In this memorandum, I will analyze the competitive environment that Blockbuster and Netflix faced, state the key income statement and balance sheet accounts for each firm and use ratios (including DuPont model) to draw comparisons between the two firms in 2008.
Blockbuster is an American-based chain of VHS, DVD, Blu-Ray, and video game rental store that has over 5,000 stores in the U.S. The rise of online rental service providers such as Netflix greatly reduced Blockbuster’s market share.
As a result, Blockbuster re-launched its online rental service to remain competitive on the market. Blockbuster faced many risks in the past decade, leading to its sharp demise. The biggest risk that Blockbuster faced was the its massive infrastructure that makes implementing changes to meet the demands of the changing technological environment difficult. Furthermore, the operating expenses to sustain business were astronomical while business was declining. Thus, management faced pressure from creditors to cut costs in order to stay afloat.
Another risk that Blockbuster faced was its “no late fee” initiative that caused a costly buildup of inventory.
This caused cash flows and revenues to suffer, causing stock price to hit rock bottom, further risking the firm’s reputation as a firm worth investing in. However, its success lies in its well-known brand and important relationships with movie studios that rely on it as a major distribution channel and source of revenue. Netflix is an American corporation that offers both on-demand video streaming over the Internet, and DVD rentals through their website.
It does not have any retail stores and mainly operates over the Internet, making it a low-cost business. Its strategy involves developing a sophisticated movie recommendation system that caters to the taste of each customer’s preferences.
Netflix’s main rivals were Blockbuster, Wal-Mart and Amazon. Nonetheless, it has a patented low-cost business model that has led to roaring success. However, one of the risks Netflix faced was the “no late fee” as customers can hold on to the DVDs indefinitely. The “late fee’ can also be used to invest in better technologies and more sophisticated technology applications. Since Netflix has opened ten regional distribution centers in major US metropolitan cities, the cost of labor (to package and ship the DVDs) in those areas are higher. Hence the low-cost business model might be risked in the long run.
According to Netflix’s 10K, subscription cost consists of postage and packaging expenses, amortization of the content library and revenue sharing expenses. Subscription cost is a critical success/risk factor vertical analysis reveals that it is 56% of revenues. Improving and developing software and technology applications are critical success risk factor thus Technology and development expense is a key income statement account and vertical analysis reveals that Technology and development is 7% of total revenues. Being able to differentiate its products is another key success/risk factor. Thus, marketing expenses is a key income statement account and vertical analysis reveals that it is 15% of total revenues. According to Netflix’s 10K, its Content Library contains DVD content through direct purchases, revenue sharing agreements and license agreements with studios, distributors and other suppliers. Acquiring more DVD content for earning more subscription rental revenues is a critical risk/success factor thus Content Library is a key balance sheet account and vertical analysis reveals that Content Library accounts for 16% of total assets.
Expanding regional distribution centers in major US metropolitan areas so that customers receive their DVDs in the shortest possible time is a critical risk/success factor. Thus, property and equipment is a key balance sheet account and vertical analysis reveals that this account is 20% of total assets. Maintaining high levels of cash is also a critical risk/success factor as Netflix is in an industry that is highly liable to potential lawsuits. In addition, the firm needs sufficient cash to constantly develop its technology applications.
Thus cash is a key balance sheet account and vertical analysis reveals that cash is 23% of total assets. Blockbuster’s Key Income Statement and Balance Sheet Accounts Sustaining rental revenue is one of the critical risk/success of Blockbuster thus rental revenue is a key income statement account thus the vertical analysis reveals that rental revenue is 61% of total revenue in 2008. The impairment of goodwill account for Blockbuster is also important because it may dominate any improvements in sales or reduction of expenses if the value is too large, as shown in 2004, where it was 25% of total operating expenses, resulting in a negative profit margin.
A key account is the property and equipment account because Blockbuster operates heavily through its retail stores. Therefore, the leasing and ownership of stores and warehouses constitute to 19% of total assets. Maintaining inventory level is one of the risk factors of Blockbuster thus inventory is a key balance sheet account, representing 20% of total assets. Comparison of Liquidity, Solvency, Profitability and Efficiency We will apply three different ratios, namely current, quick and cash ratio, to measure the firm’s short-term position. The current ratio for Blockbuster was 1 while the current ratio for Netflix was 1.67, indicating that Netflix is in a much better position to meet its short-term obligations.
Applying a more conservative standard to assess the ability of a firm to meet its short-term obligations, the quick ratio for Blockbuster was 0.66 while the quick ratio for Netflix was 1.59, suggesting that Netflix is still in a much better position to fulfill its short-term obligations. Under the most conservative ratio (cash ratio), the cash ratio of Blockbuster is 0.12 while the current ratio for Netflix is 0.65, highlighting that Netflix is in a much better position to fulfill its short-term obligations. In order to compare the solvency of both firms, we will apply the interest coverage and financial leverage ratios to both firms.
The interest coverage ratio for Blockbuster was a -4.77, suggesting that the firm is making a loss (negative earnings divided by interest) and is hence misleading. Since interest expense represents a percentage of operating income, Blockbuster’s significant increase in year-to-year losses are of greater concerns and hence a larger threat to the firm’s solvency. Alternatively, the interest coverage ratio for Netflix was 53.5, suggesting that Netflix is in a much better position to finance its interest expense. It is generally accepted that when a firm’s interest coverage ratio is 1.5 or lower, its ability to cover its interest expenses is questionable.
However, this is not the case for Netflix. The financial leverage ratio for Blockbuster was 5.62 while the financial leverage ratio for Netflix was 1.67, indicating that Netflix is taking significantly lesser risks to meet its financial obligations. In order to compare the profitability of both firms, we will apply the gross margin and profit margin ratios to both firms. The gross margin of Blockbuster is 0.51 while the gross margin of Netflix is 0.33, suggesting that the percentage of total sales revenue that Blockbuster retains after incurring the direct costs associated with producing the goods and services sold by the company is higher than that of Netflix. However, this ratio does not paint a realistic picture of the situation because it disregards operating expenses.
The profit margin of Blockbuster is -0.07 (loss) while the profit margin of Netflix is 0.06, indicating that Netflix is a more profitable company after accounting for operating expenses. In order to compare efficiency across both firms, we will apply five different metrics. The ROE of Blockbuster is -0.86 while the ROE of Netflix is 0.21, indicating that Netflix is more efficient generating returns on the money shareholders have invested. The ROA of Blockbuster is -0.15 while the ROA of Netflix is 0.13, suggesting that Netflix is more efficient in using its assets to generate earnings. The DuPont Model can explain blockbuster’s negative ROE and ROA ratio.
The negative ROA is derived from multiplying a negative profit margin (loss) to a positive asset turnover ratio. As we multiply the negative ROA value to a high financial leverage ratio, the effect on ROE is affected in an adverse manner (ROE becomes more negative). The receivables turnover ratio for Blockbuster is 8.08 days while the receivables turnover ratio for Netflix is nonexistent because each customer is charged a monthly subscription fee. Hence, it is unfair to compare the receivables turnover ratio. The inventory turnover ratio (rental) for Blockbuster is 50.62 while the inventory turnover ratio for Netflix is 47.01, implying that Netflix has a stronger turnover of rented DVDs. The asset turnover ratio for Blockbuster is 2.16 while the inventory turnover ratio for Netflix is 2.1, shows that Blockbuster generates higher sales for every dollar’s worth of assets.
In this memorandum, I analyzed the competitive environment that Blockbuster and Netflix faced, explained the key income statement and balance sheet accounts for each firm and used ratios (including the DuPont model) to assess and draw comparisons between the two firms in 2008.