August 28, 2003, 12:00 AM

Now playing: Netflix shows how to be new-age web entrepreneur

With controlled growth, a deliberate marketing plan and a nationwide build-out of distribution centers, Netflix shows what it takes to succeed in today’s e-market.

Several years ago, Reed Hastings ran into an unsettling and costly surprise at his local video rental store. Before he could rent a new movie, he had to pay a sizable late fee from prior rentals. “It was about $40,” he recalls. “It was a bad consumer experience and I remember not wanting to ever have to go through it again.”

The experience would linger in his mind until he came up with a plan to change the way movies are rented. With a background as a mathematician, software expert and entrepreneur, Hastings, along with some colleagues, in 1997 founded Netflix Inc., specializing in the online rental of the then-novel DVD. With 12 million DVDs introduced into the North American market that first year, Hastings and his partners figured the fledgling DVD industry would grow along with the use of the web as a shopping channel. Just as they had seen music CDs replace vinyl, Hastings and his co-founders figured DVDs would replace videotape for consumer rentals. “It was just a gut feeling I had as an entrepreneur,” he says.

His gut feeling proved right. And the movie rental business has never been the same since, as Netflix, based in Los Gatos, Calif., has grown steadily along with the DVD industry itself. Today, the industry produces more than 1 billion movie DVDs in North America a year, according to media research firm Cambridge Associates in Stamford, Conn. And just as DVDs were designed to offer a better and easier viewing experience than tape videos, Netflix.com has introduced a patented form of renting DVDs that lets online consumers avoid such hassles as due dates and late fees. At the same time, the process gives Netflix the ability to keep track of the logistics of customer rentals and the flexibility to send movies to customers in the order that Netflix, not the customer, chooses.

The storyboard

Call it the new age of Internet entrepreneurship. Since identifying a way to use the web to offer advantages over brick-and-mortar stores, Netflix has consistently grown revenue while cutting operating costs. And industry analysts recognize it as the dominant player as well as the innovator of its growing market niche. But unlike other Internet innovators and would-be market dominators of the early days of the web, Netflix took its time to getting where it is, establishing locally in the San Francisco Bay Area and developing a lasting business plan before putting its growth on fast-forward.

As DVDs have grown to replace tape videos as consumers’ format of choice, Netflix has steadily grown in subscribers and revenue. With 1.5 million subscribers, or about 1% of U.S. households, and second-quarter revenue of $63.2 million representing a 74% increase over the same period last year, Netflix has become a rising star on Wall Street. Its Nasdaq-listed stock price has been trading in the mid-$20s, after opening at $15 per share at its initial public offering in May 2002.

Hastings says he’s confident that Netflix will reach 5 million subscribers and $1 billion in revenue in four to six years. Analysts back him up. “The key to their growth is about 40 million DVD households, which will probably double to 80 million in five to seven years,” says Safa Rashtchy, an analyst with U.S. Bancorp Piper Jaffray who has followed Netflix for more than a year.

Revolutionizing rentals

But the secret to its success is also in the careful approach Netflix has taken to developing and perfecting its business model to build an economy of scale to support its emphasis on customer service and low prices. After initially serving the San Francisco area by supplying online-ordered DVDs to video stores as well as to consumers, Netflix evolved to a consumer-oriented online video store with value-added services such as movie recommendations.

In late 1999, shortly after Hastings took over as CEO, Netflix introduced a program that kicked off growth of 300% over the following six months: “DVD on demand,” which allowed subscribers to receive four DVDs for a monthly fee of $15.95, plus $3.98 for each additional DVD, without any due dates, late fees or shipping charges. Analysts were not surprised by consumer response. “With its ‘no due-date’ program, the company found a way to revolutionize the DVD rental market,” says Tom Adams, president of Adams Media Research in Carmel, Calif.

But Hastings and crew didn’t stop there. Three months later they fine-tuned the DVD-on-demand program to let subscribers order an unlimited number of DVDs each month at a set fee of $19.95, still without shipping charges, due dates or late fees. Subscribers can keep up to three DVDs at any one time.

To gain efficiency in managing its DVD inventory, Netflix requires subscribers to create a list of DVDs that they’d like to receive. Each time they return a DVD in a pre-paid envelope, Netflix’s computer system chooses from their pre-selected titles to send the next movie. Since Netflix reserves the right to ship what’s on hand and not necessarily what the customer wants to see next, it doesn’t have to find and ship particular DVDs for each order. Thus it gains speed and maximum efficiency in managing inventory and distribution, Hastings says.

But the young company’s success has already forced it to guard against challenges that threaten to stall its momentum in an industry that’s still developing. Its selling model has attracted similar efforts by others, most notably Wal-Mart Stores Inc., which is undercutting Netflix on price. Wal-Mart offers the same rental terms as NetFlix for unlimited rentals with up to three out at any one time, but for 6% less at $18.76.

So far, Netflix is doing a good job of fending off its rivals, analysts say. While Wal-Mart’s size makes it a formidable competitor in any market it enters, its weak reputation as an entertainment service provider should work in Netflix’s favor, analysts say. “Wal-Mart appears to have little or no traction in this market,” says Jim Preissler, analyst with Majestic Research LLC, a New York-based research and analysis firm. “The online DVD user tends to be a high-end consumer, and that doesn’t fit the core WalMart.com demographic.”

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