Netflix girds for price war for online DVD rentals

SAN FRANCISCO

The future suddenly looks shaky for online DVD rental pioneer Netflix Inc. -- a plucky home entertainment upstart that managed to hold its ground after retail giants Wal-Mart Stores Inc. and Blockbuster Inc. invaded its turf.

Convinced Amazon.com Inc. is ready to join the fray, Netflix is girding for a fierce price war that figures to make or break the Los Gatos-based company.

Netflix is betting an upcoming 18 percent reduction in its monthly service fee will lure millions of new subscribers, extending its reign as king of online DVD rentals even though its profits are expected to disintegrate amid the stiffer competition.

Investors aren't nearly as confident.

Netflix's stock has plunged 75 percent during the last nine months, reflecting fears that the 5-year-old company is destined to become another dot-com pipe dream.

Many industry analysts now view Netflix -- with 2.2 million subscribers -- as a prime takeover target, with Amazon and Yahoo Inc. shaping up as the most logical suitors.

The company's chief executive, Reed Hastings, brushed off the possibility of a takeover, saying his company is focused on achieving its new goal of quadrupling the $500 million online DVD rental market over the next two years.

"We don't feel particularly vulnerable because Netflix is a strong, independent company. We feel very confident about our future," Hastings said. "The next year will be painful for investors, but great for consumers."

Inside information

Hastings's prediction is based largely on inside information that convinced him that e-commerce leader Amazon is ready to duplicate Netflix's approach to DVD rentals.

Netflix's rental service requires customers to pay a monthly subscription fee to create a personal account so they can make DVD rental requests online. Customers receive two, three, five or eight titles at a time through the mail, depending on their subscription plan. The system allows customers to keep the DVDs for as long as they want, with no late fees, before each disc is mailed back in a postage-paid envelope supplied by the company. When a disc returns, Netflix mails out the top title on the customer's wish list, if it has that title in stock.

Seattle-based Amazon declined to comment on its plans, though company spokeswoman Patty Smith said that many of the retailer's customers have encouraged the company to launch a DVD rental service.

Hastings expects Amazon to launch its service sometime in the next six months.

When Wal-Mart and Blockbuster made their move into the market nearly two years ago, Netflix barely flinched. Netflix even raised its monthly three-DVD subscription fee from $19.95 to $21.95 about four months ago.

The Amazon threat, though, prompted Netflix to backpedal and lower that fee to $17.95 effective Nov. 1.

Netflix expects to remain barely profitable as the company slugs it out in its bid to reach 4 million subscribers by the end of next year. Hastings figures the short-term financial sacrifices will pay off in the long run.

Like many tech entrepreneurs, Hastings expects the home entertainment market to shift to a delivery system that will send digital movies over the Internet. That probably won't happen for another five to 10 years, Hastings estimated, but when it does he wants Netflix to have 10 million to 20 million subscribers so the company has a mass audience that will appeal to movie studios.

Netflix must first survive a potentially brutal fight with bigger companies.

Dallas-based Blockbuster already is undercutting Netflix by lowering the monthly subscription fee for its online rental service from $19.99 to $17.49, effective today. The recent repricing leaves discount king Wal-Mart in the unusual position of having the niche industry's highest subscription fee at $18.76 per month to check out up to three titles.

Amazon's vast online audience -- the retailer attracts about 40 million visitors during its busiest months -- gives it a significant financial advantage over Netflix because it probably won't have to spend as much money to find subscribers, said Piper Jaffray analyst Safa Rashtchy.

During the first nine months of this year, Netflix spent an average of $36.06 to sign up each new subscription.

"Amazon is going to be a much different animal than Blockbuster, which came into the market as a wounded, old-line merchant," Rashtchy said. "And while Wal-Mart has been a case study in how to build a successful business, they have almost been an embarrassing failure online."

Rashtchy believes Amazon might be better off trying to buy Netflix than in developing its own DVD rental service.

That's because Netflix already has accumulated valuable expertise, as well as a network of 29 DVD warehouses scattered across the country to ensure DVDs arrive in customer mailboxes with a day or two of a video return. What's more, Netflix's market value has slipped to roughly $650 million, down from more than $2 billion in late January.

"If Amazon is really serious about this market, it makes sense for them to buy Netflix," Rashtchy said. Amazon declined to comment about its potential interest in Netflix.

Yahoo, flush with $3.1 billion in cash and eager to build upon its own base of 7.6 million subscribers, also might be interested, Rashtchy said. A Yahoo spokeswoman, Joanna Stevens, declined to comment.

Hastings says it's difficult to predict what will happen next, but he is reasonably certain about this much: "The video stores in America soon will be vacant and the land grab in the online DVD market will be in full fury."