Tuesday, August 27, 2002

Netflix Revisited

The DVD rental company Netflix is back in the news, with strong revenue growth and 600,000 customers paying $20 per month. I wrote a piece about the company 18 months ago for Inside Magazine, which follows:

Here's how it used to work for me. Thursday afternoon, after school, my kids would say, 'Let's rent some videos.' I'd say, 'O.K.' We'd walk downtown and pick out two videos for them, one movie for my wife and me. The kids would always find time to watch at least one of their videos, although I was rarely as diligent. Then we'd all get busy with our weekend lives. Friday would become Saturday. The movies would finally get returned on Sunday night or Monday morning (through the door slot). And the process would begin anew, except that now I owed $10.79 in late fees. For some reason, it was always $10.79 or $13.05.

As it turns out, I am a fairly typical in-store video rental customer. Turns out, in fact, that 20 percent of Blockbuster's video and DVD rental revenue comes from late fees. Blockbuster does $4 billion in revenue every year. You do the math. It's a joke, except it's not. It's true.

Here's how it works for me now. I go to the Web and click onto netflix.com. I enter my password and browse through the world's largest collection of DVD movies (over 9,000 titles). Netflix employs intelligent collaborative filtering software, so the site actually makes movie recommendations that are helpful. And the more you use the service, the better the collaborative filtering works. In addition, the site employs a staff of 30 movie writers who provide capsules and reviews of each and every title. I order three movies.
They arrive through the U.S. Postal Service. Because DVDs are lightweight, the cost of mailing them is 34 cents. Each one arrives in a pouch that contains a 'business reply' stamped envelope. After you finish watching the movie, at your convenience, you simply pop it into the return envelope, drop it into any mailbox, and it is returned. No late fees, ever.

If you are like me, you have a list of movies 'in the queue' at Netflix. The moment the company receives a return, it immediately sends you the next movie in your queue. Because I am on the $19.95-a-month plan, I can have three movies out at any one time (customers who pay a higher monthly fee can 'hold' more movies). If I return two at the same time, upon receipt of them Netflix immediately ships me two more.

And that leads to what might be called the Netflix moment: the moment you get hooked. You've just sent two movies back to Netflix after a particularly rainy weekend. You've got a busy week ahead of you. You forget all about movies. You go about your business. And then you come home from work on a Friday night and there, in your mailbox, is the Netflix pouch, with a really good movie inside. And you think to yourself, great.

Netflix junkies are everywhere now. The company has 300,000 members, paying $20 a month, and by the end of this calendar year Netflix ceo Reed Hastings expects that number to reach 500,000, putting the company in the black. By the end of next year, Hastings expects the number of Netflixers to double again. And after that, well, who knows? In 2003, Netflix might no longer be just an Internet rental service. It might be a broadband movie distribution channel as well.

Hastings' confidence is based largely on escalating demand for DVDs. As the cost of DVD players collapses (as it has), the number of households with DVD players multiplies. DVD households doubled last year, will likely double again this year, and then double again next year. This rapid adoption curve is made steeper by the fact that Sony's PlayStation 2 and the Microsoft Xbox (scheduled to be out this fall) are DVD players, as well as game consoles. So, in millions of households, there won't be one DVD player, there will be two (at least).

As a result, Netflix is sitting right on the crest of a wave. It's the undisputed leader in the Internet DVD rental 'space' at exactly the moment that DVD technology is taking off. And it's causing in-store video/DVD rental businesses to change tactics. Blockbuster, for instance, recently introduced a plan that allows you unlimited DVD rentals for $20 a month, but still imposes late fees. The $4-billion behemoth is running ads about this offer everywhere. Blockbuster even took out billboard space on buses in Los Gatos, California (where Netflix is based), to send a message, as George Wallace used to say. The Netflix boys got the message, but took it the wrong way. They were thrilled. It told them they were doing everything right. And they chuckled about all those parents paying all those late fees on all those Blockbuster DVDs. By the end of this year, there will be a number of Internet service companies making money on the Web. Netflix will likely be one of them. The question is this: what makes Netflix so unusual? What did they do right that so many others did wrong?

For starters, it raised a ton of money ($109 million from institutional venture partners and other funds). It entered into smart strategic partnerships with almost everyone in the movie and consumer-electronic business. And it built a first-rate management team. But there are six other, less obvious, reasons why the company flourished as virtually everything around it crashed and burned.

1. It understood its customers. The key factor in American life today is time or, rather, the lack of it. Time is what baby boomers, especially, value most. Companies that save time, that deliver the goods, that simplify things, that eliminate annoyances like late fees, add value to their customers' lives.

2. It understood the technological context in which most of its customers live. There's a theory, especially among out-of-work dot-com types, that the reason the dot-com sector crashed is because the bandwidth wasn't there. That's one way to look at it. Another way to look at it is: what in the world made them think it would get here quickly? Netflix understood, as Yahoo and aol and Amazon understand, that most of us live in a 56K-modem world. It didn't offer to stream videos to your disk drive. It built its service to match the capabilities of the existing technology.

3. It did one thing, and it did it well. Amazon would be profitable today if it just sold books, movies and music. Priceline would be profitable today if it just sold airline tickets. Companies based on digital technology get in trouble when they get ahead of what they can realistically do for their customers. Netflix rents DVDs over the Internet, period.

4. It appreciated that back-end technology is more important than the front end. There's nothing particularly special about the Netflix Web site. It's not at all 'cutting-edge' on the screen. What is cutting-edge is the back end: the collaborative software that personalizes every screen, the digital 'assembly line' that processes shipments and returns, the e-mail system that tracks your order and informs you of its progress in brief messages.

5. It recognized the difference between word of mouth and buzz. Buzz is the equivalent of push technology. Media tell you what's cool, what's happening. Word of mouth is the equivalent of peer-to-peer technology. People you know tell you what works. Vast amounts of money were spent creating buzz and the net result was, you couldn't discern the signals from the noise. Netflix didn't spend anything on buzz. It only recently hired a public relations firm. It grew by word of mouth.

6. In an interactive environment, it understood that branding is interactive. Did anyone ever go to Go.com? I saw a hundred advertisements and a thousand banners for it, and I never went there, ever. Go to Netflix or Amazon, and you want to go back, often. That's what branding is about on the Internet, coming back for more.

These days, no one writes stories about successful Internet companies. The manic-depressive media have proclaimed them doomed. Many of them, including many owned by the manic-depressive media, are just that. But companies like Netflix that understand their customers and technology, aren't doomed at all. They're just getting started. Ask Blockbuster.