Don't Nix Netflix Just Yet

Don't Nix Netflix Just Yet

Apple's expected announcement of a movie-download service has many wondering what the DVD-by-mail provider has planned

By Catherine Holahan

SEPTEMBER 11, 2006_BusinessWeek Online

E-commerce companies are rushing to catch the next wave in home entertainment: movie downloads. On Sept. 12, Apple is expected to unveil a movie component to its iTunes store, which already dominates the music download market . The planned release follows Amazon's Sept. 7 launch of "Unbox," the e-commerce giant's response to a flood of sites offering downloadable movie rentals and purchases, including CinemaNow, Guba, and the Hollywood studio-supported Movielink.

Noticeably absent from the growing mix is Netflix . The company made its name and fortune—sales of $239.4 million in the second quarter of 2006 alone—as the online source to order movies. But it has yet to move away from the DVD-delivery and subscription business model that stole so much of the rental business away from Blockbuster .

PIRACY CONCERNS. Netflix does plan to offer movie downloads starting in January, 2007, according to corporate communications director Steve Swasey. The service has been in the works for some time. Netflix plans to set aside up to $10 million for the project this year. Company executives have planned to officially announce the launch at the end-of-year earnings call.

The new online competition has done little to change Netflix's time table. That's because, while Netflix execs agree movie downloads are the wave of the future, they are banking that the market for DVDs is still growing and won't go away anytime soon. The company points to the growth of the online DVD rental market, which brought in nearly $800 million in revenues with 5.5 million subscribers in 2005 and is expected to have as many as 20 million subscribers by 2012. "Our strategy is to grow big on DVD with a big subscriber base, and that gives you opportunities for many things," says Swasey.

Fears that movie downloads will open the door for the kind of mass piracy plaguing the music business have made movie studios slow to release large portions of their catalogs to download services. The worry is that hackers could find a way around digital rights management software, such as Microsoft's  widely used DRM technology, which prevents computer users from watching downloaded rentals after time limits have expired and passing movie files to others who have not paid for the content. Already, anonymous hackers claim to have cracked versions of the technology.

LUCRATIVE MARKET. The studios have agreed to allow movie downloads in part because they don't want to repeat the music industry's mistake: unintentionally encouraging consumers to visit pirate sites because the desired delivery method is not widely available from a legitimate source. They see the future, and they don't want to lose out on the eventual market. "With more than 25 million broadband residences, we believe the market is now ready for the launch of a new Internet movie rental service," said Movielink CEO Jim Ramo when the studio-backed site launched in 2002.

Piracy concerns have kept downloaded video from easily being watched on the television. Typically, DRM technology is not supported by DVD players. To see a movie on a home theater setup, a television must be hooked up to a computer through a cable, which can compromise resolution.

Hollywood also is likely reluctant to cannibalize the DVD market. The discs generated roughly $18 billion in sales in 2005 compared to about $10 billion at the box office for the same year. Studios have been pushing sales with added content, such as behind-the-scenes footage and blooper reels, as well as earlier and earlier DVD releases .

WEAK COMPETITION? Several studios, including Time Warner's Warner Bros., Sony Pictures Entertainment , Fox , and Walt Disney , are rolling out high-definition DVDs that they hope will drive additional sales .

It's unclear whether the studios can make the same kind of money from the relatively cheaper downloads. As a result, the content available on movie sites has been limited and offered at prices comparable to a store-bought DVD or rental. Even Movielink—a joint venture between Metro-Goldwyn-Mayer Studios, Viacom's  Paramount Pictures, Sony Entertainment, and Warner Bros., among others—has only about 2,100 titles, according to a Sept. 7 press release. Netflix, in contrast, has more than 65,000 flicks in its database.

The relative lack of content has led to mixed reviews over available download sites. In a note to investors, Jefferies & Co. analyst Youssef Squali wrote that Amazon's Unbox was "too little, too early." The service offers fewer than 2,000 movies at prices ranging from $7.99 to $14.99. A portion of those are available for $3.99 rentals . "If you look at the depth of their titles, they only have about 400 or 500 rental titles, and the price point is really not aggressive enough for people to really care," says Squali. In June, JPMorgan upgraded its valuation of Netflix stock after determining that the download market was not likely to crush Netflix in the near term.

DVDS DOMINANT? Still, the pay-to-download movie market is relatively new and the content will become more extensive as better piracy controls are developed that satisfy the studios while allowing computer users to watch downloaded videos on their television sets without linking to a computer.

Already, rumors are circulating that Apple could develop a portable device able to beam computer content directly to the television, similar to products that send iPod content to nearby speakers without the use of cables. "The studios will, over time, feel more comfortable with the offerings, so they will allow more titles and pricing will come down," says Squali. "The fact is that digital downloads will become the mainstream mode of how people will be getting their content, video or not. The issue is how long will it take and can both technologies (download and DVD) cohabit for a bit."

Netflix is confident that the cohabitation will last a while. In June, Netflix Chief Executive Reed Hastings told BusinessWeek that DVDs will dominate for a decade or more . "It is a DVD world and will continue to be for a long time," says Swasey. "America's taste in movies is broad and vast and satisfied by Netflix. The download services have a fraction of [the selection] and…we are a nation of selectors. We like to select and have it our way."

PLANS TO STICK AROUND. Investors, however, are not as confident that the movie download business will remain hampered by limited selection as long as Netflix expects it to be. The stock was down to $20.62 per share on Sept. 11, compared to a 52-week high of $33.12. It took some of its largest hits around rumors of new entries to the download market.

Netflix is aware of the concerns. Its plan to aggressively increase its customer base to 20 million by 2012 is, in part, also a strategy to be well positioned for the nascent download market. A Netflix with more than 10 million subscribers will be better able to encourage movie studios to release more content at more competitive prices than a Netflix with about 6 million subscribers.

"We are investing millions of dollars because we intend to lead the [download] market," says Swasey. "The company name is Netflix, not DVD by mail, for a reason. We intend to be the place you go to on the Internet for your movies."