Mark Perkins sends: While Blockbuster (ticker: BBI) is attempting to compete with Netflix (NFLX) in the online movie rentals business and be seen as a legitimate competitor, the obvious differences in business models gives Netflix a clear advantage. Blockbuster’s new Total Access plan allows customers to exchange and rent movies in the stores as well as online. This seems like a convenient idea, but for a company with thousands of costly stores and employees that lacks the selection available online (the average store only stocks about 6,000 movies compared to 10 times that online) it will likely be a difficult operating model to attain profitability with. It simply costs more to operate a brick-and-mortar business like Blockbuster. If there is a price war, a very real possibility implied by Netflix CEO Reed Hastings, I’m picking Netflix to win, as they have years of experience building up their online company compared with Blockbuster, who is burdened by high fixed costs. Netflix just had a hiccup with revenue and earnings attributed to aggressive pricing of Total Access by Blockbuster, but in the coming quarters Netflix’s natural advantages should allow it to prevail. The one wildcard is that rapidly changing technology might force changes in the nature of media distribution, but I am not going to venture a guess as to what will happen in this business beyond the next few years.

NFLX as of May 11th, 2007 is trading for $22.06 per share, near its 52-week low. Fear and market sell-offs that drive down stock prices but don’t reflect long-term prospects create some of the best buying opportunities. NFLX is currently selling for about 5.5x free cash flow net of cash on its strong balance sheet. Although margins are thin and have been softening in recent quarters, Netflix is still the most profitable company here.
Using very conservative assumptions (15% discount factor and halving analysts’ forecasted growth) in a discounted cash flow model implies that the market is undervaluing NFLX, and that the stock is worth at least $27/share, or 22% above its most recent close.