Small Business

Netflix


Truly ambitious web startups think of making money merely as a starting point. Real respect goes to companies that change the rules of the game. And few upstarts this side of Google (GOOG). have grander ambitions than Netflix Inc.

The online DVD-rental service is one of Hollywood's hottest stories, and it's still in the first reel. In 2005, Netflix' profits doubled, to $41 million. Revenue climbed 36%, to $688 million. The company's shares rose 157% in the 12 months through Apr. 28, all of which helped Netflix nab the No.29 spot on the Hot Growth list. A giant bottle of champagne sits in the lobby of Netflix' Los Gatos (Calif.) headquarters, to be opened any day now when the company announces its 5 millionth subscriber. This year, Netflix executives expect revenues to reach at least $990 million. Meet the next billion-dollar dot-com.

THINKING BIG.But CEO Reed Hastings is thinking much, much bigger. The 45-year-old engineer is committed to hitting 20 million subscribers between 2010 and 2012. That's nearly 20% of U.S. households. And he doesn't buy the idea that Web movie downloads will wipe Netflix out -- not with studios protecting the 60% of film revenue that comes from DVD sales and rentals. “Any great investment has at its heart a contrarian thesis...and ours is that DVD will dominate for a decade or more,” says Hastings.

Nevertheless, Hastings is hedging his bets by expanding Netflix into niches that will help it maintain an edge as new rivals emerge. He's positioning it as a film investor and source of high-quality content -- like Home Box Office for DVD rentals. He also wants to be a player in Web distribution, which it will launch by yearend even though Hastings thinks the market for downloading will be tiny for years.

Mind you, plenty of people don't think Netflix can pull all this off. Adams Media Research President Tom Adams says the market for Netflix-style rentals, where most consumers pay about $18 a month for all the movies they want, will crest at around 13 million U.S. households. Adams says many consumers rent on impulse, and Netflix makes them order ahead. And Blockbuster has also dabbled in film investing, to little effect. About 25% of Netflix shares have been sold short by investors, most of whom are betting that movie downloading will clobber the mail-order phenom.

BYE-BYE, BLOCKBUSTER.Right now, though, it's Netflix that is causing angst for Blockbuster and Movie Gallery, which lost a combined $1 billion last year. Pressure from Netflix, which doesn't charge late fees, led Blockbuster to drop most late fees last year, costing it about $400 million. Hastings' small, tart dig at Blockbuster: His cubicle sports a big chart of his rival's cash-flow collapse.

To position itself for the future, Netflix has stepped up its efforts to buy distribution rights to independent films. Depending on the deal, Netflix can show the films in theaters or on pay cable, or sell and rent DVDs. Chief Content Officer Ted Sarandos says Netflix' Red Envelope Entertainment group, named for the packaging the company uses to mail DVDs, has bought rights to 90 movies in the past year. It has also hired 30 executives, including a former chief financial officer of Miramax Film Corp. The group's impact is small now, but if Netflix gets closer to 20 million subscribers, it could be “a real disruption in an industry that's increasingly safe and homogenized,” Sarandos says.

Despite mainstream demographics, with the average customer an over-35 woman with family income of $75,000 or less, only 30% of Netflix rentals are new releases. At Blockbuster, it's 70%. Instead, Netflix builds audiences for movies Hollywood often won't take a gamble on: Sarandos says 85% of films even at festivals like Sundance don't get distribution. Netflix' support helps tiny films find bigger audiences, and is starting to drive arty studio fare. Hotel Rwanda drew 3 million people to U.S. theaters, but has been “Netflixed” 2 million times.

Netflix uses data to make decisions moguls make by gut. The average user rates more than 200 films, and Netflix crunches consumers' rental history and film ratings to predict what they'll like. The idea borrows from Oakland Athletics General Manager Billy Beane: In his book Moneyball, Michael Lewis showed how Beane pioneered in-depth use of statistics, rather than relying on scouts' intuition, to decide whether prospects can play. “It's Moneyball for movies, with geeks like Reed looking at movies as just another data problem,” says Netflix board member Richard N. Barton.

FILMMAKERS' FRIEND.Data mining also helps Netflix decide what to pay for hard-to-market movies. When it bought DVD rights to Favela Rising, a documentary about Rio de Janeiro musicians, Sarandos knew 1 million customers had rented 2003's City of God, also set in Rio. About 500,000 picked Oscar-winning documentary Born Into Brothels, and 250,000 saw both. So Netflix paid a fee based on 250,000 rentals. If it does better, producers and Netflix split the upside. A similar deal lets Patricia Heaton and David Hunt, whose documentary, The Bituminous Coal Queens of Pennsylvania, debuts on Netflix June 6, dream of a million-rental audience. “Netflix is some of the best news for filmmakers in a long time,” Heaton says.

Netflix hopes a rep as the cool auteur's friend will build an army of loyal customers before its download service competes with Apple Computer (AAPL), Yahoo! (YHOO), or Comcast (CMSCA). Even foes respect the strategy: One likely rival's CEO says Netflix' early start should keep it at No. 1 or 2 even as big boys get in. Lest anyone forget the size of Hastings' ambition, consider this: Every conference room at Netflix is named for a movie. The board meets in the King Kong Room.


Steve Ballmer, Power Forward
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