Rule #1 Finance Blog

With Investor Phil Town

SHOPPING FOR CERTAINTY

Rachael has done a very nice job of looking deeper into Netflix for us.  She’s compared Netflix and Blockbuster.  Here’s what she found out (Read everything: this is a great example of someone getting a true feeling for a business. My conclusion is at the end.):

I’ve been digging a little deeper into some reports, and I have to admit, most of the numbers are still meaningless to me, so bear with me here. I looked up the quarterly reports for both Netflix and Blockbuster and found some interesting differences…

From Netflix’s report:

"Net income was higher in the second quarter of 2005 as compared to the second quarter of 2004 though we lowered the price of our most popular service plan primarily because of our ability to grow our subscription revenues without a commensurate increase in expenses."

Blockbuster on the other hand:

"While we firmly believe that these programs will give us a critical advantage in the highly competitive rental industry, they also require us to make significant investments, which, when combined with the decline in the in-store rental industry during the second quarter of 2005, have negatively impacted our gross profit, operating expenses and cash flow."

It seems like Blockbuster is still struggling to break into this market, despite its big name, because it has to now balance its physical stores with its online store. I think they are just taking from one pot and moving it to another. The people who would normally rent in-store have just moved online…there is no net gain of renters essentially.

Worse, they might be actually LOSING renters entirely to Netflix AND they are losing revenue from late fees (end of late fees campaign) PLUS the online service is cheaper if you watch at least 4 movies a month. Blockbuster still has to operate its stores, even though less people are renting from them.

The difference in overhead for the two companies is HUGE. Blockbuster knows this:

"In light of the difficult environment in which we are operating and in order to support the investment in our initiatives, we are aggressively reducing our operating expenses and capital expenditures. During the first six months of 2005, we implemented an aggressive cost-reduction strategy, which included a reduction in force and other measures targeted at reducing our operating expenses by approximately $70 million annually."

Also, just comparing the number of subscribers, Netflix has 3M, and Blockbuster only just reached the 1M mark.

Netflix does acknowledge significant competition from Blockbuster, in the form of huge TV ad campaigns and price slashing. They also expect Amazon.com to jump in as well.

Blockbuster’s price for the same service as Netflix (most popular – 3 at a time) is the same right now from what I can tell on both of the sites, but in the past Blockbuster has been up to $3.00 cheaper. Despite this, Netflix is still the leading company.

A direct comparison table from Yahoo of their competition lists 3 other companies: Blockbuster (BBI), Hastings (HAST), and Movie Gallery (MOVI). Of these, only Blockbuster is doing the online thing.

The market cap for NFLX is 1.41B compared to BBI’s 915M. BBI is over 50 times larger than NFLX in employees, but its revenue is only 10 times larger than NFLX. They have to cut overhead or find other ways of generating significantly more revenue to catch up to NFLX.

It seems to me that NFLX has a huge advantage because of its low overhead cost, and that’s why it’s still the leader. It also offers different pricing plans based on how many movies you want at a time, so it’s more flexible. Still, NFLX has plans to increase their lead on Blockbuster by adding the option to buy previously viewed DVDs, and they are also selling ad space on the site. NLFX also continues to be the only company moving forward with technology by doing R&D on a downloadable movie service. NFLX also has more selection. BBI is still trying to get the basics right.

Wow that was long, and I’m not sure exactly what conclusions to draw from this. It seems like NFLX is one step ahead and could be for awhile, but it’s so new that it’s hard to tell how it will do in the long run! Any more specific things I should be looking for?

~Rachael

Excellent research job. To recap Rachael’s findings:

1.  Netflix is growing its net income while BBI is losing money and firing people.
2.  BBI seems to be losing customers to NFLX.
3.  BBI has 50 times more people but only 10 times more revenue and is losing money.
4.  NFLX is the low cost provider, a big advantage.
5.  NFLX is the R&D leader, the new product leader and BBI is playing catch-up.

What we’re doing is trying to get certain about making an investment. 

Certainty is the key.  Rachael, by doing some reading, is improving her sense of what this business is about.  She’s not ready to draw any conclusions yet, which is good.  She’s getting a feeling for the biz.  The feeling is that Netflix has Meaning, Moat and Management.  But it’s still just a feeling.  As long as it stays just a feeling and doesn’t become certainty, she’s not going to invest.  Rule #1 investors KNOW that the business is a long-term winner. 

So the question has two parts:

  1. Is NFLX a long term winner? 
  2. Is it available at an attractive price? 

Rachael is going to have to deal with one very important fact about Netflix: It is a new business.  New businesses are notoriously hard to predict.  It has good numbers the last couple of years but that’s all.  Not nearly enough to predict from. 

For a comparison of start up numbers take a look at Google (GOOG) and then look at Netflix (NFLX).  Google has been profitable for twice as long and is growing all its number far more quickly.  It has a big Secrets Moat and a HUGE Brand Moat.  It’s OBVIOUSLY a wonderful business… and we still can’t predict that it will be around in ten years.  Remember Netscape? Neither do I and just ten years ago Netscape was the Google of the day. 

So, guys and gals, be very careful about getting all in love with new businesses.  Keep them limited to the Risky Biz portfolio – no more than ten percent of your investment dollars.  And only do them when they are Google-like in their obviousness.  Is Netflix Google-like? Hmmmmm. I’m just not sure.  And that’s enough for me to get away from this one.

Then when we take a look at price compared to value, we know we’re in the 20% to 32% growth range and the business has to be in the upper part of that range to be a deal.  We never buy based on the most optimistic assumptions. 

In this case, the Equity is growing at 22% a year which gives us an estimated PE of 44.  With earnings of about 30 cents growing at 22% a year for ten years, the future price should be about $100 a share if all goes well.  To get a 15% return we have to pay about $25 for that today.  Which means we need to buy it for $12. It’s selling for what it’s worth – about $25.  No margin of safety. Which makes life easier since even if we wanted to, we can’t buy it.

So there you go, Rachael.  All I added was the boundary.  You did a very very nice job.  You see, you CAN do this.  It isn’t rocket science.  Its called shopping.

You just gotta know what to shop for and be disciplined enough to not buy anything else. 

Now go play,

Phil