RPCV Reed Hastings has attained every entrepreneur's dream. But his story stands as a cautionary tale for every small business
Does the Kid Stay in the Picture?
Reed Hastings, the founder and chief executive of Netflix, at his company's distribution center in Sunnyvale, Calif., near San Francisco.
By GARY RIVLIN
Published: February 22, 2005
LONG before his company celebrated its 2002 stock-market debut, and long before he learned that millions of customers also meant head-to-head competition with the likes of Blockbuster and Wal-Mart Stores, Reed Hastings was just another small-business man fretting his way through the 1998 holiday season, wondering if his 14-month-old start-up would survive the winter.
At the time, his company, Netflix, an online movie rental site, had few customers but plenty of skeptics convinced that a service that dispatches DVD's by mail was quaintly absurd.
Mr. Hastings, who had previously co-founded a company that went public, had access to venture capitalists, but "basically that meant I got to hear a lot of people say no," he said. An investment firm agreed to provide him a line of credit to help him the first year, but when the company tried to draw down money, the partners told him "they didn't think we had a workable model." So two days before Christmas, he crammed himself into an airplane seat to fly east from Silicon Valley for a meeting with Lighthouse Capital Partners, a California venture firm with a branch in Cambridge, Mass.
"If I didn't get that money, we were toast," Mr. Hastings said.
Lighthouse provided the cash the company needed to continue, but there were still plenty of heartburn-inducing days ahead for Netflix, including one more near-death experience and an aborted attempt at a public offering in the spring of 2000. "We've always struggled, but in the end I think that's given us character," he said.
Those behind Netflix need all the character they can muster. In the last two years, Wal-Mart and Blockbuster have entered the online DVD rental business, and it seems only a matter of time before Amazon.com joins in. If battling three behemoths were not enough, there is also the threat posed by the video-on-demand market, which, when it is finally embraced by both Hollywood and the public, will allow people to forgo rentals and download movies over the Internet or via cable television.
Mr. Hastings, it seems, has attained every entrepreneur's dream. But his story stands as a cautionary tale for every small business.
By some measures, Netflix has never been more successful. Safa Rashtchy, an analyst with Piper Jaffray, had predicted the company would swell to 2.2 million customers by the end of 2004, but the subscriber base crossed 2.6 million members, growing at an even faster pace, 76 percent, than the impressive 74 percent growth rate the company sustained through 2003. It also exceeded fourth-quarter revenue targets set by Mr. Rashtchy and other analysts.
Yet shares in Netflix are down 68 percent from their January 2004 high. The low point came in mid-October, when the company reported its quarterly earnings. Mr. Hastings announced that because of the anticipated entrance of Amazon in the market, he was slashing the basic subscription fee to $17.99 a month from $21.99, prompting eight of nine analysts who cover Netflix - on a single day - to downgrade the stock.
"I was one of the penguins," said Derek L. Brown, an analyst with Pacific Growth Equities who downgraded Netflix from "overweight" to "equal weight." The lower monthly fees mean the company will be pressed to earn its profits in the short run, say Mr. Brown and Mr. Rashtchy, who both see only uncertainty when considering the company's long-term stock prospects.
"That was a painful day," said Mr. Rashtchy, who changed his rating from "outperform" to "market perform." "It was like all our beliefs in the Netflix growth strategy were shattered."
THE birth of Netflix proves that even if you have a net worth of millions like Mr. Hastings, it is still maddening to pay a $40 late fee for a single video. It was in 1997 that Mr. Hastings paid a hefty fine on a movie he returned weeks late that he thinks may have been "Apollo 13." Earlier that year, the company he helped to found, the Pure Atria Corporation, which made software development products, was bought by its chief rival, the Rational Software Corporation, in a deal worth $525 million. Mr. Hastings, who taught math for two years in Swaziland right after college, had only recently started his studies for a master's degree in education at Stanford, figuring on a life that blended politics, education policy and philanthropy. He was 36.
Yet he couldn't get out of his head the idea that people might resent paying late fees so much that they might prefer to join a DVD rental club the way one joins a health club. "This was 1997 and everything was e-commerce, so I said let's do this over the Internet," he said.
"People thought this idea was crazy that consumers would rent movie through the mail," Mr. Hastings said. "But it was precisely because it was a contrarian idea that enabled us to get ahead of our competitors."
Mr. Hastings now confesses that his service was not much to boast about in the first couple of years. Netflix introduced its Web site in May 1998, but initially it was no different from a video store, except you had to wait for a new movie to arrive by mail. Early adopters rented one DVD at a time - and paid a late fee if the disk was not returned on time.
Sixteen months passed before the company began a subscription service that allows users to keep movies for as long as they liked. Then, as today, users browse the Netflix site and select DVD's they want to view. The company sends new customers the first three DVD's on their list, assuming they are available, in envelopes that are reused to return the disks at no charge. Customers can rent as many DVD's as they like but can't rent more than three at once - unless they're willing to pay more for five or eight at a time.
Today, the company operates 30 distribution centers around the country, but in the late 1990's, it operated a single facility near San Francisco, so DVD's could spend days in the postal system traveling cross-country. "It wasn't a very consumer-satisfying experience, except in the San Francisco Bay Area," Mr. Hastings said. Now, one of every nine residents of San Francisco is a Netflix subscriber, he added.
It was essential that the company set a national goal; but at the same time, staffing and supplying warehouses around the country, so that more customers could get next-day delivery, proved prohibitively expensive, especially when only one in 10 households owned a DVD player in 2000. Revenues were growing, but Netflix was still losing money at an alarming rate - so much that, although it had raised another $50 million in venture capital in early 2000, the company had less than $5 million in the bank 18 months later.
"It felt at the time very touch and go," Mr. Hastings said. By the fourth quarter of 2001, however, Netflix was enjoying positive cash flow, and in May 2002 the company went public, despite an ice-cold market for new stock offerings.
IN retrospect, Mr. Hastings wishes he had waited longer to go public. By the time the investment bankers were willing to sell shares in Netflix, the company was no longer desperate for the $94 million it ended up raising in its initial public offering.
"In hindsight, what triggered Amazon and Blockbuster to compete with us is they could see how profitable we were and how fast we were growing," Mr. Hastings said. It has also meant that Mr. Hastings is constantly fending off analysts and commentators who are convinced that long-term survival requires that he sell the company to a large suitor to ward off the competition.
Netflix has $175 million in cash and is carrying no debt, Mr. Hastings noted, and it has "no desire or need to be acquired." Mr. Rashtchy of Piper Jaffray is inclined to agree that Netflix can survive, but wondered if independence is the wisest route.
"They can survive on their own, and there's a good chance they will," Mr. Rashtchy said. "They are, after all, the single biggest player in this area, and singularly focused. It's just that they face a very bumpy road on their own."
Wal-Mart was the first large company to jump into the market, in June 2003. The impetus, said Amy Colella, a Walmart.com spokeswoman, was a spike in DVD sales.
"With clearly more and more of customers moving to that format, we decided on a DVD service for our customers," Ms. Colella said.
Wal-Mart operates 14 DVD distribution centers nationwide, and sells a subscription that allows a customer two, not three, DVD's at one time for $12.97 a month. But Mr. Hastings does not seem concerned that the world's largest retailer has entered his market. "They've been in the market two years, but they haven't been pushing it very hard," he said. Ms. Colella disputed that characterization but would not provide subscription numbers.
Mr. Hastings's reaction to Blockbuster's entry into his market has not been indifferent. "Blockbuster has been tremendously aggressive in competing with us," he said. The company has lowered its price twice and now charges $14.99, $3 less than Netflix for the three-rental plan, and Blockbuster's offer also includes two free store rentals each month.
Five years ago, physical stores were considered a huge drawback in the race for online dominance in a given sector. Yet the presence of Blockbuster stores across the country, coupled with the stores' profits that the company is pouring into a television ad campaign, are proving to be critical so far in penetrating the online DVD rental market.
"We think our in-store passes are a clear differentiator for us," said Shane Evangelist, senior vice president and general manager of Blockbuster.com. The company was building its online service for two years before its debut last July. "Being the market leader in rentals, and having the leading brand, we had the luxury to watch as the market developed," Mr. Evangelist said. The company operates 23 distribution centers.
Amazon.com has no operating centers in the United States, but Mr. Hastings said that he was convinced that it was only a matter of time. Last year, Amazon began an online DVD rental business in Britain, though the company has refused to comment on whether it has plans to enter the American market.
"We're just thankful Blockbuster and Amazon didn't enter four years ago," Mr. Hastings said.
Ultimately, video on demand poses the greatest threat to Netflix - a fact Mr. Hastings is inclined to acknowledge. "Our competitors are a bigger threat next year," he said. "But in 10 years, digital distribution is a bigger threat."
The good news for Mr. Hastings - and for executives at Blockbuster, given that the ability to download any DVD via the Internet or cable could inflict even more damage on video stores - is that video on demand is a long way off, despite more than a decade of promises.
"It'll be at least four or five years away, if not 10 years, before we reach the tipping point on video on demand," said Gary Arlen, president of Arlen Communications, a research and consulting firm in Bethesda, Md. One major hurdle, Mr. Arlen and others said, has been Hollywood studios' reluctance to accept a new delivery system as long as DVD's are still proving so lucrative.
Mr. Hastings anticipates that it will be 2010, if not 2015, before a lot of the movie-watching public is downloading films over the Internet. Mr. Hastings is convinced that the same features that draw people to his DVD rental service will induce them to use his service to download digitally delivered movies. Netflix has devoted millions of dollars to building an easily navigated Web site while it refines a complex software system that recommends movies based on customer ratings.
"If we differentiate the Web site well enough, with rating histories and other features consumers want, that's our strategic leverage" once people start receiving movies via the Internet, Mr. Hastings said.
Mr. Hastings is used to people counting him out. "To be doubted and be successful is particularly satisfying," he said.
