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MAY 20, 2005
By Robert D. Hof Netflix 1, Wal-Mart 0 That's one less competitor for the DVD rental pioneer. But Blockbuster and Amazon still loom Is the tide finally turning for Netflix? For the past two years, wave after wave of competitors had threatened to capsize the DVD rental-by-mail pioneer. Retail giant Wal-Mart Stores (WMT ) entered the market with prices that undercut Netflix (NFLX ). So did Blockbuster Entertainment (BBI ), which has quickly amassed nearly 1 million subscribers. And e-tailer Amazon.com (AMZN ), which opened a rental service in Britain last year, hinted that it might create its own U.S. service, too. Now it looks like the competitive storm is dying down -- on the surface, at least. On May 19, Wal-Mart abandoned ship, turning over its DVD rental service to Netflix and promising to promote its service in return for links advertising DVD sales on Walmart.com. "It's great to have the world's largest retailer as a partner," says Netflix Chief Executive Reed Hastings. He got the deal rolling during a dinner last January with Wal-Mart Chief Marketing Officer John Fleming, who handles the company's online operations. That's not all. Just the day before, Blockbuster announced it's testing higher prices for its online rental service, which currently undercuts Netflix's $17.99 monthly fee (for three DVDs at a time) by about $3 a month. And its aggressive move into DVD rentals by mail could get short-circuited by top shareholder Carl Icahn, who has recently said he wants Blockbuster to cut costs and focus on the basics. MINIMAL IMPACT? Still, it's not smooth sailing yet for the six-year-old Netflix -- and investors know it. After lifting the stock as much as 17% in early trading May 19, Netflix ended up just 4%, to $16.13 a share -- still far below its high of $39.77 early last year. The reason: For the short term, anyway, the company's situation hasn't changed that much. "Neither of these announcements does much for Netflix," says Dennis McAlpine, managing director of McAlpine Associates, a market researcher in Scarsdale, N.Y. "The impact will be minimal." Why? For one thing, the benefit from the Wal-Mart deal won't extend much beyond the elimination of what has proved to be a minor competitor. McAlpine estimates that the world's largest retailer had less than 100,000 DVD rental subscribers. That's a pittance next to Netflix's 3 million-plus, which is why Netflix says it doesn't expect any material impact from the deal. What's more, it still faces some pretty potent competitors, both real and potential. Chief among them: Blockbuster. The chain has said it will invest $170 million this year in its online-rental operation. And while Icahn has indicated little willingness to spend on such new initiatives, for now Blockbuster's aggressive pricing remains in force. "I don't think BBI is less dangerous -- maybe more, as they feel like they have to be more aggressive with their customer acquisition and pricing strategy," writes First Albany Corp. analyst Jason Avilio in an e-mail to BusinessWeek Online. SMALLER RIVALS. And Amazon is still looming. It's not saying when, if ever, it will offer a DVD-rental service in the U.S., and the exit of Wal-Mart is a powerful statement that it's tough to start from scratch in the face of Netflix's momentum. Even so, that may well spur Amazon to forge a partnership instead, perhaps with Blockbuster. That might present an even more powerful enemy for Netflix. Netflix also faces challenges from below. A startup called Peerflix, for instance, lets individuals swap DVDs for 99 cents a trade, avoiding the need to build costly distribution centers and a huge library of DVDs, as Netflix has. "For us, every household in America is a distribution center," says Peerflix CEO Billy McNair, whose company has 25,000 DVDs in circulation compared with Netflix's 40,000 different titles. "The capital efficiency of a peer-to-peer model is real obvious." STILL SEEKING PROFITS. But no doubt about it, Netflix is sitting prettier today. Wal-Mart's exit reveals how much of a headstart Netflix has, and how its hold on the market is stronger than skeptics thought. And its first-quarter results indicate that it's managing to keep pace with Blockbuster. As a result, even though Netflix had a first-quarter net loss of $8.8 million, its sales rose 54%, to $154.1 million, and subscribers jumped by 56%. "We're continuing to invest heavily," says Hastings. "But we've seen our business grow steadily for the past 20 quarters." The big question is when Netflix's progress will pay off with consistent profits. Avilio estimates that if the new competitive environment could allow Netflix to raise its monthly fees by $2, that would improve profits quickly, by $96 million a year. But he thinks it will be next year before Blockbuster would raise prices broadly. So as far as Netflix has come, it has a long way to go before Reed Hastings can catch his breath.  Hof is BusinessWeek's Silicon Valley bureau chief Edited by Ira Sager
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