Netflix Uses Speed to Fend Off Wal-Mart Challenge

September 29, 2003
 By NICHOLAS THOMPSON

SAN JOSE, Calif. - Reed Hastings, Netflix's 42-year-old co-founder and chief executive, has made a lot of money from starting his business. But he is not planning to retire to enjoy his riches anytime soon.

The company, one of the few surviving successes of the dot-com era, has been profitable in renting DVD's by mail through an innovative online service. But Netflix now faces a bruising challenge from Wal-Mart Stores, the $244 billion-a-year retailing monolith that has recently started a competing rental business with nearly identical offerings.

Wal-Mart has enough money "to send a man to the moon," Mr. Hastings said. "We alternate between stark raving fear and bracing optimism."

So far, Netflix has stayed several steps ahead of Wal-Mart and other threats, like movie services using streaming video technology over the Internet.

The companies' differences are evident in everything from size to strategies to attitude. Visitors to the headquarters of Walmart.com, the retailer's e-commerce operation in Brisbane, Calif., are greeted by a revolving door that spins when it senses their approach and opens up into a giant atrium with a view of San Francisco Bay. Visitors to Netflix's headquarters in San Jose are greeted by a cardboard cutout of Gandalf, the wizard from "Lord of the Rings."

Netflix allows customers to rent as many DVD's as they can handle for a monthly fee of $20. Customers select the films online from Netflix's 15,000-movie library and are allowed to have three out at any time. Netflix provides postage-paid envelopes for returning the films. Once a customer watches a film and mails it back, Netflix sends out the next on a list of movies created online by the customer. Relying extensively on word of mouth, the company has about a million subscribers, including more than 5 percent of San Francisco households.

Wal-Mart began a very similar pilot program last October and fully started it in June through Walmart.com. Its prices, envelopes and movie selection are nearly the same as Netflix's. The company will not release figures on its subscriber base. Tom Adams, founder of Adams Market Research, said that although Wal-Mart.com was gaining subscribers, it would have, at most, a fifth the number of Netflix subscribers at the end of the year. Netflix's advantage comes from having started when DVD's were rare and having developed a big lead in customers, revenue and brand recognition. "No one is going to out-hare Netflix," Mr. Hastings said. "Our danger is in a tortoise attack." Wal-Mart is an adversary that has the ability to mount a steady, relentless attack.

The retailer's advantages, said a Wal-Mart spokeswoman, Cynthia Lin, include its ability to process and ship DVD's from existing facilities and its ability to advertise directly to the 100 million shoppers it says visit Wal-Mart stores weekly. The company already packages advertising for its DVD rental service with the DVD players it sells. It currently operates 7 shipping centers (compared with Netflix's 18) and plans to open more centers at other Wal-Mart facilities.

Netflix, on the other hand, has a large subscriber base and has spent several years testing and debugging the intricate software that controls the shipping and rental processes. Wal-Mart is still working out the kinks. Of the five movies it chose to promote on its online DVD rental home page recently, for example, three required a wait of more than two weeks and one required a wait of more than a month. All of those films were immediately available at Netflix.

And in June Netflix, whose share price has more than doubled since it went public in 2002, won a patent covering much of its business model. It could use the patent at some point to stifle competitors or, more likely, to demand licensing fees. Netflix's stock closed Friday at $34.81 a share.

Blockbuster has also begun to investigate the online DVD rental market. Last year, it acquired Film Caddy, a small Netflix competitor. Blockbuster, however, considers online rental itself to be a niche market and is focused on a program it plans to start rolling out next year that would integrate online and in-store rentals. "The vast majority of people don't want to wait by the mailbox for their movies," Karen Raskopf, a spokeswoman for Blockbuster, said.

Several smaller competitors also offer similar services, but Netflix appears unfazed by them. But if Blockbuster and Wal-Mart "wanted to get at the market in a big way, they could beat Netflix," said Safa Rashtchy, a senior analyst at Piper Jaffray. So far, she added, "they have been ambivalent."

In the meantime, Mike Schuh of Foundation Capital, one of the earliest financial backers of Netflix, noted that "the barriers to entry in this market are low, but the barriers to profitability are extremely high." Mr. Hastings believes that Netflix can succeed just as Amazon.com has managed to establish itself in its rivalry with store-based book chains like Barnes & Noble and Borders. Most optimistically, he considers the entry of Wal-Mart into the market as validation of his business strategy, which he considers to be a combination of both old- and new-economy approaches that once might have been dismissed by 90's-era promoters of the "new new thing" as hopelessly old-fashioned.

On the old-economy side, Netflix spends considerable time and effort perfecting the red envelopes it uses to mail DVD's to minimize weight, maximize protection for the discsand enhance the speed at which the envelopes can be processed by the Postal Service.

At one of the company's shipping centers, also in San Jose, workers earning $8.50 to $10.50 an hour apply mailing labels by hand. The most exciting piece of technology - an elaborate conveyor belt system - has not been used in a year because the company decided that moving the video discs with trolleys was more efficient.

"We have a very, very vanilla approach," said Marc Randolph, who founded the company with Mr. Hastings but left last year.

Netflix, however, does rely on sophisticated software that allows it to process and ship DVD's as soon as they are returned. It also sees great potential in software that can offer film recommendations to an individual subscriber based on how highly other subscribers - particularly those who rent similar movies - have rated them.

This system gives life to customer favorites that were not supported by much studio advertising. For example, Netflix points to "Talk to Her," a critically acclaimed independent film by Spanish director Pedro Almodovar, which Netflix users gave rave reviews. It was rented more often in its first six months on NetFlix than   "Daredevil," the box office hit with Ben Affleck that received much less positive reviews on the site.

Wal-Mart, with a different demographic audience and lacking the large database of previous customer ratings to mine, says that "Daredevil" is doing about seven times as well as "Talk to Her" in its online rental program. Blockbuster would not release its data on those two films but said that 80 percent of its rentals came from the company's new-release selections.

Netflix says that large box-office hits still account for the core of its business, but the company notes that its customers make up about 2 percent of all video rentals compared with 30 percent of all the rentals for "Talk to Her." Netflix said it was responsible for about 10 to 12 percent of the market for rentals of small independent films. "Netflix is without question one of the most efficient and convenient resources for consumers who want niche and independent films" said Fritz Friedman, a spokesman at Columbia Tri-Star Home Entertainment, which distributed "Talk to Her."

Netflix also rents documentary films and has distributed 13 documentary films that major studios did not pick up. It does not carry pornography, partly because Mr. Hastings considers himself "a prude" and partly for fear of legal costs. The only full-length movie unrented by anyone after remaining more than 90 days in Netflix's catalog is
  "Alien Blood," a 1999 film described in its studio publicity as "an offbeat vampire/alien movie, featuring sex and bloodshed."

Netflix's most popular feature may be the fact that it has no late fees. "Returning videos is a pain," said Mia McCroskey, a Netflix user who works for a subsidiary of the New York Stock Exchange. Mr. Hastings, in fact, said he founded the company in part because of frustration over a $40 late fee at his local video store.

Kerry Echols, a Netflix user who has the longest personal queue of requested movies on record, at over 1,700 films, says that Netflix's policy is particularly good for saving money during bouts of what he calls "video guilt." A former video store worker and now a journalist in Birmingham, Ala., Mr. Echols said video guilt occurred when someone
"rents an early Ingrid Bergman film because he thinks he should; but he really wants to watch 'Gilligan's Island' reruns, so he just keeps the Bergman film and racks up late fees."

Besides new entrants in the rental market, Netflix also faces a more powerful if more distant challenge: the likelihood that DVD's will in the future no longer be the medium of choice for home entertainment and that customers will instead watch films that they download to their computers and television sets.

Netflix "has taken one step by moving its stores onto the Internet," says Michael Ramsey, chief executive of TiVo, the digital video recorder service, and a Netflix board member. "The next step is moving into electronic distribution." "I'm worried that we'll be the king of DVD's," Mr. Hastings said, "but then someday that won't matter."