Netflix Leads Video Market Forward

According to a recent market report, the U.S. DVD and video sales and rental market was valued at $7.6 billion in 2008, of which brick-and-mortar stores claimed 69% of the revenue share. Mail-order companies such as Blockbuster and Netflix together commanded 24% of the market, while kiosks had a mere 6% share and online streaming or download options an even smaller 1%. The report predicts that by the end of 2011, stores will have only 47% of the market share while mail-order companies will have 31%. Both kiosks and online will grow rapidly to 17% and 5% respectively. Online DVD rental pioneer Netflix (NASDAQ:NFLX) will surely benefit from such growth.

Netflix’s recently released Q3 results surpassed analyst expectations. Netflix already commands a 9.6% share of the 115 million households in the United States. In San Francisco alone, 21.2% households subscribe to Netflix, compared with 13% a year ago. With the company’s tie-ups with Sony’s PlayStation 3 (PS3), viewership is set to grow on the online side.

Q3 revenues grew 24% to $423.1 million with earnings per share increasing from $0.33 to $0.52. Analysts were expecting revenues of $419.9 million with EPS of $0.45. Netflix ended the quarter with 11.1 million subscribers, growing 28% over the year, and maintained a low churn rate of 4.4% in the period. During the quarter, the company managed to reduce the cost of customer acquisition to a record low of $26.86, representing a 17% drop over the year.

Netflix repurchased 3 million shares at a cost of $130 million.

Within its rental model, Netflix completed the rollout of the Saturday delivery model across its 58 distribution centers. It is now proposing investment in automating the rental return service by installing machines that will accept returned DVDs and open, clean, inspect, and prepare them for reshipment. Netflix strongly believes that despite the growth of streaming content, DVD rentals will still continue to prosper. I agree with this hypothesis and believe that the real growth at Netflix will come from the growth of its mail order business.

The digital business, however, is important in the long run because it can dramatically alter the profitability of the delivery model. It will take time to gain adoption, but let’s take a look at the landscape.

Video streaming has proven to be a good business model for Netflix. The company has already increased the number of subscribers watching streamed videos or television episodes to 42% compared with 22% a year ago. It is now looking to expand its service to international markets, and the tie-up with Sony for PS3 is expected to help further this objective. In addition to the 9 million PS3 users within the United States that the Sony deal will give Netflix access to, the company will also have a ready base of 25 million worldwide users to address. As part of Netflix’s service, PS3 owners will be able to view streamed video using their PS3 consoles. Existing Netflix users who already have a PS3 will be able to use the streaming service free.

But competition is growing in the industry. Both Comcast and Time Warner Cable are set to launch an online on-demand service that will allow streamed TV content to subscribers at no extra charge. Netflix is not worried, however, because it foresees these players focusing on cable shows. For instance, Comcast will have customers as cable subscribers while Netflix will have them as DVD subscribers. Further, while the Netflix streaming option allows users to use the service away from home, the services offered by these new entrants do not offer such a feature.

Netflix projects Q4 revenues of $440 million to $446 million with EPS of $0.38 to $0.47. It expects the user base to expand to 12 million to 12.3 million subscribers. For the fiscal, Netflix projects revenues of $1.666 billion to $1.672 billion with EPS of $1.82 to $1.90.

The stock is trading at $55.23 and has been on an uptrend for the past several weeks, hitting a 52-week high of $57.50 on October 23.  The current market capitalization is $3.1 billion.