Business | Face value

Movies to go

Can Netflix's Reed Hastings succeed in the battle to deliver movies online?

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LATER this year, Netflix will launch a new service for downloading movies from the internet. “It will be underwhelming,” promises Reed Hastings, chief executive of America's leading online DVD-rental company. Despite a recent ruling by America's Supreme Court that gives entertainment companies more ammunition to fight against illegal file-sharing, movie studios are likely to remain extremely cautious about what films they make available for a fee on the web.

For now, that suits Netflix. Mr Hastings believes that the humble DVD—and, eventually, high-definition versions of it—will remain popular for some time, not least because that is what the movie industry wants: sales of DVDs and fees from rentals are an essential source of the studios' profits from new releases. But Mr Hastings is also betting that by the time movie-download technology becomes more mature and online titles more widely available, his subscriber base for DVD rentals will be big enough to put Netflix in a strong position to prosper in the online marketplace—where he is likely to face new competitors such as Yahoo!, Microsoft, the studios themselves and, no doubt, many start-up firms offering rival download services.

Changes in technology encourage start-ups with innovative ideas to enter markets, just as Netflix did in 1999 when—having been stung with a $40 late-payment from a Blockbuster video-rental store—Mr Hastings launched its subscription service. He was already a successful entrepreneur, having built up a software company before he started Netflix. For its most popular service, Netflix charges users $17.99 a month for an unlimited number of DVD rentals. Titles are ordered via the company's website and dispatched overnight. Customers mail them back in a pre-paid envelope, which releases the next movie on a personalised list of films to see. Subscribers can have up to three DVDs out at any time. Needless to say, there are no late fees.

The Netflix business model has proved to be such a simple and highly effective combination of the online and offline worlds that it has spawned imitators in Britain, France, Germany, Australia and Japan. Netflix, which is based in Los Gatos, California, was about to launch in Britain last year when it decided it had better withdraw from going international, for now, in order to concentrate on a life-threatening war on its home front. The all-conquering retailer, Wal-Mart, and Blockbuster, the world's biggest chain of video-rental shops, both decided to offer online DVD rental at lower prices. Amazon has since started to experiment with a DVD-rental service in Britain—but has not yet launched a similar service in America, and some suspect it may instead team up with an existing competitor.

Certainly, the cost of entering the market has gone up. Netflix has slashed its own prices and launched a one DVD out at a time service for just $9.99 a month. In the past year its share price tumbled as investors saw profits being pumped into an aggressive marketing campaign (costing nearly 20% of its revenues). The company expects to make a net loss of $5m-15m this year. Nevertheless, Mr Hastings says Netflix has $175m in cash and no debt. “We can sustain this for a very long time,” he adds. Indeed, Netflix is showing signs that it is getting the upper hand. In May, Wal-Mart pulled out, awarding its online DVD-rental business to Netflix. Yet, tempting as it might be, Mr Hastings declines to trumpet that Netflix beat the world's biggest retailer. Indeed, Wal-Mart's bosses say they merely took a strategic decision to focus on selling DVDs rather than renting them. Netflix and Wal-Mart will now promote each other's products.

Meanwhile, Blockbuster, which lost $1.2 billion last year, hopes to win 2m customers by next spring for its online DVD-rental service, which costs $14.99 a month for the standard package. But Netflix has already seen its number of subscribers grow to 3m and it expects to reach 4m by the end of this year. And there has been something of a rebellion by some Blockbuster shareholders, which resulted in Carl Icahn, a well-known corporate raider, winning a seat on the board. Blockbuster has been testing out higher fees, which suggests that Mr Icahn's priority could be stemming losses, not undercutting Netflix.

War of the worlds

Why are people prepared to pay more to use Netflix—the movie they get, after all, is exactly the same? Attention to customer needs and quality of service is Mr Hasting's answer. Indeed, Netflix was recently ranked by ForeSee Results, a market-research firm, as the top internet retailer by customer satisfaction. But something else is becoming increasingly important in e-commerce: the ability to amass an inventory that goes far beyond what any high street operation can hope to sustain.

Netflix has what some people fashionably call a “long tail” business. Its catalogue of more than 45,000 titles means that it can cater to almost any interest. Such a depth of movie offerings, plus online features such as movie reviews and recommendations, increases its popularity. Unlike a typical high street video-rental store, which might get the bulk of its revenue from just a few hundred recent titles, Netflix's revenue comes from a far broader selection: some 35,000 different film titles are contained in the 1m DVDs it sends out every day.

Netflix uses 35 distribution centres within metropolitan markets to help it meet its aim of overnight delivery. Yet when online delivery of movies, in whatever form it takes, eventually starts to take off, that legacy infrastructure will count for nothing: warehouses will be replaced by huge computer servers that can be based anywhere. This will not happen overnight, however. And in the transition “we can do mixed mode,” says Mr Hastings. If a movie is not available for download—as many classics may not be for some time—then Netflix can still pop a DVD version into the old-fashioned mail.

This article appeared in the Business section of the print edition under the headline "Movies to go"

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