June 17, 2004: Headlines: COS - Swaziland: Business: Silicon Valley: Computers: Internet: Fortune: Swaziland RPCV Reed Hastings plans to tower over his competition, but right now, on this Friday morning in Silicon Valley, he's towering over his employees

Peace Corps Online: Directory: Swaziland: Peace Corps Swaziland: The Peace Corps in Swaziland: June 17, 2004: Headlines: COS - Swaziland: Business: Silicon Valley: Computers: Internet: Fortune: Swaziland RPCV Reed Hastings plans to tower over his competition, but right now, on this Friday morning in Silicon Valley, he's towering over his employees

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Swaziland RPCV Reed Hastings plans to tower over his competition, but right now, on this Friday morning in Silicon Valley, he's towering over his employees

Swaziland RPCV Reed Hastings plans to tower over his competition, but right now, on this Friday morning in Silicon Valley, he's towering over his employees

Swaziland RPCV Reed Hastings plans to tower over his competition, but right now, on this Friday morning in Silicon Valley, he's towering over his employees

The Great Race

No startup has cashed in on the DVD's rapid growth more than Netflix. Now Blockbuster and Wal-Mart want in. Can it outrun its big rivals?

By Alan Cohen

Reed Hastings plans to tower over his competition, but right now, on this Friday morning in Silicon Valley, he's towering over his employees. It's the weekly state-of-the-company staff meeting at Netflix, the online DVD-rental service that Hastings founded, and the 41-year-old with the hipster goatee is up on a bench outside company headquarters, and he's on a roll. In his affable yet cocksure way Hastings is skewering Wal-Mart, which has been testing a service that's a dead ringer for Netflix's own. Wal-Mart's test website is supposed to be hush-hush--indeed, the service wouldn't be announced until the following week--but Hastings found the super-secret address and signed up. What he hasn't been doing, he happily tells the employees gathered around him on the grass, is watching any movies. "Most of the titles I looked for were not in stock, and the ones I ordered still haven't shown up nearly a week later." The crowd erupts in laughter, and presumably relief.

For all the levity, Hastings is going through what many entrepreneurs before him have experienced--great idea, great timing, and, now that the public has vindicated the business, heavyweight competition. Not only has Wal-Mart entered the market, but Blockbuster is testing not one but two Netflix-like DVD-rental programs; Columbia House has announced that it will probably start a similar service; and others are sniffing around too. Hastings sees himself as Rocky up against Apollo Creed. The twist is that he doesn't mean the Rocky from the first movie--where the underdog puts up a good fight against the champ and loses--but Rocky from the sequel, in which the fighter tells the champ to bring it on and then pummels him. "There are two scenarios," Hastings says: "This is a niche we own, or it's a contested large market. I would much rather have the latter."

But now that Netflix has company, what's next? More of the same, according to Hastings, who's so sure of his business model that he has no plans to stray from it. Hastings has been dead-on about the DVD market so far, but that market--and its players-?are still evolving. For Netflix to stay on top, it must do more than hope its rivals remain as clueless as he depicts them today. One has to wonder whether Hastings sees the light at the end of the tunnel or just has tunnel vision.

Netflix is one of the most talked-about dot-coms today because of two traits Hastings displayed on that lofty perch: a confidence so big it can be spotted from outer space and the canny, quiet planning that underpins it. Hastings likes to portray Netflix's birth as a no-brainer. Back in 1997, while the rest of us were still fumbling with our VCRs, the math teacher turned multimillionaire software entrepreneur became convinced that DVDs were the home-video medium of the future. He raised $120 million, attracted hundreds of thousands of customers, and took the company public last May, garnering another $90 million. No sweat. What Hastings doesn't dwell on are the trials he went through to make his business appear to be a no-brainer. How he tried more than 200 different mailing envelopes before finding the one that let him safely ship DVDs without spending more than the cost of a first-class stamp. Or how he built the first version of his site with $2.5 million earned from his last business and won customers before going out and seeking venture capital.

Hastings's calculated gambles would seem to have positioned Netflix as a big winner in the DVD boom, one of the fastest-growing consumer electronics markets ever. Some 742,000 movie buffs today (up from 334,000 a year ago) pay Netflix $19.95 per month to feast on its enormous buffet of rentals: art films, Hollywood blockbusters (and duds), old TV shows, documentaries that never made it past Sundance. The result: some boffo box office. Revenue in the third quarter was up 116% from the year before, to $40.7 million from $18.9 million. And although Netflix has yet to turn a profit, it narrowed its quarterly net loss to $1.7 million from $5.6 million.

If anybody can make it in the face of ferocious competition like Wal-Mart, Hastings and his young company are as good a bet as any. For one thing, Netflix isn't your typical dot-com with a good idea and a short shelf life. In fact, it's more like the dot-com that watched all the other dot-coms come and go, and learned exactly what not to do. "What no one realizes, except maybe Blockbuster, is that Netflix is a complicated software company masquerading as a DVD-rental service," says Mike Schuh, a general partner in Foundation Capital who invested $6 million in the company in 1999. "Its film-recommendation software, its merchandising, and the inventory-control systems are sophisticated. It isn't that they couldn't be replicated, but they're hard to do, and it'll take a lot of money, time, and commitment to get it right as Netflix has."

And Hastings isn't your typical dot-com entrepreneur either. Sure, he may look the part, walking around Netflix's home base of Los Gatos, Calif., wearing a Netflix polo shirt, ready to discuss the merits of his service with every dog walker and caf? patron. He has the requisite cockiness down too, jumping into the shark--infested waters of consumer entertainment services after just one corporate gig--helming Pure Software, a company that built software tools for computer programmers. But Hastings knows that the company is more than him. He built a reputation at Pure for hiring topflight executives who could fill in the gaps in his own management expertise, something he has repeated with Netflix. He's already recruited Leslie Kilgore, former director of Amazon's U.S. marketing, as Netflix's vice president of marketing, and Ted Sarandos, vice president of content acquisition, who was in charge of product and merchandising for Video City, a 299-store chain. Netflix's investors see more in Hastings too. "He's a deep technologist, but he has tremendous sensitivities to the nuances of a market and how to create a go-to-market strategy around a product," says Tim Haley, a partner of Redpoint Ventures, who consulted at Pure and was Netflix's first outside investor.

Netflix also has some key strategic advantages over its com-petitors. It's up and running nationwide while the others are still feeling their way around. Blockbuster's in-store subscription-rental program, called DVD Freedom Pass, has been active for only a few months and in just five markets (New York City, Houston, Phoenix, Seattle, and Salt Lake City). In addition, the Dallas-based mega-renter is experimenting with an online Netflix clone called Film Caddy, which debuted in October. Wal-Mart and Columbia House are expected to launch their services officially early in 2003, and both plan versions that mimic Netflix step by step, with online queues for desired discs, no late fees, and postage-paid return envelopes.

Hastings & Co. have the advantage of experience as well. In its four years Netflix has tweaked the inventory-management software so that new orders are automatically generated even as the old orders are returned, and all 12 distribution centers can be polled before a customer is told that the movie he wants next is out of stock. It has made revenue-sharing deals with 50 film distributors (including most of the major studios), giving it its large inventory of 12,000 titles, dwarfing the 7,000 to 8,000 available at Blockbuster's largest stores. (That does come at a price: Netflix shared 19.2% of its subscription revenues with partners in the second quarter.)

In FSB's spot checks, Netflix consistently had titles in stock that Wal-Mart's site didn't (but never vice versa). And although Blockbuster stores testing Freedom Pass had plenty of copies of big Hollywood hits available, they carried far fewer lesser-known titles--art films like Kissing Jessica Stein or Croupier; those were usually checked out. Of course, anyone who's ever faced a wall of Mr. Deeds already knows this, and Hastings is count-ing on that to pitch his service over Blockbuster's in-store program. "If they launch in the stores, we emphasize our customer service and broad selection."

Hastings revamped Netflix's distribution model this past year in an effort to improve customer service with faster delivery times. The service started with just one warehouse in San Jose but began building regional mailing centers (it now has 11) when it noticed that its customer base in the Bay Area was five times higher than its national average. "Customers in San Francisco got their movies in one day," Hastings explains. "Customers in New York got them in four." The regional centers have already had a significant impact: Netflix has experienced a surge in popularity in cities such as Boston and Sacramento that are now within one-day mail distance of a Netflix distribution center. Blockbuster's Film Caddy site ships all DVDs from a central warehouse in Mesa, Ariz.; Wal-Mart from its main fulfillment center in Carrollton, Ga. Hastings sees this as proof that his rivals have discovered the market but not the logistics needed to win it. "Wal-Mart won't be competitive until they've got 25 shipping centers like we'll have by the end of 2003," he says. Wal-Mart spokesperson Cynthia Lin says the company has no plans to use regional distribution points, but Columbia House president Brian Wood is more open to the idea. "Right now we have one warehouse in Terre Haute, but if it takes multiple warehouses, we'll do it," he says.

Despite its early lead, netflix faces steep odds moving forward as it goes up against these giants. Can it change the entrenched customer behavior of going to the video store? Is it possible for the startup to outspend Blockbuster and Wal-Mart on marketing? Or beat them on price? The biggest threat Hastings faces is the size of the online DVD-rental subscription service market itself. Hastings's plan is to grow the Netflix subscriber base from 742,000 customers to five million in the next five to eight years, a target he claims is conservative. "Five million subscribers is $1 billion in revenue but just 10% of the total rental market," he says. Hastings's nonchalance aside, five million subscribers is stunningly ambitious. Blockbuster estimates the total potential online market to be between two million and three million subscribers. And Netflix's own growth, while impressive, doesn't seem to justify Hastings's optimism. With just over 100 million households in the U.S., Netflix would need to be in about 5% of homes to hit his target. But even with subscribers more than doubling in the past year, the percentage of households using the service inched up from 0.57% to 0.63%.

Hastings cites Blockbuster's in-store program as his biggest worry?and with good reason. "It's a big threat," he says. "It's instant gratification." Indeed, Blockbuster's own surveys show that for 90% of its customers, the gap between the time they decide to rent a movie and the time they actually rent it is four hours. Hastings, who relies on the Postal Service to deliver his product, would have to trade in his stamps for a fleet of Concordes to match that time frame. And Blockbuster's Freedom Pass looks headed for a national launch in 2003. "On average, we're making more in revenue and profit dollars on subscription customers than we did on them before they joined the program," says Karen Rafkopf, Blockbuster's senior vice president for corporate communications.

If Netflix is to keep growing it needs to persuade new customers that it's okay to wait for their movies. And that's going to take a lot of marketing. Thus far Netflix has been relatively frugal, spending $34 to acquire a customer. The company claims that 70% of new subscribers come via referrals, some primed by cheap Internet marketing; signup offers included in DVD-player boxes and a partnership with Best Buy make up the rest. An aggressive marketing push could be a financial drain on a company that has yet to turn a profit. And Netflix already has one strike against it: The service isn't immediately understood. "We spend three of every four marketing dollars trying to explain how it works," says Leslie Kilgore, Netflix's vice president of marketing. Blockbuster, with 5,000 stores and 48 million customers, is in a more enviable marketing position. While Netflix relies largely on word of mouth to educate customers, Blockbuster can pitch its subscription service every time a customer stops by for a Saturday-night movie.

Retaining customers may prove as challenging as finding them. Netflix's turnover rate has averaged about 7% a month for the past two years. Although Hastings downplays that number as insignificant?and so far the company has more than made up for the losses with new subscribers?he's concerned about low-volume renters. "The people who watch just two movies a month may realize that they don't use us enough to justify the price." So he has steadily been investing time and money to boost rental rates (the average Netflix customer rents five movies a month). He thinks the company's proprietary CineMatch software, which takes ratings that customers assign to movies they've rented and suggests others (significantly, it won't steer you to an out-of-stock title), is the key to holding on to customers. "Over half of our rentals come through the recommendations system," Hastings says. "It really keeps users active."

Can netflix make it? there's certainly precedent: Who would have bet that Intuit would succeed as a software company, especially when Microsoft challenged it? But questions abound for Netflix in addition to its fierce competitors. The DVD market itself is still far from established. With satellite and digital cable growing, the ever-nascent video-on-demand industry seems to be showing signs of life, which would give home viewers a cheap--and instant--DVD alternative. And studios have been loading DVDs with lots of extras, marketing them as collectibles, so no one knows how much their burgeoning sales will eat into rentals. Hastings not only dismisses these scenarios as unlikely, but also rejects natural extensions for his business such as game rentals.

Hastings has had that luxury because his early investors have given him free rein. But Netflix is now a public company, and shareholders have been voting with their feet. Its stock has been battered with the news of its bigfoot competition, dipping below $5 a share shortly before Wal-Mart's announcement. As of early November, the stock had rebounded to $9, still well below its high of $18.19. The low stock price makes Netflix an attractive acquisition candidate, but Hastings, with an intense fervor, denies he would sell.

Hastings no doubt sees his competition doing the one thing he's not: hedging their bets. Blockbuster has its stores, its site, and even a video-on-demand deal with DirecTV; Wal-Mart and Columbia House, their retail and forthcoming rental operations. Point that out, however, and Hastings gives his now predictable shrug. "The only way to build a successful business is to make a bet that some macro trend will happen." And Hastings is betting big.
Additional reporting by Julie Sloane.

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Story Source: Fortune

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