Blockbuster vs. Netflix: The DVD Death Match

Don’t look now, but there’s one of those brutal price wars happening, this time in video rentals. Unlike the cola wars of legend or the perennial PC-chip wars of the last decade or two, this is a price battle I find fascinating.

In the short-term, the DVD price wars will create one of those rare pockets where consumers benefit at the expense of investors. Longer term, it could shape how we watch movies. One of these two companies understands better how to give us the video we want when we want it, price notwithstanding.

I am a member of both. But I use Netflix more often, simply because the nearest Blockbuster store is too far from me to bother with Total Access. So thank you Netflix for dropping my monthly subscription by a couple of dollars. Or rather, thank you Blockbuster for forcing Netflix to do it. I’ll save $24 a year, enough to defray a whopping 1/30 of an annual cable bill. But really, I’d rather those negligible savings go toward a better movie viewing experience.

For now, Blockbuster’s gambit is working – sort of. It signed up more customers in the June quarter, while Netflix subscriptions fell. But the cost came from investors: The value of Blockbuster’s stock, $864 million, is a mere 16% of its revenue. Sixteen cents in stock value for every dollar Blockbuster brought in: Now that’s depressingly low. Compare the 1.01 price-to-sales ratio at embattled Netflix, or the 2.85 ratio at Amazon.com.

How is this a victory again? Well, Blockbuster will reportedly raise its Total Access fees later this year – which means so many new subscribers, weary of years of excessive movie prices, will simply revert back to Netflix when it does.

Netflix has its own loss leader, known as the Watch Now feature, which it introduced in January. Netflix currently offers nearly 2,400 videos on Watch Now, including underrated gems of old, like The Jerk (supposedly a favorite of Stanley Kubrick), and of new, like Sherrybaby. Each film streamed on Watch Now at no cost to subscribers loses Netflix several dollars, just as the Total Access plan does for each free-rental certificate it hands out to subscribers of Total Access.

Netflix has streamed more than 5 million movies this year. Now let’s say I watch an average of 8 DVDs a month on Netflix’s (recently lowered) $13.99 a month plan. That’s $1.75 per movie. And at 5 million free movies, that’s nearly $9 million lost over two quarters. And since Netflix ate the costs of those free movies, most of that $9 million would go directly to profits, split over two quarters.

For simplicity’s sake, let’s add $4.5 million to the first quarter of 2007. That raises the EPS from 14 cents to 20 cents. In the second quarter, the same adjustment raises the EPS from 33 cents to 39 cents a share. That’s a lot of money that Netflix could have theoretically made, but didn’t.

Investors may not consider this when they look at how Total Access is hurting Netflix. But think about the costs that are going into Total Access versus Watch Now. According to 24/7 Wall Street, Blockbuster has $2.4 billion due in rent for the very stores its Total Access subscribers return their DVDs to. Netflix has to pay for servers pushing out its free movies, much cheaper than retail space.

Blockbuster’s new CEO, who hails from 7-11, is pushing its stores into smaller retail spaces. That may cut overhead costs, but it also makes them even more dependent on the lowest common denominator – and against the tide driving consumers to niche-driven, narrowly targeted titles.

Netflix, meanwhile, is driving its users toward such obscure titles every time it adds new movies to its free Watch Now feature. The bulk of them, from classic Casablanca to Rescue Dawn precursor Little Dieter Needs to Fly, have a smaller but perennial audience.

This is a tough time for both Blockbuster and Netflix, by their own choice. Both are too busy hitting themselves in the head with hammers. As consumers, we should benefit while we can. As investors, you’d be better to stick with Netflix, which has the smarter – and less costly – longer-term strategy.