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The Netflix Effect

STILL WAITING FOR VIDEO-ON-DEMAND? FORGET FAT PIPES - WATCH YOUR MAILBOX. SPECIAL DVD BONUS: WATCH THE VIDEO RENTAL GAME GET SHAKEN TO ITS CORE!

By Jeffrey M. O'Brien

On the first Friday of every month, the employees of Netflix, a Silicon Valley DVD rental company, head to a charming local movie theater for a noontime morale boost. Dressed dotcom-casual in shorts and sandals, they scarf pizza and mill around before the main attraction: a mild hazing for new recruits and an update on the company's growth figures, which so far have been impressive.

Carlos Serrao Netflix CEO Reed Hastings: enemy number one of Blockbuster and Walmart.com.

Blockbuster is close behind. The nation's biggest video rental chain recently began testing an in-store subscription service that offers unlimited rentals for a fixed fee — and, Hastings says, has invested in Netflix rival DVDRentalCentral.com. "I encourage you to take them up on their offer for a free trial," he tells his staff with a smile, "and if you forget to return the discs, I understand."

Wall Street thinks it knows how this story ends — badly. Investors still remember Kozmo, Webvan, and a few pet store fiascos. Indeed, as Hastings speaks, 40 percent of all NFLX shares are being sold short. In the month that follows his presentation, Netflix stock drops from $14 to below $6. Still, Hastings is sure he's onto something. While other video-on-demand companies build businesses around broadband, Netflix is taking a half-step toward the digital future with mass-produced DVDs ($1 each) and an old-fashioned delivery mechanism: the US mail. The company has less than 2 percent of the $8 billion video rental market, but it doubled its customer base to 750,000 this year, and Hastings projects a million customers, and profitability, in 2003. Since subscribers pay up front, Netflix also has the steadiest revenue stream the industry has ever seen. "We're public now," Hastings reminds his troops, "with $90 million in the bank. For them to pull ahead will be almost unimaginable." He brings up the final PowerPoint slide: let the battle begin.

It already has. Hastings is competing not only with Walmart.com and Blockbuster but also with the pay-per-view and premium cable channels who know the same thing he does: The average video rental experience sucks. Consider Tom and Hilary, who decide to rent a movie on Friday evening. They drive to the video store looking for Kissing Jessica Stein only to find that all the copies are out. In fact, there are rarely enough copies of a modest hit film in its first few weeks of release because of a strategy known in the business as "managed dissatisfaction." Video stores don't stock large quantities of most new releases because demand is so fleeting that it's not cost-effective — they get stuck with extras. So Tom and Hilary settle for Me, Myself & Irene, and leave feeling disappointed. The movie is crap, they're too busy to return it, and then they get slapped with a $6 late fee. Not exactly a loyalty-building experience.

Netflix offers a low tech video-on-demand alternative. Jon and Alys subscribe to a $19.95 plan that allows them to rent as many movies as they want in a month, but no more than three at a time. After they watch a film and return it in a postage-paid envelope, the company mails them the next DVD from a list the couple maintain on their Netflix Web page, which offers recommendations based on their rental history. (Liked The Royal Tenenbaums? Try Ghost World.) If Netflix is out of Kissing Jessica Stein, Jon and Alys just receive the next movie on the list. On Friday, they have Donnie Darko, Piñero, and In the Bedroom on top of their DVD player. They love Donnie Darko, mail it back on Saturday, and by Tuesday, Y Tu Mamá También arrives. It's so convenient that the average Netflix customer watches five movies a month. Some subscribers rent twenty or more. (Which is a problem: Netflix loses money on postage for households that rent more than five a month.)

The convenience inspires a fervor among Netflix enthusiasts, and that's what caught the attention of Walmart.com and Blockbuster. But it's the recommendation engine that fascinates independent film producers and Hollywood studios, which see Netflix as a marketing vehicle for off-center movies that are difficult to promote through mass media. Rather than pushing the masses toward what's new — the way Hollywood does today — Netflix pushes subscribers toward titles they're likely to enjoy. Given a large enough customer base, the Netflix model could even change the way Hollywood develops movies.

Hastings sold his first company, Pure Atria Software, in 1997, for three-quarters of a billion dollars. After that, he spent a year as CEO of TechNet, the Silicon Valley lobbying organization; in 1999 he became president of the California Board of Education, where he has pushed to improve the state's notoriously underperforming public school system. That means monthly trips to Sacramento to oversee board meetings, craft motions, consider waiver requests, and review accountability standards. After one all-day assembly, he's unwinding over a latte at a Starbucks near the state capitol.

"What motivates you these days?" I ask. He lifts his mouth from his cup; a trace of foam clings to his upper lip. "The dream 20 years from now," he says, "is to have a global entertainment distribution company that provides a unique channel for film producers and studios." He nods toward the mermaid logo above my head. "Starbucks is a great example. Howard Schultz talks about building the brand one cup at a time. I'd love to be Howard Schultz. As Starbucks is for coffee, Netflix is for movies."

Senior editor Jeffrey M. O'Brien (jeffo@wiredmag.com) wrote about the Vespa in Wired 10.09.

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