A Conversation With Swaziland RPCV Reed Hastings about his company Netflix
A Conversation With Reed Hastings
No Due Dates
"Like probably 50 million Americans, I've had some terrible late fees. That was the germ, that there has to be a way to do this without the late fees."
— Reed Hastings, on how he came up with the idea for Netflix
By Scott Patterson
July 16, 2003
PERHAPS IT'S NO coincidence that Reed Hastings is a big fan of "Welcome to the Dollhouse," which he saw for the first time just a few nights ago. "I loved it," raves the 42-year-old chief executive of Netflix (NFLX), who credits his company's CineMatch service with recommending the 1996 movie written and directed by Todd Solondz. "It was so stark. It wasn't Hollywood."
In case you missed it, "Welcome to the Dollhouse" is a critically acclaimed coming-of-age tale about a nerdy adolescent girl named Dawn Wiener as she confronts junior-high-school bullies, parental indifference and the vacuity of generic American suburbia.
OK, perhaps the parental-indifference and generic America parts don't apply here — but the bully scenario certainly does. For Netflix, the rent-by-mail movie provider that went public in May 2002, is already being picked on by such notorious playground tormentors as Wal-Mart Stores (WMT) and Blockbuster (BBI), both of which entered the DVD home-delivery market during the past 12 months.
Hastings, who founded Los Gatos, Calif.-based Netflix in 1998, says he's ready to do battle with the giants. "We've been doing it for four or five years," he boasts, "so we've got a lot of experience and have worked out the kinks, while Wal-Mart and Blockbuster are just beginning that process." Netflix currently owns a 2.5% market share in the $10 billion-a-year movie-rental business. Its goal is to reach 10%.
On Thursday, Netflix will add substance to Hastings' quixotic brio when it posts its first-ever profitable quarter. Analysts expect Netflix to earn 13 cents a share for the second quarter, according to Thomson First Call, a significant leap from a year earlier when it lost 21 cents.
SmartMoney.com asked Hastings how he feels about reaching the profitability milestone, how he plans to meet the formidable competition of Wal-Mart and Blockbuster, and what he thinks about selling out.
SmartMoney.com: Netflix reports second-quarter earnings on Thursday, and it looks like this might be the first profitable quarter. You must be feeling pretty good about that.
Reed Hastings: Absolutely. We've been growing very steadily over the past four years. Our revenue guidance is for between $62 million and $64 million for the quarter, so we're very excited about that. We've got a lot of new subscribers. It's a great symbolic step forward to be GAAP [generally accepted accounting principles] net-income positive. We have been free-cash-flow positive for six quarters now, and we expect to be free-cash-flow positive going forward.
SM: The basic idea of Netflix, which you founded in 1998, is $20 a month for unlimited DVD rentals delivered by mail. How'd you come up with the idea?
RH: It's been an evolution. Like probably 50 million Americans, I've had some terrible late fees. That was the germ, that there has to be a way to do this without the late fees. In 1999, we launched the service, and it was a tremendous success right out of the gate. Within the first three months, we had 100,000 subscribers. Then we had another 100,000 and another, and we kept adding another 100,000 every quarter. We hit a million subscribers about five months ago, which is a big milestone. We continue to get the word out about Netflix. There are no due dates, no late fees and vast selection — we have over 15,000 movie titles.
SM: So why hasn't Netflix gone the way of Pets.com and so many other Web sites?
RH: We've gone the way of Amazon.com (AMZN), eBay (EBAY) and Expedia (EXPE), all very successful e-commerce companies. Not all models worked, and not all models failed. Our model is profitable on a per-subscriber basis. There's a lot of consumer interest. It's a large market. Online, we can offer a compelling selection that consumers can't get offline.
SM: Wal-Mart and Blockbuster don't really seem to have put much of a dent in your business since entering the DVD home-delivery market. Why not?
RH: It probably looks easy to imitate Netflix, but it's quite difficult to get all the details right that matter to a consumer. We've put four years' effort into building our service. PC Magazine recently did a comparison of the industry. It gave Blockbuster's FilmCaddy online service a fairly lackluster two stars out of five. It gave Wal-Mart three stars out of five. And it gave Netflix one of the rare, coveted five stars out of five. It cited faster delivery, broader selection, better Web site, easier to find movies, better customer service — the litany of things that come with experience. Our job is to stay ahead and continue to raise the bar. We're improving every aspect of our service over time, so when the reviews come two years from now, they'll still rate us five stars.
SM: You recently received a patent covering a large part of the Netflix business, but skeptics say you won't be able to enforce it on such deep-pocketed companies such as Wal-Mart.
RH: We're studying our options about what to do about the patent, but our primary strategy doesn't rely on patents. Our primary strategy is to have a service that works better than any other service — that consumers not only like but rave about to their friends — and that's what's propelling our growth. We're trying to exceed expectations and generate the "wow factor" for consumers. It's products and services that have the "wow factor" that generate large amounts of word of mouth.
SM: Over half of your rentals derive from your CineMatch recommendations system. Can you explain how that matching system works, and why it adds so much to your bottom line?
RH: About 60% of the subscribers take suggestions from us on movies, and the way the matching works is that consumers will rate movies on a one-to-five basis. Once you've rated 20 or 40 movies, we can do a pretty good job of putting recommendations in front of you, some of which you'll have heard of and some you haven't. As an example, I recently watched a movie called "Welcome to the Dollhouse" that was recommended to me, and I'd never heard of it. It was a fairly small movie made in 1995. I would've never heard about it, and I loved it. It was so stark. It wasn't Hollywood. That's what CineMatch will do.
SM: You've had a lot of success with your one-day delivery promise, but one downside with it is that more DVDs are being ordered per household, which drives down gross margins because your revenue-sharing contracts with studios tie costs to usage.
RH: Well, it's not really a downside. If you run a coffee shop and you make it a more pleasant place to hang out, then in some sense it's against your interest because it ties up tables. But that's a pretty narrow way to look at it, because you want people to enjoy the coffee house, and we want people to enjoy movies. So we might make slightly less per subscriber because people watch more movies, but they're happier with the service, and they tell their friends about it. Marketing is our biggest cost, so we look at it as a straight-ahead win, because doing that helps us to grow faster.
SM: Speaking of coffee, you've said, "As Starbucks (SBUX) is for coffee, Netflix is for movies." What do you mean?
RH: When Starbucks came out in 1992 and it went public, some people thought, How big is this business going to be? They said it's not for mainstream America. What [Starbucks founder and Chairman] Howard Schultz believed was that he could bring the gourmet-coffee experience into mainstream America and develop a mainstream taste for it, and of course it has been wildly successful, creating a multibillion-dollar corporation and a global brand. What we're doing at Netflix is the same thing. People say, it's rental by mail — who's going to do that? In fact, more than a million people are already doing it, and it's spreading rapidly. As Starbucks is bringing a higher level of taste to the coffee market and growing the coffee market, we're growing the movie market and getting people to try different types of movie like "Dollhouse."
SM: But Starbucks didn't really have the competitors that you do.
RH: Sure it did. First of all, it had all the direct competitors like Seattle's Best Coffee — which it's finally acquiring — and which was actually ahead of Starbucks for a while. Seattle's Best had more stores than Starbucks because it had franchised. And then there's Dunkin' Donuts. And McDonald's (MCD) went into espresso. For a long time it was very competitive.
SM: What about video-on-demand (VOD) — will you be moving into that once it becomes more widespread?
RH: Absolutely. There's great opportunity for us with VOD. In the future, you'll be able to get your DVDs by mail, or you can download movies to your home, whichever you prefer. We'll be offering both. It's why we called the company Netflix and not DVD by Mail — we know that in the long term, 50 years from now, we'll be downloading to every home. It's just a matter of the evolution and at what pace it happens. We realized that we could build a big business on DVD and then have the starting-pole position competing for VOD.
SM: A lot of skeptics say you should seriously consider selling to a competitor. You've always said you'd resist being acquired — but with positive earnings, you'll likely be a far more attractive target. Do you still stand by your vow never to sell?
RH: No. As an officer of a public company, I'm bound by fiduciary duty to serve the interest of the shareholders. So there are offers that you can't refuse. But it's not something that we're seeking, encouraging or engaged with. I think a lot of people don't believe Netflix is a very big business, which comes back to the Starbucks comparison. A lot of people in 1992 thought that espresso was going to be a very niche business, and of course it wasn't. Every business starts as a niche. Automobiles were a niche at one point.
SM: Were do you see Netflix 10 years from now?
RH: The world's largest and leading Internet movie network. More like HBO than Blockbuster — a real content-subscription service. What we need to do is match each person with their "Welcome to the Dollhouse."
