Netflix vs. the Hollywood Studios

In the paranoid precincts of Hollywood, a question has been making the rounds: Is Ted Sarandos friend or foe?

Sarandos is the content chief at Netflix (NFLX) and one of the studios' most devoted customers. Each year, on behalf of his company, he buys an estimated $240 million worth of DVDs that Netflix then mails out to its subscribers. All was going well until Sarandos last year cut a deal with Starz, the movie channel, to stream Walt Disney (DIS) and Sony (SNE) films, including Ratatouille and Spider-Man 3, to subscribers' PCs, Web-connected TVs, and game consoles. For an industry that jealously protects its right to license movies to the highest bidder, the move amounted to an end run.

Why would Sarandos risk angering Hollywood? Because Netflix, having prospered in the DVD rental business, needs to position itself for a future when viewers will be able to watch any movie or TV show they want instantly on their PC, TV, mobile phone, game console, or tablet. Netflix has a powerful brand and slick streaming technology. But to stay relevant the company needs access to much more of the studios' digital content. Otherwise Netflix could be overwhelmed by deep-pocketed rivals—from the cable companies to (AMZN), Google (GOOG), and Apple (AAPL) to the studios themselves.

Lately, Sarandos, 45, has been shuttling between Hollywood power lunches, film festivals, and awards dinners, telling anyone who will listen that Netflix is not the enemy but a bridge to the future. "Don't forget, the studios have fought every form of home entertainment," Sarandos wrote in an e-mail to Bloomberg BusinessWeek. "And TV and DVDs have become their largest sources of revenue and profits."

Hedging Bets

Netflix's 11-year-old DVD-by-mail model has already transformed the movie rental business. And Sarandos, who has worked for Netflix since 2000 and last year pulled down a $1.1 million salary, played a big role in the company's success. It was Sarandos, working from a Beverly Hills office, who persuaded the studios to allow Netflix to buy DVDs for much less than, say, Wal-Mart Stores (WMT). The cut-rate deal allowed Netflix to offer subscriptions for as little as $8.99 a month and grow into the largest mail-order DVD renter of its kind. This year Netflix is on track to earn some $111 million on sales of $1.67 billion, a 22% gain over 2008. Its stock is up 90% this year—partly on rumors that Amazon or Apple might buy the company. CEO Reed Hastings says he expects to be mailing out DVDs 20 years from now.

That hasn't prevented Hastings from hedging his bets, however. Three years ago Netflix launched Watch Instantly, an online service on its existing Web site. With a couple of mouse clicks subscribers can watch a limited selection of movies and TV shows right away rather than wait for them to arrive in one of Netflix's trademark red envelopes. The company says 42% of its 11.1 million subscribers have tried the service, twice as many as last year. Still, Netflix does not disclose how often its customers use the streaming service, and analysts believe that it is tiny next to the DVD business.

To turn the service into the real deal, Netflix will have to build a compelling online library. Right now Watch Instantly features only 17,000 films and TV shows, compared with Netflix's 100,000 or so titles on DVD. And apart from the few Sony and Disney films Netflix got from the Starz deal, the selection is dated. Thomas Lesinski, Paramount Digital Entertainment's home entertainment chief, wrote in an e-mail that he lets Netflix stream older titles "but not new releases."

One Movie, Many Sales

That's because the studios don't want to blow up a business model that allows them to sell the same movie over and over in various formats and venues. Typically, films move from cinemas to stores, to cable and satellite pay-per-view, to premium channels like HBO, then to basic cable and broadcast—with the studios cashing in at each step. Plus, having watched the implosion of the music and newspaper industries, the studios are moving cautiously online. "Everybody views it as a terminal career decision if you get it wrong," says Frank Biondi Jr., a former Viacom (VIA) president and CEO who now works for WaterView Advisors, a New York private equity firm.

Before Sarandos can persuade the studios that Netflix is a safe place to stream their movies, however, he has some serious diplomacy to do—and not just because of the Starz deal. Studio executives partly blame cheap rentals from Netflix and its ilk for cratering their retail DVD business. In August, Warner Brothers (TWX) said it would stop selling its DVDs to video subscription services like Netflix until 28 days after it sold them to retailers like Best Buy (BBY) or Wal-Mart unless they paid more for the discs. Hastings has said he might accept the 28-day rule but won't commit until the two sides negotiate the price. If Warner and Netflix cut a deal, other studios likely will follow suit.

Persuading the studios to let Netflix stream more recent films will be a lot harder, however. The studios are willing to do so—but there's a catch. Warner Brothers and other studios want Netflix to accept the same deal Hollywood has with the cable companies. They charge about $4 each time someone watches a new movie and then kick the studios 65% to 70% of the take.

Bargaining for Unlimited Streaming

Hastings and Sarandos aren't likely to bite, because Netflix subscribers are used to getting cheap all-you-can-eat subscriptions. Would you pay $4 to stream a film when you can watch as many as you want for $8.99 a month on DVD? The arithmetic doesn't add up.

Sarandos declined to discuss the talks with Warner Brothers. But his position is plain. He is offering to write big checks up front for the right to stream movies as often as people want to watch them. "What everyone else is asking the studios to do is 'give me your content, and if I do a really good job of putting it in front of the right people and I sell ads for the right prices, then I'll give you half,' " Sarandos said in an interview. "What I'm saying is, I'm paying what Showtime will pay you, and there's no reason not to do this deal with me."

Sarandos does have a bargaining chip that the studios like even more than a $100 million opening weekend: plenty of cash. He has been going around Hollywood making the point that Netflix will pay the U.S. Postal Service $600 million this year to ship DVDs to subscribers. "I'd love to be paying that to the studios," says Sarandos. "That's real money. But I have to get the content."

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A Red Envelope's Journey

Netflix' 58 distribution centers process approximately 2.2 million DVDs per day. USA Today reporter Jefferson Graham toured a sorting facility in Fremont, Calif., this summer to watch the intricate ballet between man and machines.

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