In a year when DVD sales are falling and studios are facing major shakeups in their executive ranks, Hollywood is beginning to look a lot like one of its own slasher films, the Los Angeles Times noted recently. Amid all the turmoil, however, there is at least one success story in the movie industry: Netflix.
Founded in 1997, Los Gatos, Calif.-based Netflix made a splash in the movie rental business by offering an online subscription model with a flat monthly fee for unlimited rentals and no late charges. Since then, despite a recession, fierce competition and the emergence of online video delivery, the company continues to thrive. According to experts at Wharton, Netflix is now in a race to transition to a business model focused on streaming content online, while continuing to exploit its current model based on physical DVD distribution via the U.S. Postal Service. "You would think that Netflix would be entrenched in its old model and fighting off digital distribution, but it is embracing the future," says Wharton marketing professor Peter Fader.
While many companies see the need to develop new business models as older, more profitable ones erode, not all of them deftly manage the transition. For years, Netflix has been mailing DVDs to subscribers in its recognizable red envelopes, but in 2008 it introduced a "Watch Instantly" service that allows consumers to stream movies on their home computers. Since then, the company has forged a bevy of partnerships to embed its Watch Instantly service in television sets, game consoles such as the Xbox, Blu-ray DVD players and set-top boxes. In its latest move, on October 26, the company announced a partnership with Sony to deliver its streaming service via Sony's PlayStation 3 game console, nine million of which have sold since it was first introduced in 2006.
Netflix had 11.1 million subscribers through the third quarter ended September 30, up from 8.67 million for the same period a year earlier. The company predicts it will have 12 million to 12.3 million subscribers by the end of the year. For the nine months ended September 30, Netflix reported net income of $84.9 million on revenues of $1.22 billion, up from earnings of $60.3 million on revenues of $1 billion for the same period a year ago. According to Fader, Netflix's low-priced subscription model -- it offers plans that range between $4.99 and $16.99 a month -- has helped to keep its churn rate low (4.4% for the third quarter).
On an earnings conference call October 22, Netflix co-founder and CEO Reed Hastings said the company's goals were simple: Grow revenue, subscribers and earnings while expanding into streaming content. "Of the 115 million estimated households in America, 9.6% now subscribe to Netflix," said Hastings. "In the greater San Francisco Bay Area, which we believe is a leading indicator of Internet behavior elsewhere in America, 21.2% of households now subscribe to Netflix, up 13% from one year ago."
Hastings added that the company expects disc shipments through the mail and its 58 distribution centers "to grow for several more years as video stores close and our subscriber base expands." For instance, Netflix rival Blockbuster, the largest movie rental chain in the U.S., plans to close 40% of its stores over the next two years as it focuses on launching kiosks and its own digital rental service. In a regulatory filing, Blockbuster said that 18% of its stores are unprofitable.
'Netflix Killers'
However, Netflix faces intense competition from companies ranging from Apple with its iTunes service, which rents movies online, to Blockbuster and an upstart called Redbox, a division of Bellevue, Wash.-based Coinstar, which rents DVDs through kiosks primarily at supermarkets and convenience stores. The Redbox plan is simple: It charges $1 a day for a rental. Each kiosk holds between 70 and 200 titles, which are updated weekly. To keep up with growing demand, the company has nearly doubled its outlets during the past year to a total of 17,900 across the U.S. It expects to add another 8,500 this year. According to Video Business, revenues from video kiosks like Redbox will reach $1 billion by 2011.
Like its DVD rental business, Netflix's video streaming model is under fire from powerful rivals. The most significant among these is YouTube, now part of Google's mighty empire, which streams films for free off its Movies channel and competes directly with Netflix's "Watch Instantly" service. To get a sense of the popularity of YouTube's movie service, consider this: In late October, a documentary titled "Home" about climate change had been viewed more than 3.4 million times and more than 13,000 people had commented on it. Another challenger is Hulu, launched in March 2007 by News Corp. and NBC Universal, whom Disney joined as an investor this year. The company is an online video service that provides TV shows and movies from more than 190 content providers.
But it's not as though competition is anything new for Netflix. So-called "Netflix killers" have surfaced repeatedly in the last decade. A significant threat loomed in 2002, when Walmart began an online rental service. However, the retail giant abandoned the project in 2005 after failing to gain traction with consumers. In addition, Walmart launched a movie download business and had to pull the plug on it in 2007 following a dispute over infrastructure with Hewlett-Packard. Now, the company has a cross-promotional deal with Netflix. In 2004, Blockbuster also started an online rental service, but it hasn't been able to stop Netflix's momentum. (Blockbuster does not offer separate sales figures for its online rental division.)
Wharton experts say that Netflix has proven its doubters wrong repeatedly, but it is unclear how the balancing act between the company's old and new business models will play out. "Netflix has won round one with physical distribution of DVDs, but that advantage won't [necessarily] persist" once the game switches to digital distribution, says Wharton management professor David Hsu.
For now, though, movie rental sales figures are playing to Netflix's advantage, Hastings noted during his call. DVD rentals have held up well as consumers opt for cheaper forms of entertainment. According to research firm Digital Entertainment Group, third quarter consumer sales of DVDstotaled $4 billion, down 3.2 % from a year ago, but digital distribution (including on-demand video rentals and other forms of electronic delivery) was up 18% in the third quarter to $420 million. Meanwhile, media measurement firm Rentrak reported that movie rentals were up 9.9% for the quarter.
According to Wharton experts, particular strategies have helped Netflix maintain its lead. These include:
- Keeping one eye on the road and one eye on the turn ahead. "Any company that doesn't keep its eye on where things are going and only focuses on the here-and-now risks having its market disappear," says Kendall Whitehouse, director of new media at Wharton. "Netflix is positioned nicely for when the digital transition comes. It can exploit the current model [distributing physical discs] now and hedge against future technology changes with its Watch Instantly service."
- Employing a subscription model. "One way to define Netflix is by the technologies it uses, but another way to define it is by its business model. Netflix took the per-item rental model and turned it into a subscription model. The 'aha' moment was really charging a subscription for a physical product," says Dan Levinthal, a Wharton management professor.
- Moving quickly to stay ahead. "Some obvious lessons that can be learned from Netflix are: Target a niche and stay flexible," says Wharton marketing professor Jehoshua (Josh) Eliashberg. "Netflix should be commended for moving fast to seize opportunities and technological trends."
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