By Ellis Mnyandu

NEW YORK (Reuters) - In a bid to cash in on the booming popularity of DVDs, Wal-Mart Stores Inc. WMT.N , the world's top retailer, said on Tuesday it has begun testing an online service that would allow customers to rent DVDs for a monthly subscription fee of $18.86.

The service, which mirrors that of Netflix Inc. NFLX.O , comes as more and more Americans switch from VHS tapes to DVDs, which among other benefits, allow users to navigate programs more easily and experience vivid pictures and crisp sound.

Using feedback gathered from an initial group of customers, Wal-Mart said it would fine-tune its DVD rental service before rolling it out nationwide next year.

Wal-Mart already sells movie tapes and DVDs at its stores but up until now had not rented them. During the test period only a limited number of customers will be able to sign up for the service, in which users order DVDs online and receive and return them via prepaid mailers.

Wal-Mart spokeswoman Cynthia Lin said customers would be able to rent up to three DVDs at any one time -- the same as Netflix -- under the subscription agreement. The DVD rental service, which some analysts have been speculating for several months was in the works, would initially be targeted only at Wal-Mart's domestic U.S. customers, she added.

Year-to-date, DVDs account for some 33 percent of the home video rental market, up from 15 percent last year and poised to grow, according to the Video Software Dealers Association.

DVD players are now also selling for as low as $59 compared with about $200 in 2000, making the newest technology a hit with consumers.

COULD TAKE TIME

Even though Wal-Mart's size is expected to give the retailer clout in negotiating with studios to source stock, one analyst said the new service could take time to garner a huge following since Netflix is regarded by many customers as an experienced player in the industry.

Moreover, analysts say Los Gatos, California-based Netflix has also been working hard to cut down rental turnaround times to about four days compared with around 14 days seen through last Christmas.

Nonetheless, Dennis McAlpine, an analyst at McAlpine Associates, said Wal-Mart would in the end prove to be a formidable challenge to Netflix once it gets its act together.

He said Wal-Mart's other advantage could be its pricing power, since the retailer can cut prices at any time, a step seen likely to lead to price wars. Wal-Mart spokeswoman Lin said the retailer would "continue to work to lower the price."

"I wouldn't want to be Netflix, with a 500-pound gorilla chasing after it," McAlpine said. "The good thing right now is that Netflix has (years) of experience," he said.

Netflix, founded in 1998, rents DVDs from its Web site for $19.95 per month, and the company recently added 10 regional distribution centers to cater to growing demand.

As with Netflix, customers of Wal-Mart's new DVD rental service would pay only the monthly subscription and would not be charged late return fees or postage, Wal-Mart said.

It said customers would choose from a library of more than 12,000 titles, similar to the number Netflix says it carries.

"Certainly, Netflix had expected some competition but Wal-Mart can be a formidable competitor head-on," McAlpine said. He added that major players such as Blockbuster Inc. BBI.N , Hollywood Entertainment Corp. HLYW.O and Movie Gallery MOVI.O appeared not be in Wal-Mart's line of fire just yet.

Wal-Mart shares were up 3.5 percent or $1.90 to $56.05 in afternoon New York trade, while Netflix gained 22 cents or about 2.9 percent to $7.70 on the Nasdaq stock market, amid a general upward trend in stock prices.