August 28, 2003, 12:00 AM

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

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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 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 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, formerly the independent 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.”

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