This DVD rental service has scored major gains against rival Blockbuster and is positioning itself to compete better with video-on-demand services. By Thomas M. Anderson, Contributing Editor December 7, 2007 Don't mess with the U.S. Postal Service. Just ask Netflix, which operates a DVD rental service by mail and the Internet. After about 70% of the company's red mailers jammed equipment at post offices, the service's inspector general launched an audit. Postal officials found that Netflix mailers cost the service $41.9 million in additional labor over the past two years and estimates that such mailings will lead to $61.5 million in extra mail-carrier costs over the next two years. The postal service recommends a 17-cent surcharge on DVD mailers to offset the expenses. Citigroup analyst Tony Wible seized on the postal audit to reiterate his sell rating on Netflix (symbol NFLX). In a December 4 report, he estimated that Netflix's monthly operating income per subscriber would fall 67%, from $1.05 to 35 cents, if the Postal Service actually imposed the surcharge. But Netflix says that if the Postal Service acts, it will change the design of its mailers to avoid the cost hike. Advertisement The postal game of cat-and-mouse masks Netflix's recent victories over its fierce rival, Blockbuster, the largest chain of video rental stores. On October 23, Netflix reported third-quarter earnings of 23 cents per share, well above the average Wall Street estimate of 15 cents. The Los Gatos, Cal., company said it had 7 million subscribers, up 24% from the same quarter a year earlier and beyond Netflix's own projections of 6.7 million to 6.9 million for the quarter. "The upside in the quarter reinforces our belief that Netflix retains the upper hand in a competitive environment that is ultimately unsustainable for Blockbuster," says Credit Suisse analyst Heath Terry, who rates Netflix's stock an "Outperform." Netflix's wins are partly because of Blockbuster's retreat, says Piper Jaffray analyst Michael Olson. Blockbuster, which has been losing money since 2005, overhauled its online subscription service -- known as Total Access -- to mimic the design and prices of Netflix. Advertisement Unlike Netflix's online service, Blockbuster's allows customers to rent and return DVDs by mail and in person at its 5,200 stores. That competitive advantage has made it more difficult for Netflix to attract and retain customers. But Blockbuster seems to have shifted from trying to generate growth at its Total Access service to making the company profitable, Olson says, and that change in strategy benefits Netflix. To prove his theory, Olson called managers at 20 Blockbuster stores and asked them if they were told to promote Total Access as much as they were six months ago. "Twenty out of 20 stores indicated that they have been directed to place less focus on Total Access," Olson says. Online traffic tilts in Netflix's favor, too. Olson analyzed traffic to the Web sites of Blockbuster and Netflix. In October and November, he found, Internet traffic fell 9% at Blockbuster.com, while it jumped 17% at Netflix.com. Advertisement "Blockbuster's performance relative to Netflix indicates that Blockbuster has continued to slow down its marketing campaign," Olson says. "Initially, Blockbuster successfully took market share from Netflix, but we believe the company has meaningfully reduced its costly marketing efforts." In any case, the biggest threat to Netflix remains video-on-demand services. Cable and satellite TV operators can steal video-rental business with services that allow subscribers to buy and view movies with a push of a button on their remote controls. To fight that technology, Netflix offers a growing library of more than 5,000 movies subscribers can watch via Internet downloads. The company aims to deliver digital movies to Internet-enabled televisions by next year but won't detail its plans until January. The stock, which closed at $23.57 on December 7, has given investors a wild ride. The shares are up 51% from a 52-week low of $15.62 July 24 but down 11% year-to-date. They trade at 27 times the 89 cents per share that analysts expect the company to earn in 2008. Olson, who upgraded the stock from neutral to buy on December 3, says less competition from Blockbuster (BBI) will enable Netflix to beat estimates over the next year. His 12-month target price on Netflix is $28.