December 18, 2001 4:00 AM PST

DVD service delivers online

The epiphany came to Reed Hastings at the video store in 1997, when he tried to return a month-late copy of "Apollo 13": Blockbuster, we have a problem.

The serial entrepreneur was hit with a $40 late charge and the idea for NetFlix, a new company that would combine the Web and mail order to give consumers a better way to rent movies while avoiding punishing late fees.

Bringing convenience to the masses through the Web wasn't exactly novel by the late 1990s. Kozmo, the 7-Eleven of cyberspace, quickly hit cult status in major cities such as New York and San Francisco for delivering anything from doughnuts to toilet paper right to your door. Online grocer Webvan was busy spending nearly a billion dollars to expand its door-to-door business in cities nationwide.

Now Webvan and Kozmo are long-gone. But, thanks to a low-key approach, the sudden popularity of DVDs in the holiday rush and old-fashioned business principles such as customer loyalty and word-of-mouth marketing, NetFlix is emerging as a star amid the dot-com shakeout.

"We were passe during the bubble because we weren't cutting-edge," said Hastings, NetFlix's CEO and co-founder. "But like AOL, we've focused on the ease of use, flat fees and unlimited usage."

NetFlix's fortunes are rising at a time when many investors consider Internet commerce a financial black hole. There are a handful of success stories, of course--the Internet travel sector and online auctioneer eBay come to mind. But those starkly contrast the heaps of e-commerce cast-offs. In retrospect, many of those dead dot-coms shared a blueprint for failure: lavish marketing budgets; young, inexperienced management; and thinly threaded business plans.

Now, as the dust continues to settle and U.S. businesses struggle with a recession, a handful of promising companies are emerging, giving investors hope for an Internet Second Coming. Along with NetFlix, companies such as search service Google, pay-for-listings engine Overture, and online florist 1-800-Flowers.com are drawing attention for their sound fundamentals, good management, future growth potential and popularity with consumers.

"The historical lesson is that as carried away as people got on the upside, they got equally carried away on the downside in 2001," said Jay Hoag, general partner at Technology Crossover Ventures, an investor in NetFlix. "And behind the scenes, some great businesses are being built."

Willing to pay for convenience
Essentially a mail-order rental service, NetFlix lets movie fans keep a limited number of DVDs for as long as they want for $19.95 a month. Customers can watch as many movies as they like but must return old movies before they can get new ones. There are no late fees.

Customers visit the Web site to set up a queue of about 10 movies in the order they want to see them. For most subscribers, the company sends off three movies at a time in thinly packaged envelopes with a postage-paid return sleeve inside. (For big-time movie buffs, NetFlix charges higher rates for more films.) NetFlix picks up the postage costs.

The simple formula has caught on with consumers. NetFlix now has more than 400,000 customers nationwide, partly because of the skyrocketing demand for films on DVD. According to trade group Consumers Electronics Association, DVD players are the most quickly adopted consumer electronic product in history, eclipsing adoption rates for VCRs, televisions and radios. In addition, about 24 percent of U.S. households have a DVD player, up from 8 percent in 2000.

Since September, NetFlix business has grown by nearly 15,000 new subscribers a month, up from 5,000 newbies a month in August.

Movie rental companies including Blockbuster and Hollywood Video typically claim consistently high gross margins of more than 50 percent; NetFlix claims similar financials. Its revenue has grown steadily over the last three years: In 1999, 2000 and 2001, sales were $5 million, $30 million and $70 million, respectively.

Hastings said the average number of rentals among subscribers is about five DVDs per month, making its per DVD cost comparable with that of a regular video store.

To expand its business, NetFlix signed a deal in June with consumer electronic retailer Best Buy. Under the deal, the Minneapolis-based Best Buy pushes the NetFlix service in its more than 1,800-plus retail stores nationwide and helps run a co-branded DVD rental service online through its Web sites SamGoody.com and MediaPlay.com, among others. NetFlix also has marketing deals with Sony, Panasonic and Toshiba, which promote the service to those buying DVD players.

NetFlix plans to become consistently cash-flow positive in 2002, Hastings said, adding that the company is not burning through cash now. Although no plans have been set, he said he eventually will take the company public, possibly in 2002.

The growth of DVDs rentals and NetFlix flies in the face of early hype about services that would stream movies over the Internet, known as video on demand. Major players such as Sony, Blockbuster and Enron planned for such services, which they feared could be set up by Napster-like communities. Since the Internet bust, video-on-demand development has slowed because of the high costs of bandwidth to stream movies.

Despite the streaming hoopla, Hastings saw more potential in the mass adoption of DVDs and the strength of its demand over the next 20 years.

"The idea that anyone can find something new and novel to the Internet around the entertainment industry had been given up for dead," said Forrester Research analyst Eric Scheirer. "Yet NetFlix has done it in the face of a lot of doubters."

A sure bet
Los Gatos, Calif.-based NetFlix was founded in 1997 by Hastings and Marc Randolph, former vice president of marketing for Hastings' software company, Pure Atria. Hastings sold the company he founded to Rational Software in 1997 in a stock deal worth $752 million. After the sale, he ran Silicon Valley lobbying group TechNet, founded by venture capitalist John Doerr and Cisco Systems CEO John Chambers, for nearly a year.

Known by investors as a strategic thinker and dynamic leader, Hastings started NetFlix with his own money in 1997. He lined up high-profile investors including Foundation Capital, RedPoint and Technology Crossover Ventures the following year when the service launched. In 1999, the company received about $30 million from luxury goods manufacturer Louis Vuitton Moet Hennessey, pushing its investments to more than $100 million.

Technology Crossover Ventures' Hoag, who knew Hastings from an earlier investment in Pure Atria, said his backing "was a bet on Reed" at the time. But the bet turned out to be one seeming winner among a handful of e-commerce bombs his company backed in the '90s, including online pet store Petopia, which is no longer in business.

"The economics made sense. It was a bet that you could have a rental business with attractive margins as opposed to a lot of e-commerce businesses," said Hoag.

One reason the company is still afloat is because it didn't spend money on marketing as exuberantly as other e-commerce companies during the Internet heyday. In the late '90s, now-defunct dot-coms such as Furniture.com and Living.com were busy signing multimillion-dollar deals to buy a "tab" on Amazon.com or aligning with major portals such as Yahoo or America Online. Dropping millions on a thirty-second spot during the Super Bowl was also par for the course for now-dot-com relics such as Pets.com or Computer.com. special report: Apart at the seams

NetFlix wasn't outside the bubble altogether. The company tested the waters with TV advertising by spending nearly $5 million over a month on local spots, only to discontinue the efforts. It also tried selling banner ads on its own Web site nearly two years ago because it "seemed like free money." After two months, NetFlix ceased ad sales.

The company also recently laid off between 5 percent and 10 percent of its employees in an effort to cut costs. It now employs about 300 in a sparsely decorated office in Los Gatos, Calif., save many movie posters plastered near employees' desks.

Although NetFlix subscribers make up only a fraction of the 25 million people who regularly visit a local Blockbuster, they typically are fervent believers in the service. Converts rave about the convenience of ordering online and savings from late fees at the likes of Blockbuster, which garners about 20 percent of its revenue from such penalties.

"Living in the city, it's a pain to get to the rental place and I'm the kind who gets the $5 late fee on my credit card," said Mari Anderson, who works at an advertising agency in San Francisco and became a self-professed "sales team of one" for NetFlix after using it for about three months. "For about $20 a month, I'm a happy girl."

But several customers complain that NetFlix's increasing popularity has cost them some convenience. Those customers grumble that greater demand puts many blockbuster movies out of circulation longer. In addition, some subscribers say that it takes too long to receive DVDs by mail to their states.

NetFlix plans to expand the business when demand for digital distribution emerges, allowing customers to choose films by mail or download, Hastings said. At that point, with a hefty subscriber base, NetFlix will be poised to play in a market likely filled with major movie studios and distributors.

"Having survived the nuclear winter, now the company is on firm footing, with solid competitive dynamics...The sky's the limit," said Hoag.

Despite the service's popularity, NetFlix may have some tough competition within next year, as many expect major players such as Blockbuster to enter the market. With more than 25 million active customers and revenue 50 times that of NetFlix, Blockbuster could easily set up a comparable service, analysts say. But this could also make the company an attractive acquisition for the likes of Blockbuster or AOL Time Warner, Forrester's Scheirer said.

This is possible especially since NetFlix is a temporary business as it stands now. When video-on-demand services over cable and on the Internet take off, as expected in 2005, it will slow demand for a physical subscription service, Scheirer said.

"It's quicker to deliver a DVD through the mail than it is to download the equivalent over 14.4K modem," he added. "At some point that crossover happens when it becomes more efficient for consumers to get a movie over the Internet or through the cable box. At that point NetFlix will have to move over" into digital distribution.

 

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