Dvd Video Net Rental Takes Off

An upstart California company that rents DVDs over the Internet—without imposing late fees—is starting to give traditional video stores a run for their money.

Although the company, Netflix of Los Gatos, Calif., still has a small share of the rental market, it is turning heads by offering online ordering, a wider selection, a subscription rental plan and free home delivery.

And it is all happening at a time when the DVD is revitalizing the home video marketplace.

"We seem to be growing the market rather than taking share away," Netflix CEO Reed Hastings says.

The DVD and the online rental concept both emerged as market factors in the late 1990s and have grown together.

In fact, Netflix's success has prompted other retailers, including Wal-Mart and Blockbuster, to explore similar online rental options.

Mass merchant Wal-Mart launched its walmart.com DVD rental store last October (Billboard, Oct. 26, 2002). And rental giant Blockbuster recently acquired the online rental site film caddy.com, formerly called dvdrentalcentral.com.

Though Blockbuster has entered the online rental fray, spokesman Randy Hargrove says the area is "a limited business opportunity" for the chain. "Consumers spent more than $8 billion on rentals last year in the U.S.," he says. "They spent less than $200 million renting movies online."

A Movie Gallery representative would not comment on whether the the chain has plans for online rentals. Calls to Hollywood Video were not returned by press time.

A number of other retailers, including Best Buy and Tower Records, do not have any online rental plans but are keeping close watch on this sector, according to company representatives.

An abundance of smaller online DVD rental sites are also operating, including cafedvd.com, dvdavenue.com, dvdbarn.com, dvdovernight.com, qwikfliks.com and solodvds.com.

Netflix, which launched in 1998, has grown into the largest online renter of DVDs, with a 5.5% share of the total DVD rental market and more than 90% of the online market, according to New York-based research firm Alexander & Associates.

POTENT PATENT

Although competition is building, Netflix may have some potent weapons in its quest to maintain market leadership.

In addition to being the first to establish itself as a significant online rental brand, Netflix was recently granted a patent on its rental subscription model (Picture This, Billboard, July 12).

The patent covers the entire rental process, including such elements as the return envelopes used in each transaction.

Netflix is still determining how to wield this patent. "We are just studying our options," Hastings says.

The odds are likely that this will not be a "sword of Damacles over the industry," says Bo Andersen, president of the Video Software Dealers Assn. (VSDA). "Sure, it could potentially be used as a market-clearing device, but nobody wants to stunt the growth of online rental in general."

Andersen believes Netflix will be willing to license the core elements of its patent to other sites "at very reasonable terms."

Netflix and other subscription plans address the most common customer complaint about traditional rentals: late fees.

Consumers annually fork over more than $1 billion in late fees to brick-and-mortar stores, according to Hastings.

"The subscription plan is the master stroke of the online rental mechanism," Andersen says.

Netflix users pay $19.95 a month for an unlimited number of movies. They can rent up to three titles at once from its selection of 15,000 offerings. More than half of Netflix customers are guaranteed one-day delivery based on their proximity to the Netflix distribution centers. The company currently has 20 distribution points in the U.S.

As Netflix has grown, it also has increased its distribution centers and implemented a "queue" feature for consumer selections.

At walmart.com, consumers can choose from one of three subscription plans—for $15.54, $18.76 or $21.94 a month—which allow for two, three or four discs to be rented at a time. The site carries 13,000 titles and promises two-day deliveries for 93% of the country.

Blockbuster's filmcaddy.com also offers up to four films at a time for $19.95.

"The Internet allows for a good technology solution to avoid the late fees and overcharges that make video stores their money," says Matt Sevick, manager of Wal-Mart's DVD rentals division. "We wanted to present an honest and fair way of bringing people movies."

Brick-and-mortar stores are just beginning to get into subscription plans.

Blockbuster has been testing a store-based subscription model called the Freedom Pass since last summer in six markets and 700 stores. Customers can rent as many movies as they want, keeping two or three at a time, for about $25. Fees vary in the different test markets.

Similarly, grocery chain Albertsons has launched a rental subscription plan at more than 800 stores in California; Portland, Ore.; and Seattle. The plan costs $19.95 per month.

Most in-store subscription plans are still in the test phase, as retailers determine customer interest and the financial impact of decreased late fee revenue. More than 10% of a store's gross rental revenue can be earned from late charges, according to the VSDA.

Studios also are looking for alternatives to traditional video rentals. Buena Vista is testing Flexplay's limited-play, EZ-D discs in August in a few markets nationwide (Billboard, June 7).

The disposable discs use a chemical process that enables play for only 48 hours, eliminating the need to return them to the retailer.

"We are looking forward to seeing how the test does," notes Matt Lasorsa, senior VP of marketing for New Line Home Entertainment.

"Each new development will hopefully incrementally broaden the category as opposed to cannibalizing it. This could be a boon to us. We have an obligation to try to meet consumer needs," he adds.

RENTAL MILESTONES

Increasingly, the consumer is opting for DVD rentals, whether online or from traditional stores. DVD hardware sales have grown steadily since the format's debut in 1997, and players are now in more than 50 million U.S. households, according to the DVD Entertainment Group.

For the DVD rental business, a number of milestones have been reached of late.

For the first time, consumers rented more DVDs than VHS cassettes for the week ending June 15, according to the VSDA (Billboard, July 5). DVD rental revenue also surpassed VHS revenue for the first time in the week ending March 16.

The VSDA reports that U.S. consumers spent $2.22 billion renting 692.3 million DVDs in the first half of 2003, a 71.1% increase over the first half of 2002. The total rental market for VHS and DVD in the first half was $4.34 billion, a 3.5% increase over last year's mid-year total.

While VSDA's Andersen was unable to provide figures detailing how much DVD business comes from online rentals, he is certain that online rental spending has added a healthy nudge to the industry's totals.

"Going forward, we're going to be able to identify the amount of turns in online rentals," he says.

What can already be identified is the growth of Netflix. The company generated revenue of $152.8 million last year.

Netflix launched its initial public offering in May 2002 and posted its first profitable three-month period in second-quarter 2003. CEO Hastings further reports that revenue for 2003 is expected to hover around $255 million. Netflix stock, which is traded on the Nasdaq market, closed July 22 at $24.70, up from $11.45 on Jan. 1.

Although these numbers are impressive for a 5-year-old start-up, they are no competition to the big brick-and-mortar companies.

The 1,800-store Hollywood Video chain, for example, had $389.4 million in revenue during the second quarter alone, a 13% increase over last year. In the first quarter, the 1,678-store Movie Gallery generated $168.6 million in revenue, a 37% increase over last year.

Meanwhile, Blockbuster, which has more than 8,500 company-operated and -franchised stores, totaled $1.39 billion in revenue in the second quarter, a 9.5% increase over last year's second-quarter total of $1.27 billion.

PERSONAL LINKS

If other online rental companies are going to expand or join the business, customer-friendly features will be critical.

Walmart.com and Netflix users make lists of the movies they would like to view. Netflix calls this a customer's "queue."

Customers are automatically sent other DVDs listed in their queue after they return previous rentals to Netflix by mail. Netflix also recommends DVD titles based on customers' queue preferences. It sends out about 30 million personal recommendations daily.

Video suppliers praise this feature, because it can drive traffic to catalog or lesser-known titles.

"With a studio like us that has smaller titles mixed in with big ones, it helps create awareness for titles that are direct-to-video or theatrical titles that didn't see the light of day," New Line's Lasorsa says. "These titles would get lost on a shelf in a brick-and-mortar store."

Netflix has taken this even further with its recent launch of Netflix First, a program designed to expose customers to films they may not otherwise see.

Their first partner in the initiative is Docurama, a documentary film label. Four Docurama projects are being made available at Netflix in an exclusive window before they are distributed elsewhere.

"This is sort of the equivalent of opening a film in New York, Los Angeles and Chicago and getting the critics to create a buzz," says Steve Savage, president and co-founder of New Video, the parent company of Docurama. "Netflix sees the big picture; they know this isn't going to make or break their business plan. It will help them serve their customers better."

Despite its success, Netflix says it is not tied to its mail-order model.

"In the long term, we plan on offering our consumers the choice of getting their DVDs by mail or DVDs downloaded to their computer," Hastings says. "That won't be until at least a few years from now, but it is just a matter of time."

Blockbuster is also searching for a way to combine online and in-store rentals.

"We believe the real win for Blockbuster customers may be a fully integrated store and online combination," Hargrove says.

"This approach would allow our customers to rent online or in one of our stores and return their movies by mail or to a store. They would have the flexibility to rent either through a subscription program or a single transaction."