Wednesday, May 18, 2005

Netflix Fix

Netflix (Nasdaq: NFLX) reigns as the world's largest online DVD movie rental service offering access to an extensive 35,000 movie library to over three million members. Netflix's founder, Reed Hastings, revolutionized the video rental market with his introduction of the "no late fees, no due dates" model in 1997, by eliminating the hassle involved in renting and returning movies. Once a near-monopoly, today the company is embroiled in a bitter price war over its coveted share of the online DVD rental market. Online newcomers, such as Blockbuster, Wal-Mart, and potentially Amazon, have entered following Netflix's success. Blockbuster announced its 'end of late fees' campaign for stand alone stores to begin in early 2005 and further put pressure on market prices with a $14.99 online subscription offer. Netflix fought back with a $17.99 price and subsequent results are that both Blockbuster and Netflix have reported Q1 losses this year. Likewise, Amazon launched an online DVD rental pilot in the UK and some speculate its likely U.S. entry by early 2006 will further fuel the fire.

So as the early leader, what should Netflix do? In his investigation for the Motley Fool, Beirne White describes the company as a "Rule Breaker" because of its disruptive advancements in the rental world. Years ago, the market leader failed to evolve thus allowing Netflix to radically change the way we rent movies. We agree with Mr. White's conclusions, however, he fails to further portray the reality: that in the near future, Netflix stands to have the rules it broke thrown back in its face.

Currently, Netflix operates a lean business model with low fixed costs, an extensive library of movies, a scalable model, an online recommendation platform, and fast delivery options. In its 2004 Annual Report, the company lists all of these as its competitive advantages. Clearly, most are not because they are easily duplicated. The market is now saturated with competitive "me-too" services capable of challenging Netflix's leadership solely on brand or price and costing the company increased subscriber churn rates and acquisition costs. Ultimately it is Netflix's established, strong subscriber network that is its primary advantage. In the short term, Netflix must capitalize on its customer database in order to grow and survive. We suggest allowing the loyal, tenured consumers the opportunity to benefit from helping the company through active recruitment and referral incentives. This might thwart subscriber migration and stabilize the rising churn during the price war. The company can also grow organically through product differentiation or by increasing purchase frequency within its existing customers, such as upgrading them to more profitable services. These ideas are only a temporary solution as each are easily mimicked, but they might help the market leader buy time to better position itself to tackle the long term dilemma faced by the online rental market.

Aside from the aforementioned escalating competition squabbles, the online rental market faces a real threat to its core business from video-on-demand (VOD) or some equivalent. As bandwidth becomes cheaper and the diffusion of digital video recorders (DVRs) continues to occur in the market, the increase in VOD users is expected to follow suit. It is certainly plausible that consumers of the near future will easily order a recent release from the Internet for viewing on a television, computer, or mobile DVD player. Better yet, customer may soon be able to order right from their Cable or Satellite TV Service, whether mobile or based at home. But at this point, the market has yet to take off, and as with any technology, there is not a 100% guarantee that it will. However, and based on recent history, it seems likely that something will soon better suit the publics' rental needs. Just as online DVD rentals were highly disruptive to the home movie rental market, VOD poses equal threats to the long term existence for the online rental market.

To combat this looming risk, Hastings plans to initiate the next round of 'broken rules' by announcing Netflix's dedication to transitioning into the VOD market and offering its first services by later this year. The company clearly recognizes VOD as the emerging technological disrupter to Netflix's existing business model and is ramping up its development and partnerships to better compete in the future. Competition in this early-stage market is still expanding and barriers to entry (and revenues) are still fairly low from a dollar standpoint. It will be a tough climb within the rapidly evolving new market that is currently dominated by a few select cable monopolies (a segment with even deeper pockets than those with which Netflix is currently competing). But given its choices, this is as good a move as any and plays well off its one major advantage—the Netflix subscriber base. If Netflix can convert its users to VOD subscriptions, it can continue to provide value to its customers long after the online DVD rental market dissipates. The move also complements the company's leverage within Hollywood (due to its buyer power) and Netflix has already signed on TiVo as a partner in this venture to broadcast its catalog directly into the home.

Ultimately, Netflix must recognize that its strategy to enter the VOD market will be difficult if it continues to spend all resources defending only its online rental lead. To help the company through the price war at hand, Netflix needs to innovate—shake up the market by causing some product differentiation, such that customers no longer select a service based solely on price—then focus substantial resources on infiltrating the VOD market by transitioning its loyal customer base. Netflix definitely broke the bricks-and-mortar rental rules. If it hopes to survive in the long run, it clearly needs to break the rules again.

Jon Hassert, Ryan Malone, Kristin Wisotzkey

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