Wednesday, May 25, 2005

IT'S A BLOCKBUSTER NIGHT - MAYBE?

The landscape in the DVD rental business has changed significantly over the past few days. On Thursday, May 19th Wal-Mart announced that it would exit the DVD rental market, and partner with online innovator Netflix. This adds a spark to the highly competitive sector which has seen numerous pricing and structural changes over the past several years. Walmart.com began offering DVD rentals online in late 2002 in an effort to grab a share of what appeared to be a profitable and growing online rental market. Wal-Mart’s use of scale and leverage didn't pay off as hoped, evidenced by its ability to capture just 1% of the online DVD rental market. Wal-Mart's effort was fiercely combated by pricing and convenience incentives pushed by Netflix, eventually forcing Wal-Mart to reassess their key goals. Bowing to Netflix on DVD rentals, Wal-Mart decided to align itself with the Los Gatos, CA-based Internet company creating synergies for both parties. Wal-Mart will now direct all 3 million of its DVD rental subscribers to Netflix.com, while in return Netflix will promote DVD sales for Wal-Mart. Wal-Mart CEO John Fleming indicated that the company’s online relationship with its customers is intended to drive the user back to the store. The relationship with Netflix is geared to do just that. "The decision was really a question of focus", Mr. Fleming indicated in the May 19th announcement.

Whether or not the new relationship between Netflix and Wal-Mart will bear fruit is yet to be determined. However, one thing is for certain, Carl Ichan and the restructured management team of Blockbuster did not sleep well Thursday night. The major third party player in this multiyear struggle for DVD rental dominance is Dallas, TX-based Blockbuster. The brick and mortar behemoth has dominated the rental landscape for almost a decade through scale and the numerous locations of their retail outlets. With progress and threats in the virtual world increasing by the second, Blockbuster began to see pressure from the more convenient and user friendly online model created by Netflix. As Netflix's subscriber base grew, Blockbuster was forced to press new initiatives in an effort to level the playing field. Entry into the online market was the first attempt by Blockbuster to compete directly with Netflix on the web. This process was accompanied by a significant increase in infrastructure and marketing spending. Blockbuster’s management team is slated to direct 170 million dollars to grow the online effort in 2005 alone. The acceptance of the online subscription-based model (vs. the traditional rental approach) that allowed users to keep movies for a non-specified period of time, forced Blockbuster to become more dovish on their traditional rental penalties. The Board of Blockbuster decided to eliminate late fees, even though they made up 16% of Blockbuster’s total revenues. The repeal of late fees, coupled with increased spending on new ventures, and the lack of attention paid to the core business model infuriated large shareholders, most notably financier Carl Ichan. As a result, Mr. Ichan strong-armed his way onto the board in an effort to return shareholder value to the company. No more than a week after Ichan succeeded at securing a spot on Blockbuster's board, Netflix and Wal-Mart announced their new partnership. This prompted an immediate reaction from Blockbuster's disheveled leadership. By offering two months of free rentals, Blockbuster is making a clear attempt to poach Wal-Mart subscribers during the transition to the Netflix platform.

Reaction to the news was generally positive (though analyst opinion of Netflix as a whole remains divided). Analysts cited the addition of Wal-Mart’s customer base of 500 million visits per year as a significant gain for Netflix. Wal-Mart would benefit from an increase in its customer base for DVD sales as well as the ability to exit a market in which it failed to make significant inroads. One pundit did put forth the question, however, of whether Netflix sold itself short in some respects by forgoing a potential partnership with Amazon.com (and its coveted IMDB.com database) by partnering with Wal-Mart.

We tend to agree that this is a good move for both parties. We view the DVD rental and purchase markets not necessarily as substitutes for one another, but as complementary in their ability to draw customers from one segment to the other. This partnership will offer customers a one stop shop where they can first preview a movie (Netflix) before deciding to purchase it (Wal-Mart). We believe this arrangement can both increase the size of the DVD market and enable Netflix and Wal-Mart to capture a large share of it.

Korb, Shade and Thornton

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