Showtime for Netflix
Reed Hastings, CEO of the online DVD-rental service, is facing competition from the biggest, baddest retailers around. His plan to survive: Be like Dell.
By John Heilemann

(Business 2.0) – When I first met Reed Hastings in 1998, he had recently founded Netflix, but his main identity in Silicon Valley was as the first CEO of the lobbying outfit TechNet. I wasn't sure TechNet was remotely useful, and I'm still not sure today. But I couldn't help having a soft spot for Hastings, an eager-beaver type with a neatly trimmed goatee, who had just sold his company, Pure Atria Software, for three-quarters of a billion dollars--and was now prattling on earnestly about education reform. In the Valley, the gulf between business and politics had long been seen as unbridgeable. Yet not only did Hastings have his feet in both worlds, he didn't seem to consider it a stretch. He struck me as slightly bent. Which is why, as I say, I liked him.

Hastings's political adventures have put him in the news lately: In January his reappointment to the California Board of Education was torpedoed by his fellow Democrats in a row over bilingual education. But nasty as that scrap was, it's nothing compared with the battle that lies ahead for him on the Netflix front. After years of essentially having the field to itself, the pioneering Web-based DVD-rental firm is suddenly facing formidable rivals such as Blockbuster and Amazon.com. The conventional wisdom loudly declares that Netflix is toast. But Hastings has some wisdom of his own on his side, and he also has a plan. It's enough to keep those of us rooting for Netflix from writing off the company just yet.

It's hard not to root for Netflix, really, even if you're not one of its devoted, even cultish, customers. It's among the tiny handful of Internet upstarts that managed to thrive in the depths of the dotcom meltdown. In 1999, Netflix introduced the subscription service that's been its engine ever since. For a flat monthly fee, subscribers could order as many movies as they wanted, up to four at a time, and keep them as long as they wanted. With no due dates, no late fees, titles rarely out of stock, and movies usually arriving by mail in a day, the Netflix service was screamingly superior to in-store rentals. And it took off accordingly. In 2004, subscribers grew from 1.5 million to 2.6 million, and churn was virtually nil.

As Hastings points out, "What you have here is a $500 million market growing 100 percent a year. And any market that big, growing that fast, is bound to attract competitors." The first to take on Netflix was Wal-Mart, which began offering online DVD rentals in June 2003. Then, last summer, Blockbuster dived in, sinking a whopping $100 million into its fledgling service. And now, finally, comes Amazon, which in December waded into the British market--a move seen as a test run for an American service, probably launching midyear.

"You've got the biggest rental company, the biggest e-commerce company, and the biggest company, period," Hastings observes. "So if it's true that you should be judged by the quality of your competitors, we must be doing pretty well." Maybe so, but you wouldn't know it by looking at the company's performance on the Nasdaq. In the past year, Netflix's stock price has fallen from nearly $40 to just above $10, and roughly half of its traded shares are currently sold short.

The size and savvy of Netflix's new competitors aren't the only factors fueling this pessimism. There's also the particular form the competition is likely to take: a price war. In a bid to preempt Amazon's U.S. play--which that company has yet to announce--Netflix cut the price of its primary subscription plan by $4 to $17.99 in November. A few weeks later, Blockbuster slashed the price of its main plan by $2.50 to $14.99. (It also eliminated the dreaded in-store late fees that drove many customers to Netflix in the first place.) Who will make the next move? How low will they go? It's impossible to say. But the pricing trend is undeniable, irreversible, and ominous for all concerned.

Hastings admits that price wars suck, especially with firms bigger and better capitalized than your own. But he sees the looming battle as a "classic case where our competitors have size, but we have focus." The asset behind that advantage is the Netflix subscriber base, the size of which gives the company what Hastings believes is an insurmountable lead. In a word-of-mouth-driven industry like online DVD rentals, growth is an increasing-returns phenomenon: The more satisfied customers you have, the more new ones you get a shot at. And also the more cost-effective it is to invest in new features--for example, Netflix Friends, a service that lets users share movie reviews and recommendations with each other.

Of his company's new rivals, Hastings fears Blockbuster most. After two years in the market, he says, "Wal-Mart hasn't made a dent." And he wonders if Amazon is really willing to spend on the scale required to keep up with Blockbuster, let alone catch Netflix. He notes that Netflix currently has 30 distribution centers, which allow it to reach 85 percent of its customers overnight. Blockbuster has 23 centers and plans to build more. "If Amazon is serious, they'll do the same," Hastings says. "If they don't, they won't be competitive." For Amazon, he adds, DVD rental is "just another potentially interesting market," whereas for Blockbuster, "it's the core of their franchise--they're highly motivated."

But Blockbuster faces a quandary. As it spurs a price war online, it is, in effect, turning its own in-store customers into less profitable Web-based ones. (Similarly, Blockbuster's bottom line is already suffering from the end of late fees.) Hastings argues that Netflix is better equipped to handle such dynamics. "After five years in business, our systems, software, and processes are highly tuned, so we can quickly break even on rapid growth and low prices," he says. "Our favorite analogy is Dell, which makes money on prices that no one else in the industry can profit from."

Another analogy Hastings is fond of involves Amazon and Barnes & Noble--in which Jeff Bezos's firm secured an early lead, ran like hell, and was never overtaken. Yet this analogy suggests to me that the rival that Netflix should truly fear isn't Blockbuster (read Barnes & Noble) but Amazon: another purebred Internet firm, with a vast user base, experience moving small packaged goods (including DVDs) efficiently around the country, and "systems, software, and processes" that are as finely tuned as Yo-Yo Ma's Stradivarius.

However aggressive Amazon turns out to be, the pillars of Hastings's strategy are rapid growth (he's aiming for 4 million subscribers by year's end and 20 million by 2010) and relentless innovation. Sometime this year, Netflix and TiVo will unveil a Web-based movies-on-demand service that--though Hastings downplays its short-term significance--may help both companies define the all-digital future of the industry.

Or maybe not. Maybe Netflix will be crushed or, more likely, bought (perhaps by Amazon itself). But for a guy supposedly in dire straits, Hastings's calmness and clarity are striking. He's scrappy and free of delusions. And now that he's been, as he puts it, "excommunicated from politics," he's also free of distractions. "All my energies now will be devoted to Netflix, and I'm happy about that," he says. "Over the last five years, politics was sometimes satisfying, but Netflix has been pure joy."

Unless Hastings is a masochist, the next five years will likely be less purely pleasurable. But if he manages to outrun his rivals, he'll erase any doubts that, in addition to being a really nice guy, he's an executive to be reckoned with.

Competition in Store

This year Netflix could be facing off with the largest video-rental company, retailer, and e-commerce site. Hastings is counting on Netflix's early lead in DVD rentals to match their advantages.

[*] Estimated. Sources: Blockbuster; Netflix; Business 2.0 research