Victor Dricks thinks he's got a jump on the future. Tired of waiting for "video on demand" to arrive at his Gaithersburg townhouse, he bought a fancy home theater system in March and signed up to get his movies by mail -- an unlimited number of DVDs for $19.95 a month from an online rental club called Netflix.
"Now I watch things I never would have considered before because it's so convenient," said the 48-year-old, who works for the Nuclear Regulatory Commission. "I am making my way through the original "Avenger" series from the 1960s. I'm also watching all the old Humphrey Bogart films and Jimmy Stewart films."
Dricks is among the 670,000 people who subscribe to Netflix, a Los Gatos, Calif., start-up that had its initial public offering of stock in May and is being hailed on Wall Street as a new way of delivering movies that packs more punch than it might initially seem.
Perched at the confluence of big changes in the movie industry, Netflix has lofty hopes of boosting movie viewership at home and helping little-known films get wider distribution. Over the past year it has more than doubled its membership, partly because of its convenient mail-order model.
But the club is also riding the back of bigger trends in home entertainment, many of them spurred by the DVD itself. With digital technology, a skinny disc that costs only 37 cents to mail across the country can hold not only a feature-length film but also a host of extras -- the theatrical trailer, perhaps, plus deleted scenes and directors' commentary. Prices are falling on DVD players and the big-screen TVs that often share space with them. And then there's the Internet's ability to store and analyze people's movie tastes on a mass scale.
While high-speed Internet access is taking longer to reach most American homes than pundits predicted, delaying the advent of movies-on-demand, DVD players have become one of the fastest-selling products in consumer electronics history. More than a third of U.S. households now have a player, and people are buying, as well as renting, more DVDs than analysts expected. The upshot is new viewing habits that Netflix is trying to exploit.
Netflix works like this: A subscriber such as Dricks keeps a running list of movies, in the order he wants to watch them, at the service's Web site (www.netflix.com). Netflix sends him three DVDs, then mails the next title on his list every time he returns one. Each disc arrives at Dricks's house inside a prepaid mailing envelope, which he uses to return that movie. He keeps three at a time, for as long as he likes, with no late fees. Turnaround in the D.C. area has been running from one to three days since May, when Netflix opened a 12,000-square-foot distribution center in Gaithersburg.
"At $20 a month, I calculated that if I watch at least five movies a month it's break-even compared to the cost of renting movies from a video store," Dricks said. "I'm watching at least two or three a week and sometimes more."
If movies-by-mail is such a hot idea, why isn't the King Kong of movie rentals stomping its giant feet all over Netflix's tiny tracks? Because Blockbuster Inc., with 48 million active customers and nearly 8,000 stores, doesn't see a payoff in a mail-order system that could bypass its costly stores and yield less profit than the operation that helped it claim nearly 40 percent of home movie rentals. And, in fact, Netflix remains unprofitable, having lost $6.5 million on $36.5 million in revenue in the second quarter. For the past year, Blockbuster repeatedly pooh-poohed movies-by-mail as a "niche" business, saying it may be nice for a minority of Americans who don't live close to a video store but serves little purpose for most folks, who rent movies spontaneously and typically watch them the same day.
That's not to say Blockbuster is sitting still. The rental giant acknowledged that America's instant love affair with DVD players is changing the economics of home movies when it announced two weeks ago that it will move aggressively to expand beyond rentals into DVD sales, going disc-to-disc against such leading retailers as Wal-Mart, Best Buy and Circuit City.
Blockbuster, a subsidiary of Viacom Inc., is also hedging its bet on rentals. Two weeks ago it rolled out an in-store version of a DVD subscription service in four trial markets, with its national release tentatively slated for September. Blockbuster's new "DVD Freedom Pass" resembles the all-you-can-watch part of Netflix, only it costs $5 more a month and involves customers picking up and returning movies at stores.
But maybe not for long.
"One of the things we are actually going to be testing in our stores in the not-too-distant future is a prepaid mailer," Blockbuster chief executive John Antioco told analysts in a July 24 conference call. "We don't know whether there is going to be a huge demand for that product."
Others in the movie-rental business are wondering the same thing, including Columbia House, which does a huge mail-order business selling music and movies to millions of club members.
"We are exploring the rental market," said Brian Wood, president of Columbia House, which got its start as a rental club 20 years ago before switching to the purchase model. "We have been impressed with Netflix. I have to admit I am impressed with their ability to generate subscriptions -- 670,000 for a whole new business model is a lot."
No Blockbuster Beginning
One man who seems tickled to have the movie-rental king skeptical about his tiny operation is Reed Hastings, the 41-year-old serial entrepreneur and multimillionaire who founded Netflix.
"The longer Blockbuster doesn't take us seriously, the better for us," said Hastings, adding that Blockbuster's in-store subscriptions could validate the monthly-fee concept in the minds of many consumers.
Sitting at a folding table in the lunch room of his Montgomery County warehouse, hidden behind a junky-looking auto sales lot in a remote area outside Gaithersburg, Hastings sipped coffee and likened Blockbuster's view of mail-order movies to the way Dunkin' Donuts executives must have viewed Starbucks when the Seattle retailer introduced upscale coffee as a lifestyle business.
"They said, 'Who is going to do a $3 coffee just because you put steamed milk in it? That's ridiculous,' " Hastings said with a grin. "Well, we are as different from Blockbuster as Dunkin' Donuts is from Starbucks."
Hastings believes that by filling key psychological needs, Netflix can expand a seeming niche into a big global business, much the way Starbucks did. "We cater to people who are more 'convenience-centric,' " he declared. The appeal, he said, lies in not having to drive to a video store, being able to choose from twice the movie selection most video stores offer, and being able to create personal viewing lists and get custom recommendations online.
And, of course, in the lack of late fees. Hastings loves to talk about how he got the idea for Netflix when he was late returning "Apollo 13" and got socked with a fat fee. The story, mentioned in most of what has been written about Netflix, makes for a great marketing weapon against Blockbuster, which rakes in big dough -- $795 million in 2000, around 15 percent of revenue, though now down to about 10 percent -- when people miss their due dates. (And in what seemed like a nod to Netflix, Blockbuster last week lengthened its standard rental window for all rentals except new releases by two days, to seven.)
But the truth is, Netflix didn't start as a subscription service, much less an all-you-can-watch one. It launched in April 1998 as a traditional pay-per-movie rental store, its innovation being that it took orders on the Internet and sent DVDs by mail. Industry analysts credit Blockbuster's decision the next year to start stocking DVDs as the catalyst that pushed Netflix into subscriptions. DVD players were so new, why risk letting purchasers choose Blockbuster stores over the Internet as their primary source for content? So late in 1999 Netflix introduced a monthly fee of $14 that let people get four rentals in the mail.
It went further in 2000, introducing the first unlimited-title rental service at $19.95 a month. Members could keep four discs at once, one more than its standard plan today, and watch as many as they could handle. (Netflix also offers more expensive plans now, up to eight discs for $40 a month.) At the time he announced the first all-you-can-watch plan, Hastings declared he was changing the rules of renting in the hope of spurring more movie viewing, much the way America Online boosted Internet usage when it abandoned time limits for online access.
Like AOL, Netflix has grown fast partly because of shrewd pricing and marketing moves, and also by presenting itself as a convenience for mainstream Americans. Even though he's a techie with an engineering background, and president of the California Board of Education, Hastings oozes Silicon Valley entrepreneurial smarts. After all, this is his second time around the IPO block. Back in 1997 he made a killing when he sold his first publicly traded company, a maker of software-development tools called Pure Software, for $700 million.
Computerizing Rentals
Hastings's roots in software are on display in his Gaithersburg distribution facility, which looks like an empty airplane hangar with the vast majority of space unused. On one side is a tidy row of 12 workers clad in screaming-red T-shirts, each sitting at a desk holding a Dell computer with a label printer and a scanner attached.
The operation looks primitive but is subtly clever. Each morning, about 12,000 DVDs get returned to the center in red envelopes via the U.S. Postal Service. Each worker rips open a stack of 1,000 envelopes over the course of a few hours, scanning in a code imprinted on each label to identify the title and who rented it.
When the workers go to lunch, their computers transmit all that information back to headquarters in California via a high-speed Internet link. There Netflix's main computers log each disc into a central database, identify the subscriber who rented that movie and move the next available title on that person's list to the top of hisqueue.
The central computers then beam the name of a customer waiting for each disc back to the same work station where the disc was scanned in the morning. So when a Netflix worker sits back down after lunch and re-scans each of the 1,000 discs he opened that morning, his Dell computer spits out the name of the customer who wants that disc and prints a mailing label on the spot. The worker slaps the label on a new envelope and pops the DVD in, and the cycle begins again.
Hastings's team created software to manage the distribution system so it's integrated with what customers see on the Web site. Netflix also wrote software that works like Amazon.com's book recommendations -- it compares the movies each person watches, and rates, with the likes and dislikes of thousands of others who rented the same titles. It then presents titles in the order the computer thinks each subscriber will like, customizing almost every page as users browse movie genres.
"If you decide to look at action movies, the benefit is that you won't have to wade through 3,000 titles to find one you like," said Neil Hunt, vice president of e-commerce.
By presenting different movie titles to different customers, Netflix aims to get wider distribution for its large library and do more efficient marketing for lesser-known movies. Using its five-star rating system, subscribers so far have rated movies more than 100 million times on the site. The more they rate, at least theoretically, the more Netflix knows about their tastes.
The Personal Touch
But not everybody cottons to this idea. In fact, some customers said they aren't even aware of the personal touch, partly because the Web site doesn't do much to explain it. Others are indifferent.
"I don't pay any attention to what they recommend," said Lawrence Lee, a 47-year-old computer specialist in Gaithersburg. He and his wife have been using Netflix for several months and primarily like its wide selection and mail delivery.
Carol Duncan, a 57-year-old postal carrier who lives in rural Dillwyn, Va., 70 miles west of Richmond, said she has little use for the recommendations. She finds the long lists of "ancient movies" -- to her, anything that's not a new release -- especially annoying.
Duncan and her husband also wish Netflix would deliver movies faster. While the service can be speedy in urban areas (Netflix opened 10 regional distribution centers this year), Duncan says delivery to Dillwyn hasn't improved since the Gaithersburg facility opened. While she's entitled to three titles at once, often she has none or only one.
"I want to get my money's worth if I'm paying $20 a month," she said. "Otherwise my husband and I will just watch pay-per-view movies on our DirecTV system."
But Martin Kane, a trade show manager in Bowie, said he and his wife generally get their replacements within two or three days of returning one. Occasionally they have to wait for their top choice. "We have been waiting for a while for 'All the President's Men,' " he said. "That apparently is a hot rental for older movies."
Indies Score Big?
In the long run, Hastings predicts one impact of Internet mail-order rentals will be a bigger audience for niche films. Most movies made today never get past screenings at a film festival, if they're that lucky.
But consider "Nice Guys Sleep Alone," about dating woes of thirtysomethings, which reaped attention at the prestigious U.S. Comedy Arts Festival. It got a six-month run at Hollywood Video, then probably would have disappeared into the dead-film zone had a Netflix buyer not picked it up. "There is a demographic that film appeals to, and we promoted it to that demographic," Hastings said. "We have rented it to over 10,000 people."
Largely as a result, a flick by a total newcomer got picked up by other video retailers and is now airing on HBO and Lifetime.
"The biggest challenge any independent film faces is finding its audience," said Stu Pollard, who wrote and directed "Nice Guys Sleep Alone." "Netflix helps bridge that gap with their ratings and recommendations."
Pollard also believes that the ability of computers to recall and sort personal movie tastes will boost the number of films people watch at home. That, after all, was the original promise of video-on-demand -- watch what you want, when you want. And it may turn out that the U.S. Postal Service, coupled with the DVD format, proves more efficient than the Internet at fulfilling that promise for years to come.
But it's not only rentals that are at issue. Industry observers say sales of DVD movies are also skyrocketing, and it's not clear whether this will help or hurt the rental market. Either way, it suggests a wave of change in movie-viewing analogous to what happened in music when compact discs replaced albums and cassette tapes.
Before CDs, consumers typically bought five albums or tapes a year, Columbia House's Brian Wood recalled. Afterward, they began splurging on about 10 or 11 CDs annually. "We are seeing the same thing with VHS and DVDs," he said. "There is almost a doubling of household purchasing."
Wood said Columbia House has spent time studying why people seem to want to own DVDs more than videotapes.
"I think it's partly the fact it's the same medium they have their music and computer stuff on, and it's a cool silver disc that's easily stored," he said. "But my personal theory is people buy because it's an emotional connection with the movie."
One question facing Netflix may be how many people will switch from renting their movies in stores. Merrill Lynch analyst Justin Baldauf recently wrote that Netflix has a shot at grabbing a market share of 5 percent or more, roughly comparable to that of Amazon.com in books, but a far cry from Blockbuster's 40 percent. The other question is how to hold on to subscribers once they've gone through their 50 favorite movies. Exactly how deep into filmdom's backlist will regular folks be willing to go? If Carol Duncan, the postal carrier, is any measure, maybe not so deep.
After two years of its unlimited-rentals model, Netflix's churn rate -- the rate at which people drop out -- went from 7.2 percent in the first quarter of 2002, when all of its DVDs were still mailed out from the West Coast, to 6.7 percent in the second quarter. Any churn is bad -- it means people don't like what you have to offer -- but Netflix's rate isn't bad for a monthly subscription plan.
To survive, Netflix needs fewer dropouts and more customers like Dricks, the Gaithersburg movie buff.
"It's displacing my TV watching," Dricks said of the red envelopes he rips open several times a week. "It adds an element of surprise. The other day I got a documentary on Cleopatra in the mail and I thought, good, that will break up watching 'The Avengers.' "
Media
