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Will Netflix Survive iTunes Movies?

Posted on Friday, Jan 25th 2008

Amidst weak economic conditions, Netflix reported a solid 4Q07 beating the street’s expectations. Revenues in 4Q07 was $302.4 million, up 9% y-o-y. Gross Profit margin was 33.8% compared to 38.9% a year ago. Net profit increased to $15.8 million, up 6% driven mainly by a 9% q-o-q decline in Subscriber Acquisition Cost (SAC) to $34.60, its lowest level since 4Q03. EPS in 4Q07 was $0.24, up 12%.

For the full year 2007, the Company recorded revenues of $1.205 billion, up 21% from $996.7 million for fiscal 2006. GAAP net income in 2007 was $67.0 million, or $0.97 per diluted share. Gross margin in 2007 was at 34.8%. The Company generates $45.5 million in free cash flow in 2007.

Total subscriber base at the end of 4Q07 was around 7.48 million, up 451,000, q-o-q. Of the total subscribers, 98% are paid subscribers. Churn was up at 4.1% in 4Q07 from 3.9% in 4Q06. As per Alexa’s latest quarterly data, Netflix’s page views have shown an increase of 4% vs. a fall of 6% in Blockbusters.com.

Robust growth when you consider the revenues and the profits but look deeper and you will find that the Company is facing steep competition. Net additions of subscribers were down from 2.1 million in 2006 to 1.2 million in 2007 due increased competition. Average revenue per paying subscriber was down to $14.22 from $15.87, a year ago. Gross margins have fallen over 510 basis points in 4Q07 from 4Q06. Both operating and free cash flow for the quarter were down compared to 4Q06.

However, the Company is bullish on the future prospects and expects bundled service and the delivery of TV episodes and movies over the Internet to aid long-term growth. The management guided for revenues of $1.30 – $1.35 billion, GAAP net income of $75 – $83 million and GAAP EPS of $1.12 – $1.24 per diluted share in 2008. It expects to end 2008 with 8.4 – 8.9 million subscribers.

Meanwhile, Apple has launched iTunes movie rentals, which analysts expect to impact Netflix negatively but the management feels it will only expand the market by creating awareness and since its business model is different (based on service) the impact will be minimal. Weak explanation. I have a better one. Most users still don’t have the patience to download movies online, so DVD rental is still a better option. When technology gets to a point where we can download a full movie in minutes rather than hours, real competition will begin. For now, DVDs in red envelopes are a better user experience. At least for me.

I see the embedding of Netflix in LG set-top boxes as a good experimental opportunity. The Company feels it ability to offer online streaming and DVD rental at low cost and better service will aid in differentiation and future growth. The problem, however, is elsewhere. IPTV has a business model problem, and buying set top boxes, something which has traditionally come for free, will not be acceptable for consumers.

I have talked about Netflix acquiring Flixster and rolling up an online movie community that earns advertising revenues. There have been rumours about IAC acquiring Flixster, which today Om Malik says is untrue. Netflix should act.

The stock is currently trading at $21.94 and has a market cap of $1.44 billion with a 52-week range of $15.62 – $29.14. Increasing competition, impending economic slowdown, falling margins and the FUD created by Apple’s iTunes Movies will hold the stock down inspite of a reasonably robust guidance for 2008. It is essential that they rethink their business model this year.

On final point: I like what they are doing with Red Envelope Entertainment, producing and distributing independent cinema.

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Sramana, I think you are right in the sense that Apple TV and the associated iTunes movie rental will not be much competition; but I don’t think the reason is not that iTunes is inconvenient. My understanding of the situation is that the movie starts playing in a few moments, before it finishes downloading. This is also true of Netflix’s Instant Watch feature on Internet Explorer (I usually only have to wait a few seconds when I start watching and anytime I seek).

I think iTunes movie rental is a dud because it is overpriced for the product. If they can come out with a buffet model like Netflix, then I think they are in direct competition and Netflix may suffer.

I know I am the millionth person to say this, but it is as clear as day to me that the future of content delivery will be online. Its just simply a matter of time before the red envelopes fade into history.

Look for Netflix to take the Microsoft approach to solve this problem. Look for them to partner with every Tom, Dick, and Harry that produces anything that connects to a TV to include a Netflix Instant Watch feature.

You are wrong that people don’t want to purchase set top boxes, they do, in droves! I point to the millions of DVD players, Tivos, XBoxes, PS3s, etc, all of which could include internet connectivity and a bit more brain power.

If Netflix intends to compete in this area, they need to dramatically increase the number and quality of movies they have on their Instant Watch service (perhaps resulting in increased prices.) The recent additions from NBC are a welcome move in the right direction. If they can expand this library to match their DVD library…

No one should even think of writing Netflix’s obituary yet. Netflix is but a metaphoric pre-pubescent teen on the verge of its prime.

Apple is a big Gorilla, and there maybe others lurking in the dark, but Goliath fell to David before.

Krishna Chodavarapu Friday, January 25, 2008 at 12:55 PM PT

Krishna,

Good set of thoughts.

You see, everything has a time value. In the long term, yes, everything will be online downloads. However, in the next 5 years, I think Netflix’s postal DVD rental business will continue to grow in subscribers.

As for the box business, I am sorry, I don’t agree with you. It is a highly nichy business. Even in a household like mine, which, by all measures, is a tech savvy house, there is neither xbox, nor PS3, nor Tivo. You would be surprised how many households are more like mine.

Sramana Mitra Friday, January 25, 2008 at 1:10 PM PT

Your analysis is spot on. It is essential that Netflix rethink their business model this year.

Netflix’ greatest asset is also its’ greatest weakness. Netflix has an impressive collection of DVDs accumulated over the years. As the party moves away from DVDs and onto the net, they will lose their built-in advantage. As iTunes, and possibly other online competitors, fills in their catalog, there will be shift to online distribution. Netflix’ titles will be in a older static non-HD technology, where on line downloads can adapt more easily.

iTunes will have 2 competitive advantages. These are at both ends of the movie demand curve. First, when a movie first comes out, everyone with an AppleTV can download it the very first day. No running down to Blockbuster and having all copies checked out already or waiting for Netflix to get around to sending you a copy weeks later once the new release demand for that particular title has died down.

Second, online distribution is also ideally suited to fulfill the longtail of demand for low-volume niche movies in many genres. Netflix was able to exploit this advantage against Blockbuster and other bricks and mortar DVD rental shops, who were unable to stock as many titles as Netflix’ central distribution. iTunes can use the online advantage to outflank Netflix, as can any other online distributor with the resources and resolve to assemble a collection to rival Netflix’ DVD collection. The beauty of online distribution is that as soon as a digital copy of a title is catalogued, you have unlimited copies of that title to rent or sell forever. No lost disks, no damaged disks.

I agree that the cost of set-top boxes is a barrier to consumer adoption of online services. The advantage that the AppleTV has in this overcoming this barrier is that AppleTV also ties into the iTunes/Mac ecosystem. It not only allows movies-on-demand, it does so without the $50 a month or so cable/ satellite bill. $600 a year buys or rents a lot of content.

AppleTV deals with your ease of use concern. Not only will you be able to push a virtual button and watch a movie in minutes as you suggest is important, but you’ll have easy access to the Apple/ iTunes ecosystem. The AppleTV functions as the iPod connection for the home stereo and TV for their iTunes collection of music, music videos, TV shows, movies, podcasts, and for their photos in iPhoto and flickr, plus access to YouTube and other internet services that will be added over time.

I disagree that the entire movie needs to download in minutes. I do believe that for the movie-on-demand consumer, the movie needs to start playing in minutes and be able to play uninterrupted until end, except for any user-initiated potty break or snack run. Constant interruptions to allow for movie downloading and buffering will adversely impact the quality of the experience, and therefore reduce uptake of the service. With the increasing penetration of broadband, including fiber direct to consumer, this concern will diminish over time.

In addition, with 30 day downloads, some people will download movies in advance for viewing later after dinner, or even download overnight in advance to have movies available for weekend viewing. No need to worry if Blockbuster will have the movie available on busy Friday and Saturday nights. Also, no need to worry about the availability of the next Netflix movie in the queue, or the timing of the postal delivery of the physical DVD.

The rate of uptake of online service vs the Netflix delivery model will be affected by the cost of service and the availability of movies. At the moment, Netflix has the cost advantage vs iTunes for households who consume a large number of titles on a constant basis. They also have the long tail variety of title advantage at this moment. Both of these advantages can disappear when an online distributor, such as iTunes, builds their online catalog and offer a subscription service respectively.

Blockbuster Total Access has similar characteristics to the Netflix subscription model, plus integrates with the bricks and mortar stores to adds bonuses. This battle between the two has led to a price war which gives these subscription services the price advantage but also cuts away most of the profit.

Netflix will be around for a while, but your prediction of 5 more years of substantive growth is overly optimistic, unless as you say, they rethink their business model this year. Apple is monetizing the their community by offering additional services to their installed base. Netflix is failing to do so by not building, on top of their dead-end low-profit commodity business, a community serviced by new original content created to differentiate their brand.

Once, Netflix and Blockbuster move to online distribution, there will be a new level playing field. Each will have little or no advantage naturally arising from a consumer’s experience with the respective entity previous distribution business model. However, users of Apple technology will have an ecosystem of which AppleTV is but one part of the whole.

There is a lot more stickiness to Apple’s business model than that of either Netflix or Blockbuster. I would not own either stock right now. Tower Records had at least as good a customer experience as either of two. It is now a relic of the past because it failed to transition to the net. On the other hand, Apple is down about 35% from recent highs, even after having just announced a record quarter with historically high revenue, profit and cash flow, and with margins that are tending higher. Further, Apple has four businesses with lots of room for growth for at least the next 2-3 years: Macs, iPods/internet appliances, phones, AppleTV/media distribution.

It would be interesting to see if and when Apple gets into the content creation business to serve their much larger community, as you suggest Netflix do. There have been calls for Apple to start a record label. Jobs already did Pixar. It would not be a stretch to think that he could help Apple get into content creation.

As you can see, I agree with the market and don’t as much value in Netflix as you do unless something changes drastically. I would be looking to someone in a position to do well in the net sphere, like an Apple or an Amazon. Apple is making a lot of money, their products and business models look good, and their prospects for continued growth are solid. And as a value buyer Apple is back at a level that I can justify getting into.

Realtosh Sunday, January 27, 2008 at 8:22 PM PT

so many businesses now depending on bandwidth, and the wars over control of bandwidth and content may be quite shocking

and here in india with my 6KBPS reliance usb modem download speed, it is all a dream

gregory Sunday, January 27, 2008 at 8:28 PM PT

Movie content via download is YEARS away from being the mainstream method. It has been proven this time and time again. This is snakeoil talk…it’s the late ’90s all over again, and it’s the same people and their protoges who are selling it.

Physical media is going nowhere.

mike Monday, January 28, 2008 at 9:21 AM PT

Mike,

If Jobs or any other distributor can convince the labels and studios to accept the SAME royalties for the content regardless if pressed on physical media, then the situation will change very quickly. Some people like to hold physical media. But the cost saving of not having to produce physical media, warehouse it, transport it and sell it in a retail location will allow the content to be sold much cheaper over the net.

Keep in mind that the labels and studios are making much more profit per song or movie at the moment selling on iTunes. This in spite of all the protestations to the opposite. Prices on iTunes are kept artificially high on iTunes so that the sales at the bricks and mortar shops aren’t completely devastated.

Steve Jobs wants to give the savings to the consumer. The content owners want to control the retail price so that their product doesn’t lose its’ perceived value.

Over the last couple of years Walmart has tried to exert influence over the content owners because iTunes prices are cheaper than buying physical media at Walmart, even with their efficient operation. See all those huge Walmart stores, Walmart trucks, Walmart warehouses, factories in China and Mexico. Somebody has to pay for that. Not if you buy on iTunes.

The variables are lined up favorably now. Barriers to entry have been mostly eliminated. The cost of computers has come down, just about all computers have the computing performance necessary to handle media, and the household penetration of media-able computers is way up.

All other things being equal, distribution of content will move to the net. More variety, lower cost. Notice that the iTunes music store is steading growing its’ sales. All the other sellers of physical media are treading water, or are seeing revenue declines or have already closed their doors.

Realtosh Monday, January 28, 2008 at 12:40 PM PT

Also, the Box issue is key. Who pays for the box?

Sramana Mitra Monday, January 28, 2008 at 3:45 PM PT

I agree that the cost of set-top boxes is a barrier to consumer adoption. 1) In subscription model, like Netflix but digital; there is a recurring revenue stream that can subsidize the box, which could be free or really cheap. 2) For Apple, they are building an ecosystem so that the AppleTV set-top box won’t be a one trick pony. That box does movies (rental and purchase), TV shows, audio and video podcasts, music videos, music, family photos, family movies, YouTube, internet, etc. In ecosystem such as Apple’s, the value proposition of the box is altered in balance of being able to EASILY connect one’s life that exists in the digital realm with the TV in the living room.

Earlier boxes were movie-only. Plus the penetration of broadband internet is only now beginning to reach critical mass. Also, penetration of media-capable computers has only recently become ubiquitous; in large part because of the internet and email. So we’re only now becoming ready for movies online to be a real possibility. Before now, no one could have succeeded even with a FREE box.

Don’t underestimate the Apple ecosystem. With iTunes, AppleTV, and video-capable iPods, and laptops, we will have our music and movies wherever we are, whether we remember to bring CDs and DVDs or not. Plus having an iPod in your pocket, travel case or back pack is much simpler and more convenient than carrying a bunch of CDs and DVDs around.

Don’t forget that iPods (without the AppleTV) are already capable of performing the functions of a set-top box, either at home or on the go. There are over 100 million iPods sold, and a large portion of those sold now or in the recent past are video-capable (now all except the shuffles). The iPod ecosystem is bypassing the barrier of the set-top box. Others have tried with the Xbox 360 and the PS3, but the installed base of gaming systems has not and will not ever compare to the scale that the iPod has already reached.

I’ve played Netflix DVD movies on the TV from a Mac laptop, so I could imagine some people playing their iTunes rentals on TV straight from their MacBooks, some more-capable Windows laptops, and iPods. Other 20’ and 24’ iMacs will double as TVs, as could any Mac or PC with a large monitor and iTunes. These solutions will add to iTunes movie volume and help iTunes reach a critical mass for movies, but the set-top box will necessary to make iTunes a more permanent solution for regular movie watching. The recent announcement of movies available from all major studios has had a dramatic effect on the sales of AppleTV set-top boxes. We’ll hear more about it at the next earnings teleconference.

The set-top box question is real, but Apple seems to have a working solution to avoid that trap altogether. For everyone else including Netflix as they transition to net, the cost of the box will be a real question.

Realtosh Monday, January 28, 2008 at 7:36 PM PT

Apple has a shot at this, I agree. But the size of movies is much larger than the music and short video clips, so I don’t see how the iPod can serve as set-top-boxes. How many movies can an iPod hold?

Sramana Mitra Tuesday, January 29, 2008 at 4:14 PM PT

Good question.
I picked the first 4 random movies on iTunes and got the following file sizes and viewing times:

Movie 1 1.83G 2.48.50
Movie 2 1.12G 1.36.20
Movie 3 1.03G 1.34.18
Movie 4 1.03G 1.32.47

Total 4 movies 5.01 G
7.31.35 total viewing time
1.52.75 average viewing time per movie
Note: The first movie, Pirates of the Caribbean, is nearly 3 hours long which is much longer than most.

Most people can squeeze an extra 5G on their iPod to carry 4 movies for a movie marathon, weekend getaway, or a vacation. In fact, I have capacity for up to 20-25 movies on my 4 1/2 year old iPod.

Movies would be downloaded via iTunes onto a desktop, laptop, or AppleTV. An extra gig or two for a movie could be synched onto iPod from a Mac or PC in minutes.

So I could easily see someone picking a movie from their iTunes collection and synching onto an iPod while the popcorn pops, to view on the big screen in the living room or to take over to a friend’s place to view later. All you need is an iPod and a video out cable.

All the hardware and software already exists in the iTunes ecosystem somewhere; and Apple is known for creating extremely easy to use solutions.

So yes, movies are quite large. But most iPods have sufficient capacity for movies. Not for an entire collection; but for occasional everyday viewing, synching a movie or two would only take minutes.

Realtosh Wednesday, January 30, 2008 at 5:59 PM PT

Can I tell you something? I just won’t bother with this.

And I am a tech-savvy consumer.

What does that tell you?

Sramana Mitra Wednesday, January 30, 2008 at 6:21 PM PT

I hear you, and agree. Most people will not do this unless the solution is provided and supported by Apple. In that case it will be easy.

I make your same argument all the time with geeky types who manually manage their music and movie collections without an iTunes-like solution.

My point is that it is possible for Apple provide such a solution using iPods to expand its’ video consumption.

It’s possible now with the video iPods. You can synch various iPods with the same master collection, and each iPod can have a different subset of the music and movies. Each individual chooses which media they want to sync. A teenage daughter will consume very different music and movies than the dad in the house. That’s possible now; teenagers and their households are doing that now. They will just be adding movies to the mix.

We tend to want to stick with physical media more than the younger generation. They don’t feel so attached to the discs as we do.

And I agree with your point, if it is not easy most people including yourself just won’t do it. My point is that a teenager or young adult with an iPod on a limited budget will have a cheaper option, even without the box, that will contribute to Apple’s critical mass in movies.

Some families will just go out and get an AppleTV box, which makes it easy.

I understand that the reports are that sales of the box picked up quite a bit after the rental movies announcement at MacWorld. We’ll hear more about it at the next earnings conference in 3 months. Let’s see if the sales of the AppleTV box keep up the new higher pace.

Right now Netflix has many niche movies that are hard to get otherwise, from artistic movies to ethnic movies. In time, Apple or someone else will amass a digital collection to rival Netflix’ collection. If Netflix doesn’t keep up and build a robust solution online, their current collection will lose much of its’ value.

All other variables being equal, online distribution will be easier, cheaper and make more options available. I would think that if anyone understood that, it would be you. You constantly advocate for good internet strategies.

If the number of movies per month, the total cost per the month, and the availability of movies was at least as good as Netflix now — Do you not think that many people including yourself would consider online rentals?

I think that Apple offering RENTALS is what is making the difference. Many people who want to own still show a preference for physical media. But for a short-term rental, digital file is cheaper and easier to move around; No envelopes or driving to the store. Plus, online will be much more profitable, if the royalties and subscription costs are the same. Digital distribution will have a cost advantage over physical media.

If it can be done and I think it can, then Apple will find a way to make it easy and profitable. Netflix better not fall asleep. I think they have the better solution right now, but that will change soon. I already stopped my Netflix subscription over a year ago. I was just too busy to always keep up with the movies that kept coming constantly. For an occasional movie a quick download is easier than driving 10 minutes to the video store, just to find that the movies I prefer to watch are out or not carried at their location.

If and when Apple builds out their inventory of rental movies, they will get a lot of impulse rentals. Right now Apple is best positioned to take advantage of the shift to web, even more so than Netflix.

I agree with much of what you say. However, I don’t think Netflix has any room to make a mistake right now. The online movie business will be more competitive than the online music business. However, it is now Apple’s to lose; not Netflix. Netflix will have to fight hard, create a very good product, and make some good strategic moves while they still have a chance.

Realtosh Thursday, January 31, 2008 at 5:57 AM PT

Here’s an article whose author also sees Netflix as superior to Apple’s current offering.

https://www.applematters.com/index.php/section/comments/sorry-apple-netflix-is-just-too-good/

Realtosh Thursday, January 31, 2008 at 6:56 PM PT

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