Netflix Wins First Round in DVD Rental War

By Gina Keating

When the head of Netflix Inc. said rival Blockbuster Inc. threw "everything but the kitchen sink at us," the world's largest video rental chain responded by sending him ... a kitchen sink.

The message from last January's interchange was clear: Blockbuster, with $6 billion in 2004 revenue and 5,500 domestic stores, intended to own online DVD rental, an $8 billion industry pioneered by Netflix.

"This year was about Blockbuster taking a run at us," Netflix Chief Executive Reed Hastings told Reuters at the company's Beverly Hills offices. "They chopped price. They emptied their balance sheet."

But despite Blockbuster's costly offensive, Hastings said Netflix was on track for net subscriber additions of 1.5 million for 2005 for a total of 4.1 million -- the midpoint of its target range.

Meanwhile, Blockbuster, which has been roiled by management and debt problems, saw the subscriber base at its 16-month-old online service stall at 1 million.

Chief Executive John Antioco told Reuters that Blockbuster Online was "proud of what it has accomplished in 2005 with over 1 million subscribers in over a year after it was launched."

Antioco had threatened earlier this year to leave the company -- and take a $54 million severance package with him -- during a proxy fight launched by dissident investor Carl Icahn.


The companies also switched places in market value over the course of an intense, yearlong price war, with Netflix -- which has no debt -- now worth $1.5 billion, compared with Blockbuster at $684 million and more than $1 billion in debt.

"Online rental is the only thing we do, and (our) advantage is focus and desperation," Hastings said. "So we have nowhere to go, right? It was win or die, and that's very focusing."

Citigroup, which initiated coverage of Netflix this week with a "buy" rating, said the company "should put added pressure on in-store rentals, causing more locations to close.

"This creates a chain reaction that should further help (Netflix) sign new subscribers, as consumers increasingly find themselves having to travel farther to find an in-store rental location," the Citigroup note said.

Citigroup put a $39 price target on Netflix shares, which now trade in the $27 range. A year ago, Hastings had seen the price plunge from $39 to $9 on his decision to run at break-even and spend heavily to quickly add subscribers.

The company plans to maintain this approach for at least the short-term.

"We're feeling confident of another strong quarter," Hastings said. "We're investing very heavily in marketing this quarter. Our view is that a very aggressive marketing investment now will help widen the competitive gap between us and Blockbuster."

Netflix is testing lower prices in all its subscription plans to see if the resulting subscriber growth makes up for the reduction, he said.


Despite holding $182 million in cash, Netflix has no plans to go shopping in the coming year, Hastings said.

"You (make) acquisitions if your current market does not look like it has enough room for you to grow, and our current market look enormous," he said.

Growth will come at the expense of stores operated by Blockbuster, Movie Gallery Inc. and smaller chains, Hastings said. These companies saw their collective rental revenue decline by nearly 12 percent in the third quarter, prompting them to accelerate store closings.

Netflix itself has had setbacks. The appearance of Blockbuster Online and the threat of Inc. entering the U.S. Internet rental market forced Netflix to halt its expansion into the United Kingdom.

The company also had to withdraw its plans to launch a limited online delivery service for movies because of problems obtaining licenses for films from Hollywood studios.

The competitive landscape improved in May, when Wal-Mart Stores Inc. got out of online DVD rental and agreed to direct its subscribers to Netflix for rental services.

As for Amazon, whose online video rental presence is limited to the UK, Citigroup agreed with Hastings that Netflix's growth and market dominance are increasing the barriers to entry in the United States.

"It was the shortest, most intense competitive squall that I have ever seen," Hastings said. "The last thing on my mind was walking away from it. I would have ridden it down to the very bottom, still fighting."

Copyright 2005 Reuters Limited.

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