How Netflix Is Fixing Hollywood By finding a market for niche titles--and keeping discs in constant circulation--the online DVD rental pioneer is shaking up the movie biz.
By Christopher Null

(Business 2.0) – Stu Pollard is your typical indie filmmaker: mid-30s, wide-eyed, earnest, and willing do just about anything to get people to see his movie. Four years ago, Pollard showed his $800,000 film around the festival circuit, to decent reviews. But he couldn't talk any distributors into releasing the romantic comedy, Nice Guys Sleep Alone, to theaters. ¶ Then he got a call from Ted Sarandos, vice president for acquisitions at Netflix, who'd seen it at a festival and liked it so much he bought 500 copies on the spot.

Granted, it was no windfall--Sarandos paid just $1 per copy, about the same as the cost of producing one. But he offered Pollard a cut of each rental for the first year. The 10,000 rentals in 2000 generated sufficient buzz to get Nice Guys a 2001 airing on HBO. And Pollard has already reinvested the $12,000 he's earned through Netflix rentals in his next movie.

Sarandos, for his part, spends most of his days indulging Netflix's voracious buying habit, whether it's 60,000 copies of My Big Fat Greek Wedding or just a few hundred from a director out of film school. But as Hollywood (and Pollard) knows well, the real trick is getting the movies in front of paying viewers. Major film studios have for years dumped staggering quantities of videotapes and DVDs of the most popular films into the biggest rental outlets, hoping that something will stick. Older movies and smaller titles with niche audiences, meanwhile, get relegated to the stacks and the bargain bin.

Netflix is turning that idea upside down by offering a serious market--1 million subscribers and counting--for every movie, not just the blockbusters. How? Part of its success is due to its proprietary software, called the Netflix Recommendation System, which constantly suggests movies you might like, based on how you rate any of the 15,000 titles in the company's catalog. But beyond that, Netflix has figured out how to get DVDs from one address to the next with ruthless efficiency--and without the overhead of the offline world. That's turning the company into Hollywood's most promising new business partner.

In the longer term, success for the $153 million company is hardly assured. Walmart.com recently launched its own version of the Netflix model, has already built six distribution centers for it, and is charging $1.19 less per month for the service. Blockbuster bought another copycat, now called FilmCaddy, and is still debating how to promote it nationally. And, as video on demand from satellite and cable companies takes hold, who wants to hassle with sending discs in the mail?

But for now, Netflix accounts for 3 to 5 percent of all U.S. home video rentals--an astounding figure when you consider that Kozmo.com and other online companies that experimented with video rentals barely got out of the starting gate. And for last year's indie hit Amelie, Netflix says, it generated better than 20 percent of U.S. rentals. Boutique movie studios like IFC Films, which released last year's critical hit Y Tu Mama Tambien, love Netflix because it provides a huge market for movies that can't muster a widespread theatrical release, as well as for those that last only a few weeks on the big screen.

That helps explain why Columbia TriStar Home Entertainment, Dreamworks International Distribution, Warner Home Video, Twentieth Century Fox Home Entertainment, and Universal Studios Home Video collectively own about 3 percent of Netflix stock, and have deals in place that give the studios a small cut of Netflix's rental revenue on their films for the first year after release. Mike Dunn, president of Fox Home Entertainment, says Fox's business with the outfit grew about 30 percent in 2002 and will exceed that this year. The studio's top-performing titles, Dunn says, tend to be those from Searchlight, Fox's boutique film division, which distributes films such as One Hour Photo and Donnie Darko. "Those films found their audience on Netflix," Dunn says. Just three months after its video release, for instance, One Hour Photo was already No. 36 on Netflix's list of all-time top renters.

All of this bodes well, especially given that just four years ago, Netflix was on the ropes, having spent 18 months renting DVDs by mail--to dismal public response--as it tried to emulate the video-store model. Including shipping, a single rental cost more than $4, and you paid late fees if you didn't get the disc back within a week. Netflix tried lowering prices and extending the rental period to two weeks, but in its first year of operations, only 250,000 discs were rented and few customers returned for a second helping.

"It wasn't working. People weren't coming back," Netflix CEO Reed Hastings recalls. In a late-night brainstorming session in 1999, Hastings and his lieutenants hit on the idea of a subscription model, and they launched it that September. Customers could rent as many movies as they could watch for $20 a month, as long as they had no more than three DVDs out at a time.

Since then, the company's growth has been staggering: By December 2000 it was shipping 300,000 discs a week and had 292,000 subscribers. Netflix, which went public in May 2002 (NFLX), has been doubling the size of its subscriber base about every year, hitting the magic 1 million mark in February.

But the spectacular growth is creating unforeseen problems. The company's recommendation software promotes older and independent titles so well that it's threatening to cost the company: Customers are renting an average of 5.5 movies per month, compared with 4.5 two years ago. By encouraging people to rent more films, Netflix is only encouraging more shipping costs, and training its happy users to pig out on the all-you-can-eat DVD buffet.

For Netflix, that means that as many as 3 million discs are in the hands of customers at any given time, with an average of 300,000 DVDs shipped out of the company's 20 leased distribution centers each day. It's the kind of logistics task that makes handling user ratings for 15,000 titles seem like a kid's programming project.

Until recently, managing the ebb and flow of all this was pure chaos: Netflix production workers would spend their mornings checking in discs and returning them to shelves, and their afternoons pulling discs and stuffing them in envelopes to be sent to customers. When inventory costs reached red-alert levels, Hastings asked his engineers to create software that could balance inflow and outgo more effectively.

What they came up with was a system, introduced in January, that dramatically reduces shelf time. Now when discs arrive in the morning mail, operators scan a bar code on each label. The software retrieves the name and address of the next person on the waiting list for that DVD, prints out a label, and ensures that the disc is mailed out that afternoon. (How Netflix chooses this next person has become a thorny subject with customers, after one user's online expose revealed that Netflix bumps the most frequent renters to the bottom of the waiting list for popular titles--another problem triggered by the site's success.) The payoff? Netflix has slowed hiring and reduced labor costs by about 15 percent, and the vast majority of discs never touch the shelf before they go out again.

Netflix's library of discs, now 5.5 million, continues to grow. But the company can't buy nearly enough of some DVDs (such as the wildly popular 8 Mile) to keep everything in stock. It almost never sells used copies, and it doesn't promote new releases either. So it merchandises films from its stock of what's immediately available to ship. That's why Hollywood loves the model: It keeps older titles in motion and gives life to smaller releases. On any given day, in fact, 98 percent of the 15,000 titles in Netflix's inventory are in circulation with customers.

It's a niche Hastings seems determined to further exploit. Netflix has recently announced deals with small distributors like New Video and Seventh Art Releasing, which have made Netflix the premier outlet for numerous hard-to-find DVDs. Among them is a well-received documentary called e-Dreams. Never heard of it? Hastings certainly has. It's about the brief life of Kozmo.com. --CHRISTOPHER NULL