Friday, May 27, 2005

This Ain’t Cola (the DVD rental wars)

Following its Deal with Wal-Mart, Netflix Hopes to Set the Rules for the Online DVD Rental

Last week Wal-Mart, the juggernaut of the retailing world, announced that it was conceding defeat and giving up its DVD rental business. Well known for dominating every market segment in which it operates, Wal-Mart seems to have been pummeled into submission and has agreed to transfer its DVD rental business to its upstart competitor, Netflix. In the deal announced last week, Wal-Mart’s subscribers will be referred to Netflix’s web site and offered to continue their membership with Netflix, while Netflix will promote Wal-Mart’s DVD sales to its three million customers. With this deal, Netflix hopes to finally achieve a level of pricing power that will allow it to stop the flow of red ink.
Netflix entered the DVD rental market in 1997 and offered an innovative model that eliminated the despised late fees, increased selection and offered the convenience of on-line ordering, mail delivery and low price. Blockbuster, the long-established market leader in brick and mortar DVD rentals, entered the online rental market last fall offering a service similar to Netflix’s at a lower price. Although the competitive war between the companies extends to the fronts of selection, availability of titles and service, the main competitive weapon remained price. This led to rapid and heavy price cutting that sent both companies into the red. Most industry analysts have pointed to this lack of industry profitability, caused by the Netflix – Blockbuster price war, as the main reason for Wal-Mart’s sudden exit.
The impact of the exit on the online DVD rental industry and the end result of the partnership with Netflix are contentious. Will this partnership change the dynamics of the battle? Some think that the partnership will radically change the competitive landscape by establishing a clear market leader who can set the rules of the game. Others argue that, in reality, Wal-Mart’s exit doesn’t change the fundamental dynamics of the competition, since Blockbuster will continue to challenge the dominance of Netflix. This week Blockbuster has already fired a responsive shot, and begun offering special deals to those subscribers who defect from Wal-Mart and Netflix. Indeed, Blockbuster seems to be showing signs that it will not quietly accept the number two position in this market.
Traditionally, Wal-Mart is known for flexing its muscle in extracting value from all parts of the value chain. Wal-Mart has built on its strengths in low cost distribution and procurement to provide value to customers. Wal-Mart has some power over suppliers and has experience dealing with DVD distributors thanks to its DVD sales business, but we believe that these are not significant enough to support Wal-Mart’s low-cost model. Wal-Mart may have some room to bargain, but pushing hard on suppliers may not be possible due to the numerous and fragmented channels through which movies are distributed.
Both Netflix and Blockbuster are likely to have comparable DVD distributor relationships. Blockbuster also has greater synergies in the rental marketplace, already a core part of its business model. Netflix is supplied by 67 studios and distributors. Although exact costs are not published, we assume that the three competitors had similar costs per movie in the rental business and therefore, Wal-Mart did not have a long-term sustainable competitive advantage in this market and were not able to gain significant market share (analysts estimate their number of subscribers by anywhere between 100,000 and 250,000). After seeing nothing but losses, Wal-Mart finally decided to cut its losses and leave the battlefield to the Netflix/Blockbuster duopoly.
In the DVD online rental market, we would expect customers to have low switching costs due to lack of long-term subscriber contracts. In addition, Consumers now have a plethora of options for obtaining DVDs, both through the rental and purchase markets. However, Netflix states in its annual report that new subscribers are more likely to switch than old subscribers, meaning that Netflix benefits from its first-mover advantage. “Despite is size and merchandising savvy… Wal-Mart couldn’t overcome Netflix’s headstart in the rapidly expanding niche of online DVD rentals.” This could be explained by customer loyalty, or low customers’ sensitivity to price.
Analysts seem to disagree on what signal the deal sends to other potential market entrants. As a result of Wal-Mart’s exit, Amazon, which has already started a DVD rental program in England and had been planning to enter the US market, may now be less likely to do so due to Netflix’s now dominant position. Others point to Amazon’s recent talks with Blockbuster and Netflix as indication that Amazon may still enter, although they may now do so in cooperation with another existing market player.
Wal-Mart may have decided that it has more to gain from cooperation than from further competing. By agreeing to remove itself from the industry, Wal-Mart has immediately reduced the competition that has been driving down prices in the DVD rentals market and potentially cannibalized its DVD sales. Additionally, the exit sends a signal to Amazon and other potential entrants that the industry is not profitable, even for a power like Wal-Mart. This strengthens the positions of the remaining players (i.e. Netflix and Blockbuster), possibly allowing them to raise prices. Wal-Mart hopes that this will drive customers back to Wal-Mart stores to buy DVD’s that will be comparatively cheaper to renting. Furthermore, by engaging in cross-promotion, the deal may help both Wal-Mart and Netflix to grow both the rental and sale market pies.
As mentioned above, Blockbuster has already responded to the deal and offered subscription discounts to those defecting from Wal-Mart and Netflix. However, there are some indications that this may be a sign of desperation and a one shot, short-term reaction to take advantage of a fleeting change in the marketplace. This strategy is clearly not sustainable by Blockbuster. Price reductions affect their online and store business. Blockbuster’s online DVD rental business has been bleeding cash since inception and has also been suffering from internal management problems. Carl Icahn, who recently joined Blockbuster’s board, has publicly criticized Blockbuster for its loss making businesses. Carl and other board members are expected to push for higher prices sooner rather than later.
The market for on-line DVD rentals is expected to continue to grow at 60% over the next few years. With a market potential of 70 Million potential households, the current DVD rental market is far from mature. However, to show short term profits, Blockbuster may be forced to concede to Netflix the number one position, and be content to remain the follower in this market. While this will be a new and unfamiliar spot for Blockbuster after dominating the bricks and mortar video rental market for so long, it will probably come to realize that the pie will be large enough for it to sustain a large customer base and finally start to realize future earnings.
Both Wal-Mart and Netflix hope that their deal will lead to higher rental subscription costs. This would bring Netflix back into the black, and might also help Wal-Mart to sell more DVD’s as they become comparatively cheaper. Wal-Mart may also be getting a cut of future Netflix profits, allowing them to have something to show for their failed foray into the online DVD rental market. The only holdout remains Blockbuster, which tested higher rental fees last week and matched Netflix’s price.
Stability in price may decrease competition and allow both players earn hefty profits. However, studios, who earn more than half of their income from DVD sales and rentals may object to price increases, and support new players or other channels. In the short term however, it seems that customers are likely to see fewer price promotions and should prepare to increase their entertainment budget.

Leann Tchaikovsky, Ohad Reshef, John Rhoads

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