, and will probably look more closely. I’ll resist the urge to bet any money just yet.