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Risky Netflix Strategy Has Investors Twitchy

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Risky Netflix Strategy Has Investors Twitchy
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By virtue of mathematical coincidence, every million dollars that Netflix C.E.O. Reed Hastings spends to build a digital download service for his DVD-by-mail company sucks away roughly one penny of profit from each share of its stock.
The simplicity of the calculation could grow increasingly inconvenient for Hastings as he and his management team fend off criticism from investors who prefer profits in their pockets rather than risk building a parallel business of streaming movies and TV shows over the internet.
"We're spending a lot of money," Chief Financial Officer Barry McCarthy said at an analyst conference earlier this week, "and if we fall on our face I have no doubt investors will vote us off the island."
The death of the DVD looms over Netflix like an elderly uncle who pays the rent. When he finally moves on, Netflix had better have another source of income.
But at what cost? Hastings spent $40 million last year to build up a library of 10,000 movies and TV shows that its 8 million subscribers can watch online. He's partnering with consumer electronics companies to build Netflix streaming capabilities into TVs, DVD players and set-top boxes.
As inspirational as it sounds, transformation costs money—as much as $70 million this year, or 70 cents a share in 2008 profits. And investors want to know in the cold language of accounting what the financial benefit is for each dollar spent on buying the rights to show a movie online.
Hastings this week asked investors to bear with him for a few years as he primes the pump for a new business model. To that end, he invented a metric that he asks analysts to use in judging his online strategy: The number of TVs and other Internet-connected consumer electronics with Netflix software built in.
Hastings calls it the Dolby model—making Netflix reception as ubiquitous as the noise-reduction technology. LG Electronics, the South Korean company, is already on board, as is a start-up company called Roku that makes a $100 Netflix-on-TV box.
"I think the way to measure us is the number of millions of Netflix-ready devices installed in homes," Hastings told investors. "If that's a big number at the end of '09, then our strategic investment has greatly paid off. If it's a small number, you have every right to be whiny about management having wasted a lot of money."
Analysts were not convinced. Michael Pachter, who covers Netflix for Wedbush Morgan Securities, said he would prefer that Netflix stick to selling movie-rental subscriptions, not giving investment analysis. "I don't really care what they think we should focus on," he said. "I would never presume to tell them how to do their job."
Pachter has pushed the company to disclose more about the nuts and bolts of its online investment. He points out that if Netflix spends $70 million this year for a service used by 100,000 customers, it works out to $700 per customer.
"I would say they're crazy; it's not worth it," Pachter said. The math only makes sense as the number of users increases dramatically, he added. At 7 million users of Netflix online, for example, the annual investment comes to $10 per customer, or 85 cents a month. "I would support that," Pachter said.
For now, Netflix doesn't disclose these kinds of figures. The $70 million figure is Pachter's estimate based on data in the company's first-quarter earnings release. He reckons that more than 1 million Netflix subscribers have tried the online feature, but there's no official word from the company. "They have an overdeveloped sense of secrecy in the name of competitive disadvantage," Pachter said.
If enough analysts go for it, Hastings' pro-forma figure of installed Netflix-ready devices would be a stroke of investor-relations brilliance. The company could win enough support to fend off short-term-minded investors who want to be rich and retired in Hawaii by the time the DVD business dies in 20 years.
Hastings may already know that he's got this pro forma figure covered. Pachter, who also covers video games, says he is confident that Netflix will soon unveil a partnership with Microsoft to make its service available on Xbox 360 consoles—of which there are 10 million in the U.S. (Hastings sits on Microsoft's board.)
"I'm kind of baffled why the two companies don't think they should announce that before it's up and ready for the consumer," Pachter said.
Netflix spokesman Steve Swasey declined to comment on unannounced partners.

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