Netflix (NASDAQ: NFLX), the leader of online movie rental, had revenue of $997 million and 6.31 million subscribers in 2006 (year end). Netflix revenue increased 45% in 2006, adding $309 million to the 2005 total revenue of $688 million. Netflix ended 2005 with 4.18 million subscribers (year end). An average Netflix subscriber spends about $16 for monthly subscription. Netflix added 654,000 new subscribers during the December, 2006 quarter alone. Netflix business appears to be firing on all cylinders, and is poised to repeat the performance or even surpass it in 2007. It appeared for a couple of years that Netflix will take over the movie rental business altogether. Wal-Mart (NYSE: WMT) tried the online movie rental business, launched it in a huge way, and quietly closed it down, bowing the leadership position to Netflix.
The leader of movie rentals, Blockbuster Inc. (NYSE: BBI) was nowhere to be found. Until recently. Blockbuster was once thought finished. Netflix single-handedly created the online movie rental business, a new category killer that caused total disruption in the movie rental industry. Netflix business epitomizes disruptive innovation. Netflix, the disruptor, went up against the market leader, the sustainer, Blockbuster, and carved out a huge bite of the movie rental business. Blockbuster was caught napping. Blockbuster did not know how to respond to the Netflix business model of mail-order movie rental. Blockbuster tried many models of its own by luring customers to the thousands of Blockbuster stores. However, the customers enjoyed the flexibility of renting movies online at Netflix, where they could browse the catalogs in the comfort of their own homes, read reviews, choose the movies to rent, and submit the order online. The movies arrived within a few days, by which time the customer has already viewed the previously rented movies multiple times. Customers simply shipped the movies back in a pre-paid postage return envelope. No trip to Post Office necessary. All for a monthly subscription of about $20 (which is now $17.99).
Blockbuster, the established leader of movie rental business had it made with over 5,000 stores in the U.S and over $5 billion in revenue in 2001. The movie rental business was in a status quo, with hundreds of thousands of customers going to Blockbuster stores, choosing the movies (or video games) by browsing around the stores, and renting the movies one at a time. Blockbuster required a paid membership to rent movies, and the business model was pay-per-rental. Blockbuster grew by creating local stores, and the topline revenue growth was tied to the number of new store openings. The incremental business per store was flat or tapered (Blockbuster tried selling movies and games, previously rented movies, and other movie add-ons without a tangible upside). Customers essentially paid anywhere from $2 or higher to rent out the movies. Customers were used to this model, and rivals such as Hollywood Video and local movie rental stores offered similar business models. The business model of pay-per-rental had a huge drawback: Late fees. Most customers forget to deliver the movie back within one day or two days, and ended up paying extra day charges (some even argued these late fees from time to time). Late fees were a sizable percentage of Blockbuster business; hence, there were no real plans to change the business model. Other drawbacks included not finding the movie you want to rent (it's already checked out), and the high cost of rental of a new movie. The customers quietly rented from Blockbuster, frustrated by the late fees, but content to rent (there were no viable alternatives). No one could really match the presence, the size, the selection and quality of Blockbuster. And Blockbuster was getting bigger each year, to the tune of $6 billion plus in annual revenue in 2004.
Enter Netflix
Netflix attacked the pain point of Late fees head on. Netflix introduced "No Late fees". The customers loved this. No more frustration of paying a late fee if you forget to return the movie on time. You simply return the movie when you are ready to return in a postage pre-paid envelope. And the icing on the cake: unlimited Movie rentals. Albeit up to three movies at any given time. The only limit was really the time it took for movies to ship from Netflix warehouses and arrival at your home. If you are into watching lots of movies, you can essentially time your orders so that you can end up watching fifteen or more movies each month. All for a low monthly subscription fee. Netflix essentially emulated a monthly service fee business model similar to a telephone company. And Netflix made it simple to rent online. Of course, Netflix had no stores, i.e. physical stores. Netflix was completely an online movie rental business, similar to a mail order business. Netflix also reduced the pain points of knowing which movies to rent ahead of time, without making a trip to the store. For instance, if a movie was rented out, Netflix customer simply had to put that movie on the wait list. And as soon as it became available, it was automatically shipped out. Finally, the cost per movie rental became somewhat cost-effective - especially if you watch at least half a dozen or more movies each month. When Netflix entered the movie rental business, Blockbuster and others scoffed at the whole online business. However, Netflix became hugely popular, and movie rental buffs from college dorm students to teenagers, adults to families, became Netflix loyal customers. To the tune of 6.31 million subscribers as of December, 2006. Netflix created a $1 billion movie rental business from nothing. Netflix disrupted the likes of Blockbuster, whose businesses essentially stalled or were in a free fall, became unprofitable, and even closed.
The second coming of Blockbuster
Netflix served notice. And Blockbuster business came under attack. However, Blockbuster, like a tried and tested champion, held up. Blockbuster tried many business models, eliminated late fees, introduced two for one rental, provided incentives to renters, and even introduced unlimited on-premise rentals. However, the business was spiraling down, and customers kept leaving the stores. Blockbuster even had to close stores, and put plans on opening new stores on hold. However, it did not succumb. Eventually, Blockbuster got it right. Blockbuster realized that it was in a unique position to address the customers on its given strength: store locations. However, in order to captivate the online movie renters, Blockbuster also needed to create an online business. With a twist. Blockbuster provided movie renters the best of both worlds - rent online or rent at the store, rent online and return to the store, rent at the store and return online (possibly), rent online and return online. Whereas Netflix only provided customers one service model: rent online and return online, Blockbuster now had the flexibility and delivery model to offer customers tremendous flexibility and choice. All for a monthly subscription fee which is the same as Netflix's monthly subscription. In retrospect, this innovation from Blockbuster made perfect sense. And now it was simply a matter of time before customers returned. Blockbuster became aggressive in the marketing, including the recent promotion inviting Netflix customers to rent movies on President's Day (when post offices are closed), and over the weekends. Also, asking customers to bring in their Netflix return labels for free rentals (with a membership). Blockbuster is appealing to the emotions of customers with the message that you can rent a movie on the weekend, when there's no mail or "just when the mood strikes" - providing a "freedom of choice" and not having to wait for movies as they arrive in the mail.
Blockbuster's new Total Access provides customers unlimited movie rentals, online or in the store. Blockbuster ended 2006 with 2.2 million subscribers and revenues closing in on $7 billion (to be announced next week). Importantly, in the last quarter of 2006, Blockbuster added 700,000 subscribers, beating Netflix by about 55,000 subscribers. Blockbuster's Total Access Model has the momentum. With timely promotions such as President's Day promotion, and Valentine's Day (where Blockbuster offered a list of favorite movies for the special occasion), Blockbuster is capturing the mindshare from movie renters.
Netflix answers back
Netflix Chief Executive Reed Hastings, in a Marketwatch story, told analysts after the recently concluded earnings call "that the company expects to see a modest increase in subscriber cancellations in the first quarter of 2007 as rival Blockbuster Inc. aggressively markets its new Total Access program, which enables its online customers to either return DVDs through the mail or exchange them at stores for free in-store movie rentals."
Hastings believes though that "Blockbuster's impact on its subscriber base should decrease in the second quarter." He added that Netflix observed a similar pattern in 2005, when Blockbuster cut its monthly subscription price and heavily marketed that move. In that case, Blockbuster "had already captured in [the first quarter of 2005] the few consumers most likely to switch," Hastings said.
The very fact that Blockbuster added more subscribers than Netflix's in the latest quarter has to make Netflix rethink their strategy. Netflix recently introduced the long-awaited plan to offer movie and TV downloads over the Internet. "Our accomplishments during the year -- strong subscriber growth, continued improvement in the customer experience, and increased profitability -- together with the recent launch of the first generation of our online video option, leave us better positioned than ever to achieve our long-term objective of being the movie rental leader," Hastings said in a press release.
Winner Takes All?
Who will be crowned the winner of movie rentals? Would it be Blockbuster whose stock price has appreciated more than 80% in 2006, and importantly, has finally figured out the appropriate formula: Blockbuster Total Access. Or would it be Netflix, who has found time and again to improve upon its business model, and has shown ability to innovate with the recently announced online movie downloads? What about Apple (NASDAQ: AAPL) with the iTunes Movie download service available to the millions of iPod owners and iTunes subscribers alike. Apple recently added 150 movie titles from Lions Gates (movies including "Saw", "Basic Instinct", "Dirty Dancing - Havana Nights") to the iTunes store, and is poised to grow the online movie business. Wal-Mart has re-entered the online movie rental business as well offering its own version of online movie downloads in partnership with the major movie studios and powered by HP (NYSE: HP). Finally, Amazon.com (NASDAQ: AMZN) has also recently expanded the Unbox online movie download service. Amazon.com and TiVo Inc. (NASDAQ: TIVO) recently announced "Amazon Unbox on TiVo," a soon-to-be-launched service feature that will provide TiVo subscribers with the ability to rent and purchase movies and television shows from leading studios and networks. There is also the DVDPlay rental kiosk service available at the local grocery stores through a station similar to a vending machine and providing DVD rentals for less than $1.30. And then there are all the cable operators and satellite TV operators coming up with various options to rent movies as well. The entire movie rental industry has many players vying for the top spot. If the online movie download business takes off, it can cause yet another disruption in the movie rental industry - in the same vein as what Netflix did earlier. It's only a matter of time before Blockbuster will offer its own online movie download service as well. Why not? Offer the customers all the choices, simplify the business model, and make it extremely easy for customers to rent a movie through any of the available mediums: in the store, online through mail, online through immediate download or directly through cable or satellite. Perhaps Blockbuster is in the best position to address this changing market of movie renters and movie rentals worth $25 billion dollar annually and growing. Perhaps no one player is.
References:
Blockbuster Press Releases, Quarterly and Annual Earnings reports
Netflix Press Releases, Quarterly and Annual Earnings reports
Marketwatch
Top Ten Innovations for 02-14-07
The Innovation Index
Disclaimer: I invest in the stocks comprising The Innovation Index, beginning in 2007.
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