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

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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.”

A double-edged sword

Perhaps an even bigger challenge looms from within Netflix’s business model. Though lauded by analysts and recently awarded a U.S. patent, the Netflix method of renting and delivering DVDs has an inherent bent toward reducing the company’s profit margins as it improves service. “It’s a double-edged sword,” Rashtchy says.

Because there is no limit on the number of DVDs a customer can order each month under the fixed monthly fee, Netflix runs the risk of high costs per customer that the company would be unable to reduce through economies of scale. “My worry is that Netflix will have a base of customers that is unprofitable, as the company bears the cost of shipping each incremental movie each customer watches every month,” Preissler says.

Still other challenges lie within the unknown course of technology in the entertainment business, such as whether DVDs themselves will give way to the distribution of digital movies directly into TVs or personal computers connected to the Internet. And, despite Netflix’s steady growth, the great majority of consumers who rent videos still browse their local video store.

But Hastings sees opportunity in such challenges. He figures Netflix, recognized by analysts as the leader in online DVD rentals with 2.5% of the current $10 billion DVD market, has plenty of room to grow.

While Wal-Mart may be the biggest worry in the strategy books of most retailers, it has so far helped Netflix’s cause, Hastings argues. “Our biggest challenge is getting people to try us, because consumers are so used to driving to the video store,” he says. “So when Wal-Mart talks to their customers about online DVD rentals, it helps us. Wal-Mart has helped grow the market faster.”

Rising expectations

Since Wal-Mart launched its online DVD rental service on WalMart.com about 10 months ago, Netflix has twice raised its own revenue guidance for 2003, from $230 million to $250 million, then to $265 million.

But how will it gain business from Wal-Mart’s playing in its market? By offering better service to customers who, once they become aware of online DVD rentals, try Netflix after they hear about it through word-of-mouth or through the many Netflix banner and pop-up ads that appear online, Hastings says. Netflix also lures newcomers with a free 2-week trial period, and nine out of 10 become paying customers, Hastings says.

In addition to an ambitious online advertising campaign, Netflix has developed numerous marketing alliances, such as with Best Buy Co. Inc., whose stores and web site refer customers interested in DVD rentals to Netflix. Netflix returns the favor by forwarding customers who want to buy DVDs to Best Buy. Netflix also maintains marketing alliances with several manufacturers of DVD players.

While Wal-Mart has been trying to focus on Netflix’s strategy, Blockbuster Inc., the leader in video rentals, has been developing a mixed and yet-to-be-proven approach, analysts say. It has tested a service through which customers pay $19.99 per month for a service similar to Netflix’s, allowing customers to sign up at Blockbuster.com but requiring them to pick up and return DVDs at its stores. It also offers a pure online DVD rental service at its less well-known FilmCaddy.com, formerly the independent
DVDRentalCentral.com site, which Blockbuster acquired last year. “Blockbuster is more formidable than Wal-Mart for DVDs, but it doesn’t seem to have a coherent online strategy,” Rashtchy says.

As its backbone to customer service—which is based on quick deliveries, easy returns and quick replacements from a library of 15,000 movie titles—Netflix has built out a network of 20 warehouses throughout the U.S., and expects to add another five by year-end, supporting its goal of providing overnight deliveries to half or more of its customers through the U.S. Postal Service. It has also developed a logistics system, built in-house with software from Oracle Corp., that provides headquarters with web-based visibility into its distribution of DVDs.

Analysts say Netflix’s emphasis on customer service is paying off, as the company appears to be holding a strong lead over its competitors—at least for now. “The good thing for Netflix now is that its competition is minimal,” Preissler says.

Controlling expenses

Regardless of how its external competition turns out, Netflix will continue to sharpen its focus on customer service—even if that means cutting into its per-subscriber profit margin, Hastings says. Rashtchy cautions that Netflix will have to watch how many DVD exchanges subscribers request on average each month, so as not to cut into its profit margins per subscriber. But it’s reasonable to expect that most subscribers will max out at five or six DVDs each month—a number low enough to maintain good margins, Rashtchy says.

So far, Netflix has done a good job of juggling its profit margin and its fulfillment and marketing costs. First-quarter marketing costs rose to $13.2 million from $7.9 million a year ago, sending its per-subscriber acquisition cost to $31.67 from $25.44. Fulfillment costs rose to $6.4 million from $4.2 million, helping to push down its gross margin 4.3 percentage points to 46.1%. But an 88% increase in the average number of paying subscribers boosted first-quarter revenue 84%, to $55.3 million from $30.1 million a year ago, dropping its total operating expenses as a percentage of revenue to 55% from 64%.

Moreover, Hastings insists that Netflix is not concerned about the number of DVDs it has to ship to subscribers each month, because he figures that large numbers of shipments will lead to more subscribers. “Our brand is about freedom to watch as many movies as you want, freedom from late fees,” Hastings says. “For us to continue to succeed, we have to embody that freedom for consumers. The more DVDs our customers watch, the more they enjoy our service, the more they tell their friends about it and the longer they stay on as subscribers.”

Two years ago, he notes, the average length of time a customer remained a subscriber was one year. “Now it’s about 1-3/4 years,” Hastings says. “The longer the better.”

Digital delivery

Within 10 years or so, the distribution of movies to the home will likely occur electronically, as increased bandwidth and digital compression technology cuts the time it takes to electronically receive a full-length movie to about 10 minutes, Rashtchy says. It would take over an hour with current technology, he notes.

Whether electronic delivery of movies occurs through cable TV or the Internet, or both, Netflix will be in a position to play a major role, Rashtchy says. It would likely get directly involved in Internet distribution once that becomes more feasible and in demand, but its subscriber base alone would be valuable to a cable distribution system as well, he says. If future digital movie distribution takes off through cable TV systems, he adds, Netflix could command a hefty premium for use of its subscriber list by a TV network operator.

In addition to its growing subscriber base, Netflix is making other subtle moves that could help it play an important role in the future of movie distribution. Its board members, for example, include Michael Ramsay, co-founder, CEO and chairman of Tivo Inc., a service that lets people automatically record TV programs on a special DVD-playing system. If TV does indeed play a bigger role in distributing movies, Ramsay could help find a way to leverage Netflix’s expertise, such as its movie recommendation service, in adding value to a TV-driven market. “Netflix is setting itself up to have long-term value,” Rashtchy says.

Rashtchy notes that Netflix could make a good partner for Movielink.com, the movie industry’s own startup system of digital distribution. Hastings says Netflix is not cooperating with Movielink, which offers a limited selection and requires users to have high bandwidth and the latest computer system upgrades, but adds that he’ll watch how it develops and leave open the possibility of a role for Netflix. “It’s expensive to pioneer a new market, so we’re glad they’re willing to do that,” Hastings says.

In the meantime, he figures Netflix has its hands full trying to continue growing in the U.S. DVD rental market. Other potential markets on the Netflix horizon include Europe and a broader range of entertainment products, Hastings says. But analysts suggest that it may have to secure its patent through court action to provide for an easier foray beyond DVDs.

Patenting the process

Netflix’s patent covers the process by which it sells and distributes products as well as methods of using computers to channel customers’ requests for DVDs. Because Netflix’s model is based on distributing DVDs from a broad base of DVDs pre-selected by customers—instead of having to find and ship specific DVDs for each order—it can manage its inventory with a high degree of efficiency. Combined with the market reach and self-service advantages of operating online, Netflix’s distribution method is key to its ongoing success whether it deals in DVDs or other products, Rashtchy says.

“Every patent has to be upheld in court, so Netflix will probably have to sue other retailers for infringing on its patent, then the courts will have to decide if its patent is too broad or should be upheld. If the courts uphold it, it could be significant for Netflix,” Rashtchy says. He adds that a favorable court ruling could help Netflix get established in new product markets. “If Netflix can get this upheld, they can use their process for other types of products like books, music and games,” he says.

Further possibilities

Indeed, Netflix’s patent points out that it is designed to also apply to products other than DVDs, such as video games. But it may have to act soon to build a market share in the game rental business, which others have already entered. Gamefly Inc.’s Gamefly.com offers rentals of video games for $19.95 per month under terms similar to Netflix’s DVD program, and Blockbuster lets customers sign up on Blockbuster.com for its $19.99 monthly Freedom Pass for games rented through its stores.

But whether Netflix will seek legal action to enforce its patent remains to be seen, Hastings says. “We’re studying our options,” he says. “Our main focus is on providing a great customer experience. That’s how you win as a consumer brand.”

And if it succeeds in building its brand, Netflix will be in a position to withstand challenges from price-cutting competitors, analysts say. “That’s how Amazon became a successful brand, by satisfying customers at a decent price,” says Majestic’s Preissler. “Netflix won’t have to be the lowest price in the market.”

paul@verticalwebmedia.com