Playing the Online DVD Rental Market

After years of trailing Netflix (NFLX), movie rental giant Blockbuster (BBI) has finally realized that it might have a competitive advantage over its main rival; about 8,500 storefronts worldwide. By integrating in-store and online DVD rentals into its new Total Access movie rental program, Blockbuster is finally making some gains at Netflix’s expense.

However, looking at the share prices of both companies, one has to wonder if Wall Street is too optimistic about Netflix’s future and too pessimistic about that of Blockbuster. Despite having annual revenue that trounces NFLX by a factor of four, Blockbuster’s market cap ($1.09 billion) trails that of Netflix ($1.75 billion) by nearly 40 percent. Netflix’s EBITDA for the first nine months of 2006 came in at $46 million, only 25% of Blockbuster’s $188 million.

So, Blockbuster at first blush appears to be a much cheaper stock with 60% of the market cap of Netflix, but with 4 times as much revenue and EBITDA. Even using a P/E ratio, which hurts Blockbuster given they have a fairly high debt load, BBI shares trade at more than a 10% discount to Netflix based on 2007 projections.

Given these numbers, there has to be some explanation for the wide valuation disparity. Growth investors would surely point out that Netflix is focused solely on the high growth online DVD rental market, whereas the bulk of Blockbuster’s business comes from the storefront, which is a deteriorating market.

That said, Blockbuster’s 8,500 stores are worth something, even if it is far less than five or ten years ago, and Netflix has no stores. Going forward, does NFLX have an advantage over Blockbuster when it comes to securing incremental online DVD rental customers? Making the case that they do is difficult, especially since BBI is now allowing customers to return their online DVD rentals at local stores.

Another way to look at it is to analyze the online DVD rental market itself. I have made the point before on this blog that five or ten years from now it is very possible that nobody will be renting DVD’s on a web site and returning them through the mail. The cable companies seem to have a powerful distribution network via the on-demand model, and there is no reason to think that every movie that Blockbuster and Netflix have could be part of a mass digital library, accessible to every customer who has a cable box.

If the online mail order model does indeed go away, it would be hard to argue that Netflix is better positioned than Blockbuster. Both companies could very well die under such a scenario, but Wall Street seems to be unfairly down on Blockbuster’s prospects versus those of Netflix. The current valuation disparity seems pretty drastic to me, and I’m not sure it makes any sense.

As always, your comments and opinions are welcome.

Full disclosure: No positions in BBI or NFLX.

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