Neither Blockbuster, Nor Netflix

I still have my ten foot pole out and it is NOT pointed towards the movie rental industry. Starting with Blockbuster (BBI), I had zero confidence in their ability to execute on a compelling online Web 3.0 strategy. Blockbuster’s past efforts to battle competitor Netflix had cost the company dearly. Trying to dilute Netflix’s momentum, Blockbuster ended late fees, started a price war against a well-funded innovator with little debt, and cannibalized their own higher margin in-store business in the process. Netflix added to the woes with a patent lawsuit against Blockbuster.

Blockbuster announced Q3 earnings on November 1, 2007, and, prior to discussing the financials, management gave an update on the 100-day transformation plan outlined in the previous earnings call. The first priority was to establish a new leadership team. Second, Blockbuster was going to produce a $45 million annual savings by reducing 400 positions.

Unfortunately, the new leadership has yet to prove itself. Q3 Earnings were disappointing. Q3 revenues decreased 5.7% to $1.24 billion for Q3 from $1.31 billion in 2006 and down 2% from Q2 2007. Net Income was a $35 million loss, as compared with a net loss of $24.7 million in Q3 2006. The silver lining was that the Blockbuster’s results posted better than analysts’ already pessimistic expectations.

The most notable point in the earnings call was CEO Keyes strategy to turn Blockbuster around. This includes:

1. Raising prices and reinstituting late fees – bottom line, it has the ability to raise revenues, but it could also drive away customers. Keyes later indicated that he doesn’t want to raise prices multiple times, so there is confusion on the pricing strategy.

2. Shifting to revenue-sharing arrangements – don’t they already have these?

3. Investing in Kiosk technology – focus on burn on demand, providing fast copies of movies for a price.

4. Dedicating more square footage to retail – video games sell, period.

Both Blockbuster and its main competitor Netflix (NFLX) are wounded from their protracted fighting. With the encroachment of Apple’s iTunes, digital download, and continued portability of movie products at cheaper and cheaper prices, customers won’t be interested in higher rental prices either. Instead, with increasing food and gas prices, customers are more fickle, hopping from lower to lower prices for the same goods. What Blockbuster needs desperately is a new product that separates them again from the crowd of movie rental providers, or better yet a new business paradigm. I have little confidence that the company can come up with either.

Netflix, in the meantime, suffered a sudden loss of market share to competitor Blockbuster’s Total Access program, and found itself on unfamiliar grounds playing catch-up. Price cuts made to compensate and compete also brought Netflix share price down, and the price wars dampened any interest I might have had in investing in this sector. Ultimately Blockbuster’s Total Access was unsuccessful, but more because of Blockbuster’s own fussing with the fees.

Bruised, Netflix still posted Q3 earnings better than its competitor and based on its existing Internet ordering business model. Netflix reported revenue of $294 million for Q3 2007, a 15% increase YoY. However, gross margins have decreased to 33.9% in Q3 versus 38% 2006 Q3 and 35.2% in 2007 Q2. Cash provided by operating activities for 2007 Q3 was $77.6 million, versus $61.5 million a year ago and $65.1 million for 2007 Q2. Netflix reported a net income for Q3 of $15.7 million, versus $12.8 million last year, for Q3 2006. Analysts expected revenue of $286.5 million, so the company delivered some positive surprises.

The company ended Q3 with a 24% subscriber increase, with 7.028 million subscribers versus 5.66 million for the same quarter last year. However, only 6.8 million or 97% of the subscribers were paid. The net subscriber change in Q3 was an increase of 286,000, compared to an increase of 493,000 a year ago. Lastly, the company is churning a lower percentage of new customers (4.2% versus 4.6% in 2006), and that is also good news.

Clearly, online downloading is going to be an avenue of sales for movies and related products. Netflix has already embraced this model with its Internet platform for DVD deliveries, so it is well-poised for the time when the market takes off.

Meanwhile, I am interested in seeing Netflix changing its business mix to include a large chunk of advertising revenue, which is much higher margin, and will start making the online film category interesting to me. I gave an example of this earlier with the idea of acquiring Flixter, to seed a great user community. Netflix hasn’t taken that leap yet, still beating itself senseless trying to pound Blockbuster into submission, harping on the same business model.

Come on, Reed, time to do things differently!