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Netflix Script Spells Disruption

 
3/22/2004
Netflix revolutionized how people rent movies. Now Wal-Mart and Blockbuster are scrambling to catch up. Who gets the happy ending? From Strategy & Innovation newsletter.

Renting movie videos has become a form of entertainment so mainstream that most of us forget it was once a classic disruptive innovation, undermining all sorts of entertainment-field incumbents in the process. Now yet another marketplace battle is taking shape within this niche, this time between Blockbuster, the movie-rental giant and former disruptor, and Netflix, an online DVD-rental start-up with disruptive aspirations of its own.

Adding to the complexity of the skirmish, retailing giant Wal-Mart entered the online rental field in 2002, hoping to snatch the video-rental segment of the consumer marketplace away from the other contenders.

By making it easier for people to rent DVDs, Netflix has established a position where it is difficult for incumbents to respond. But Netflix, which had a disruptive success, now has to ask if it can do it again: Can the company find a way to deliver video on demand (VoD), the next big technological innovation in this arena? To succeed, Netflix has to stave off both Blockbuster and Wal-Mart and manage the transition to the Internet-based VoD.

The evolution of this video competition is a classic tale of disruption and holds important lessons for anyone trying to understand what their customers want now. Establishing a disruptive foothold early on creates a strong position for the disruptor. And developing a unique business model makes incumbent response difficult since the disruptor crafts the processes needed to deliver the exclusive value that customers demand from the innovation. Plus, if disruptors are squarely focused on what jobs customers need to get done, they'll be able both to strengthen and to maintain their leading position. Competitors are either unmotivated to respond, slow to respond, or lack the skill to respond.

Any way one looks at it, the disruptor has the best chance for coming out on top—but success is, of course, never guaranteed.

Netflix's meteoric rise
Founded in 1999 and based in Los Gatos, California, Netflix in its original incarnation was a Web-based catalog service that rented older, lesser-known movies in DVD format and delivered the merchandise by mail.

From the company's inception, CEO Reed Hastings and his management team sought to ensure that they understood which services their customers wanted. Netflix quickly realized that though customers had to wait for days to receive their DVDs, they preferred the slower pace over the hassle of choosing, renting, and returning videos from conventional retailers. Thus was born Netflix's innovative subscription service, which allowed customers to keep videos for as long as they wished.

By making it easier for people to rent DVDs, Netflix has established a position where it is difficult for incumbents to respond.

Subscribers now create on the Netflix Web site a list of DVDs they want to rent. For a monthly fee of $19.95, customers receive by mail three DVDs from the top of their list, with no return deadline and thus no late charges. Subscribers mail back the movies at their leisure in postage-paid envelopes before receiving the next titles on their list.

Netflix, which has 15,000 titles in its library, has enjoyed stunning success, surpassing 1 million subscribers in 2003. At the same time, offline retailer Blockbuster is struggling to turn around in the face of declining movie rentals.

Blockbuster's conundrum
Netflix, which has a 2 percent share of the market, entered the video-rental marketplace just as the growth of this segment was slowing. The company capitalized both on the new DVD format and on the growth of the Internet. As the new business was gaining ground, Blockbuster was undergoing a variety of changes at the hand of John Antioco, who had been named CEO in 1997. With a resume full of convenience-store retail experience, Antioco implemented a cost-cutting program and focused on selling higher margin products like DVDs.

His strategy made an impact. In its third-quarter reporting in October 2003, Blockbuster had increased gross margins and net income but still saw a decline in revenues, with same-store sales dropping 7.5 percent. Though cash flow remained strong, questions abounded regarding the weakness of the video-rental market, which lost 3 percent in volume in 2002. The increasing sales of DVDs as compared with DVD rentals, competitors like Netflix, and alternatives like VoD—in which video is streamed over the Internet—seem to be slowly chipping away at Blockbuster's profit base.

VoD services and online video-rental companies like Netflix are disruptive to the Blockbuster business model, which depends heavily on store ownership and increasing sales per store. In addition, both VoD and online video-rental services divert focus from the sale of products such as DVDs that can more readily increase in-store profits. With its orientation toward supporting franchisee P&L, Blockbuster can quickly and easily implement a push for higher-margin DVD sales, but promoting an online rental program, especially one that does not enhance in-store revenues, will be a tougher sell.

Blockbuster's leaders clearly understand, and fear, the threat of online and subscription offerings. They've responded with the Movie Freedom Pass, a subscription service that offers in-store and online rentals. After field-testing the concept in 1,000 stores throughout the United States, Blockbuster plans to roll out the program in 2004. While this new service acknowledges the growth of the subscription market segment, it may bring a level of schizophrenia to the company's existing strategy. Blockbuster still views online rental as a niche market, and the company's management may not be able to devote full attention to this new arena.

As Blockbuster pushes further into DVD sales, it has to compete with low-cost movie retailers like Wal-Mart, which uses low-priced new-release DVDs as loss leaders to drive sales of other items in the store.

Wal-Mart joins the fray
Complicating things further, Blockbuster and Netflix face equal competition from Wal-Mart, which in October 2002 introduced an online video rental service similar to Netflix's. The new option is offered under the company's Walmart.com platform.

At first glance, as Wal-Mart, Netflix, and Blockbuster battle for this growing segment of the video rental market, it might be tempting to bet on Wal-Mart's overwhelming resources. But Netflix's Hastings believes that his company holds a strong position, given the less-than-stellar track record of Walmart.com. "We look at it and say, 'Online, their brand has not extended,'" says Hastings. "Their core area is selling goods—i.e., competing with Amazon. And they have not beaten Amazon or come anywhere close to it. So how much focus are they going to put on online rental subscriptions, an area that's not their specialty? `Not much' is our answer. So we look at it and say, `If they ever beat Amazon, then we'll have real issues.'"

Indeed, the plethora of ancillary offerings at Walmart.com point to a problematic process for launching new-growth businesses within Wal-Mart. Unlike its warehouse unit Sam's Club, which is branded separately, the online products and services offered on Walmart.com are directly linked to the Wal-Mart brand.

Although Wal-Mart customers think of the retail giant as the top choice for low-price retail deals, they do not view the company as a provider of online movie rentals. And internal processes at Wal-Mart likely focus more on the core business of retail than on online services. Rather than creating a system that allows each online business to flourish under its own name and establish is own route to success, these divisions are hobbled to the weaker brand of Walmart.com.

Distribution may create another problem. Wal-Mart's expertise in this area seems like a perfect match for a movie-rental service dependent on efficient delivery, but the company's priorities are funneling products to warehouses, not directly to customers. Netflix, in comparison, has internal processes devoted solely to mailing movie rentals and ensuring customer satisfaction in movie selection.

The battle shapes up
Most analysts believe the real battle in the movie rental business will be in competing with VoD technology, which even in its current state of low functionality is also a disruptive innovation, even to the start-up Netflix.

Most analysts believe the real battle in the movie rental business will be in competing with video-on-demand.

Hastings recognizes that reality. "If I survey my customers and ask, 'Do you want the low-quality Internet offering being downloaded to your computer?' I'll get a response telling me that .001 percent of customers are interested in it. So, by being customer-centric, I would probably say downloading is snake oil." But Hastings is planning Netflix's strategic response accordingly. "We are actively investing in [VoD] and will continue to try and find niches where downloading is actually a better solution for the customer," he says. "You know it's not going to be a mainstream customer."

Hastings is betting that Netflix's ability to focus its strategy toward VoD using the experience gained from its established online rental service will put it several years ahead of its competitors in that market. While Netflix is focused solely on growing its online service and preparing for VoD, Blockbuster faces an established franchise system that will combat a transition to VoD. It will take an extraordinary act of management will to institute a strong commitment to VoD within Blockbuster management while pressure continues from franchisees to keep in-store sales strong.

Ultimately, Blockbuster might be forced into a solution that is good for Blockbuster stores but bad for Blockbuster customers. The company's Movie Freedom Pass already shows that Blockbuster cannot innovate in this segment without including its stores. In fact, that product exposes the limitations of Blockbuster's ability to alter its store-based strategy in the face of new technologies.

As for Wal-Mart, with a smorgasbord of online offerings ranging from contact lenses to patio furniture to online DVD rentals, it's difficult to imagine that the company's management will be able to focus significant time and energy in preparation for a move to VoD. By the time Wal-Mart actually achieves success in online DVD rentals, the game will likely already be over, with true opportunity and value having moved on to the VoD market. Wal-Mart will then once again be forced to play catch-up. And who knows what new technologies it will need to master in the future?

Reprinted with permission from "Movie Mania," Strategy & Innovation, Harvard Business School Publishing, January/February 2004.

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Sally Aaron is a consultant and freelance writer in Minneapolis. She can be reached at innovation@hbsp.harvard.edu.