Netflix

Thesis: (Please see the Details section for explanations of each bullet point below)

* Expectations on Wall Street are extremely high, as Netflix gave up 20% following days after its 1Q earnings update.

* With high 2Q expectations, investors may be disappointed again with lower gross margins and a higher churn rate than expected. To add to this, competition is finally picking up with Blockbuster and Walmart entering the market.

* On the side, short interest has increased and insiders have begun selling their shares.

* Lastly, investors may be missing the large picture of Netflix's true market potential in the long run.

Background:

* Launched in 1998, Netflix is the world's largest online movie retail service.

* For a set monthly fee of $21.99, subscribers can rent as many DVDs as they want, with three movies out at a time and keep them for as long as they like.

* The company now operates 24 shipping centers in the United States and can reach 80% of its customers with 1 day delivery.

* The company grew revenues by 80% to $100.8 million in 1Q, and has 1.932 million subscribers and 760,000 new trial subscribers, an increase of 82% year-over-year.

Details:

* Expectations on Wall Street are extremely high as evidenced by the 80% STRONG BUY/BUY ratings. (10% HOLD, 20% STRONG SELL)

o Stock fell over 20% following days after 1Q earnings update.

 Company reported larger 1Q loss (11 cents a share) and gross margin 43.6% in low end of guidance.

 Company blames falling margins on increased movie rentals per average paying customer. Netflix thus reacted by raising prices from $19.99 to $21.99 (effective June 15)

o 2Q Expectations are also set very optimistic

 Analysts have forecast a profit of 16 cents a share in the second quarter and 50 cents a share in the full year. Wall Street analysts, on average, forecast earnings per share growing 86% in 2004 and 161% in 2005.

 Netflix expects to earn $1 million to $3.5 million on a generally accepted basis, with sales of $116 million to $120 million. The company expects total subscribers of 1.935 million to 2.14 million, with churn of 4.9% to 5.9%.

o However, there may not be a drastic improvement in 2Q.

 Online consumers are sensitive to price increases, and cancellations may increase, new subscriber growth may slow, and churn may increase as subscribers look to fully take advantage of the unlimited rental policy following the price increase.

 Along with this, high marketing costs ($35.12 per customer), an increase in spending on content (movies), increase in number of shipping centers (new Las Vegas Center--June 16, 2004), may increase the churn rate--thus dampening gross margins--as the company sends more movies to more customers monthly.

o To add to the problems, credible competition is increasing quickly.

 Blockbuster

* 8,900 US Locations

* Currently experimenting with in store monthly subscription service, allowing customers to rent 2-3 movies/month at a time, at $24.95.

* Company planning on starting online subscription service in 4Q.

* As Blockbuster moves towards split with parent, Viacom, (June 18) the company can pursue more a more aggressive strategy targeted at Netflix.

 Walmart

* Recently started online subscription service, at price lower than Netflix--$15.94.

* Few barriers to entry: excellent distribution network already in place.

* Financial muscle to sustain short term loses in order to fulfill longer time horizon strategies.

* High quality operator at low prices.

 Minor competition: Starz and RealNetworks are offering