Investors in DVD-rental service Netflix Inc. (NFLX) have been pounded since the July 15 announcement that its second-quarter profits were less than expected -and that Netflix was boosting its marketing budget 10% due to rising online ad rates, a few months after telling analysts it could keep marketing spending steady for several years. Then rival Blockbuster Inc. (BBI) unveiled the test site for its own DVD-by-mail service to directly compete with Netflix, which Blockbuster has been vowing to do for years.
Wall Street changed its mind, overnight, on whether Netflix could deliver the expected quadrupling to quintupling of its profits from 2004 to 2005. Analysts' earnings estimates for next year fell 20% to 30%. It's probably of small solace to Netflix CEO Reed Hastings that on July 22, Blockbuster announced that its second-quarter profits fell 23%, saying earnings would fall sharply through the rest of the year and into 2005 because of soft revenue and $90 million of new capital investment, including heavy spending to compete with Netflix.
BusinessWeek E-Business Editor Tim Mullaney talked CEO Hastings on July 23 about the many challenges facing Netflix. Following are edited excerpts:
Q: First of all, can you explain what Netflix does and what underserved niche in the market you found?
A: We offer a $22-a-month Internet DVD-subscription service. Consumers can rent as many movies as they want, keep them as long as they want. There are never any late fees or due dates. We have incredible selection, tools to help people find great movies, and it has been a cult phenomenon.
Consumers fall into three categories: those who come to us because of better value, those who come to us because we have better selection, and those who come to us because of convenience, because we offer free home delivery. Which one is most motivating depends on the consumer. But we love them all.
Q: On July 15, you announced that second-quarter earnings were light and you that need to boost marketing spending about 10% going forward. What happened?
A: We've been growing at a very rapid rate. Last year we had $270 million in revenue. This year we'll do $525 million to $530 million. So nearly doubling. And most businesses that double experience margin pressure, including ours. However, despite that rapid growth, we've remained free-cash-flow-positive for 11 quarters. And as you mentioned, we're spending about an extra $2 million in a quarter where we expect to do up to $10.2 million in net income.
So how much does that hurt us? It's about 20% in terms of net income. In one sense, it's quite material. In another, it's phenomenal that we're even able to generate net income despite this extremely rapid growth.
Q: Netflix investors were also spooked by the mid-July launch of Blockbuster's beta site. It costs $20 a month instead of your $22. How serious is the threat from Blockbuster now?
A: Well, the reason Amazon did so well against Barnes & Noble (BKS) is that they took the threat from Barnesandnoble.com seriously. And we certainly do take the Blockbuster threat seriously. The difference is that we've got five years of experience. We're shipping nearly a million movies a day, so we've got tremendous operational perfection in what we do. We've had a lot of practice at it. We have overnight delivery to nearly 90% of our subscribers.
We look at it and say at the low end there's Wal-Mart (WMT), which only charges $18.76, for consumers who only care about price. At the high end, there's us, for consumers who want value and a service that really works. And in the mushy middle, there's Blockbuster.
Q: One analyst told us your 2005 profits will fall nearly 50% if you have to match Blockbuster's beta-test price. Will you have to match it? And if not, is Netflix worth the extra $2?
A: Netflix is worth the extra $2 because the service has consistent overnight service to 90% of our subscribers, we have great recommendations, we've got a well-developed and mature site, and the service works extremely well. All people have to do is ask their friends who are using Netflix to see that. We think consumers will prefer the service that is well developed and mature at a slight price premium, which is $22.
Q: Since raising your price, you've said customer defections kept coming for longer than you expected. Do you think churn will resume its pre-June pattern of falling?
A: The more that we improve the service, and every quarter we make a number of improvements, the more customer churn drops. That has been a consistent pattern over the last two or three years. When we increase the price, it causes some customers to leave, but pretty quickly customers select in or out. But what we're trying to build is the greatest movie service in the world. To do that, we really need to charge $22.
Q: Well, what are you doing with the extra $2. And can Blockbuster do the same things without that extra $2?
A: What we're spending it on is more and better content. And Blockbuster is going to find the economics very challenging, because we have the economies of scale. We ship nearly a million movies a day, and Blockbuster is going to start from a very small base. So they're going to have to subsidize that from the general corporate treasury for quite a while.
Q: The long-run question about your business is: What happens when cable and phone companies are ready to deliver video-on-demand?
A: Back in 1997, when we started the business, we named it Netflix, not DVDs by Mail, for a reason. We intend to grow a very large DVD business, then expand and win in the downloading space.
When we started, we thought it would be in three years - that is, by the year 2000. By the time 2000 came, we said, well, it's got to be within three years of then. And now here we are in 2004, and still the downloading and VOD infrastructure has not been built out. So we're constantly waiting for it.
We look at it as a great way for us to have electronic delivery, in addition to DVD delivery. Let consumers choose what they want, mix and match, on a single subscription. We're very much looking forward to that era. Hopefully by 2007 we'll be a major player in that era.
Q: Netflix has said it plans to begin distributing movies digitally next year, but hasn't added much detail. How will your plan work, and how will it be better than what the cable companies do?
A: That's a very exciting vision - about any movie, any time - and we're much more likely to deliver it because of our philosophy about selection and our 25,000 movie titles. We're focused on downloading to your TV, over the Internet, and that's about all we've said to date. The big advantage we have is that mixing it with DVD, customers can get unlimited DVDs and unlimited downloads under one subscription.
Q: Will people need a set-top box, or a TiVo, or do DVD players have hardware that'll let them receive movies over the Net?
A: There's a wide range now of companies bringing the Internet to the TV. There are Wi-Fi DVD players emerging. Most consumer electronics over the next several years will have integrated Wi-Fi. That's really what we see as bringing the Internet to the television.
Q: As VOD gets big, does Netflix stay independent?
A: It's really hard to tell, as you can see from Disney (DIS) and Comcast (CMCSA). People can make offers for your company at any time. We don't try to predict. If you look at the fundamentals, Netflix is really set up to be a stand-alone brand. We're getting big enough to sustain that for a very long time, but again it's not essentially under our control. It's really up to the shareholders of much larger companies, such as Comcast.
Q: The sharpest criticism is that confidence has been shaken in Netflix' management. People wonder if you don't underestimate Blockbuster or VOD the same way you underestimated ad rates. What's the plan for regaining respect from the Street?
A: Steady focus on earnings growth. In our quarterly press release, we actually increased earnings [guidance] for this year. And we're continuing to focus and deliver on earnings. Any time you've got a really innovative business like Netflix, you really have to compare it to America Online (TWX) in the 1994-98 time frame.
We're learning a lot, and it's true we're not as predictable as we and other people would like, and we've got to deal with that. What we are focused on is steady earnings.