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Tomorrow Version 2.0

So where do we go from here? Last week I began writing about how Netflix (Nasdaq: NFLX  ) finally has a worthy challenger in Blockbuster (NYSE: BBI  ) and its boldest foray yet into mail-order DVD rentals.

With Netflix topping the 2 million subscriber mark, growing revenues by better than 80% over the past year, this is clearly a growth market. However, how Netflix responds to the Blockbuster threat may kick this entire market into an even higher gear.

Follow me on this. I'm a film buff. I have kicked the virtual tires. I have been a satisfied Netflix subscriber -- and investor -- for more than two years. I tried the Wal-Mart (NYSE: WMT  ) offering and was left unimpressed with the lengthy turnaround times and scarce title availability. Blockbuster's initial attempt was a dud, but when I learned that one of its 10 distribution centers was right here in Miami, I signed up last week, and my initial results have been comparable to the speedy turnaround that I have come to expect given my spoiled Netflix ways.

So does that mean we are headed into the squeezed-margin daze that rears its shrunken head in a cutthroat commodity community? Not exactly. Netflix is commanding two dollars more out of its subscribers a month than Blockbuster for its basic three-out plan. Blockbuster also includes two coupons a month for free in-store rentals. While obviously Blockbuster is assuming that doling out two rentals gratis will result in incremental sales at the physical storefront and make its own online service more compelling, on its own it's a cost burden. If someone uses the coupons on new releases, which is likely, we're talking about another $2 a month in overhead for Blockbuster in revenue-sharing fees alone.

That doesn't mean that we can just award Netflix a $4 profit advantage on each paying member. However, if consumers value the proven Netflix interface, its reputation, established queues, and the quality of its proprietary title recommendations based on past renting habits and movie ratings -- enough to still lean toward the Internet pioneer over the blue and gold -- Netflix will make out just fine in retaining its established base.

However, for the 97% of the market that Netflix still hasn't penetrated, Blockbuster will be an intriguing option. They don't know about the smiles elicited from red mailers in the postbox. They don't have months or years of movie ratings and rental histories to appreciate the beauty of Netflix's recommendation software.

Of course, we can't afford to be naive. Some homes don't -- and won't -- have DVD players and many that do will never justify paying for loaner DVDs in a monthly buffet format. However, the potential market is more than a few times over what Netflix currently has in its clammy grasp. That's why Netflix and its upstart rivals cannot squander this golden opportunity to not only grow but also evolve by differentiating their services.

That is why Netflix will have to lead again before the once-bitten, twice-bright Blockbuster closes the sizable gap between them. Here are some new growth possibilities and how I see the scenarios playing out.

Video games killed the DVD star
It never fails. Every couple of months on our popular Netflix discussion board, someone will blast Netflix for not getting into the video game market. Obscure outfits with even more obscure domain names are doing it, so why not Netflix? Well, let's get into the negative aspects of renting out video games first. For starters, yes, the acquisition costs do run higher on games than they do for the DVD film library and not by an insignificant sum. That adds up when you're a renter often having to eat the costs of titles that, for one reason or another, are reported missing along the way. The other major drawback is the medium's rapid obsolescence. It's been 32 years since its theatrical release, but you can still get a good return on renting out The Godfather. Good luck trying to give away copies of Madden 2002. The life cycle of game consoles has also been typically shorter than that of the video platforms.

But let's chew on the positives. Naturally a video game is going to be played quite a bit more than a movie and held for a longer time. Given the mailing costs and revenue-sharing fees that Netflix must cover every time someone flips back a DVD, adding video games would help trim the number of titles that Netflix has to ship in any given month while actually enhancing the service's value.

However, to truly make it work, Netflix has to flex its muscle as a shaper of public opinion with 2 million of the most desirable consumers in its perpetual reach. Find a video game publisher that is willing to absorb some of the costs in order to get its titles into the hands of this prized demographics group. It won't be market leader Electronic Arts (Nasdaq: ERTS  ) , but perhaps a hungry house like Activision (Nasdaq: ATVI  ) or the kid-friendly mavens at THQ (Nasdaq: THQI  ) that will cut a generous revenue-sharing deal with evergreen titles the way independent film distributors will yield Netflix a break in the celluloid. It's OK to start small. Just offering the service, on Netflix's own cost-effective terms, may get investors excited again.

Face it. Blockbuster has been renting out video games at its stores for years. It's only a matter of time before it bleeds over into the bricks-and-mortar giant's online DVD service. Netflix can't afford to follow Blockbuster's announcement on this.

Big blue
You can snicker all you want, but the Internet has been a major purveyor of erotica. This is a sensitive issue -- no pun intended. If Netflix were to open the floodgates by offering up hardcore, would it lose more subscribers on moral grounds than it would gain from those rushing in? However, this is an important issue because Blockbuster's clean slate in its stores practically shackles it to following prim and proper suit online if Netflix were to add randy discs to its library.

So how does Netflix get seedy without alienating some -- if not many -- of its users? Thankfully, there are gray areas in blue movies. While Netflix can always brand an adult video service under a different moniker while still utilizing the company's effective network of established distribution centers, softcore erotica may do the trick. Skin flicks that are adult-oriented without being overly explicit -- think Playboy (NYSE: PLA  ) -- may work as diluted porn without disrupting the mainstream.

Netflix offline
One of the heartiest testimonials that I received from a Netflix user was from someone whose mother did not have a computer, yet he gifted her a Netflix account and went on to populate her queue himself. That got me thinking. There are a whole lot of movie buffs out there who either lack the means or the desire to go online. Why should Netflix be at the mercy of generous wired friends and family to get them hooked up?

So play along with me here. Imagine if someone could sign up for, say, the John Wayne Netflix Ticket. That would create a queue immediately populated with dozens of the Duke's DVDs. How about the American Film Institute 100 Ticket or a critics corner that would include, say, Roger Ebert's 4-Star Ticket?

Taking a page out of the Time-Life playbook with an interactive twist, the subscriber wouldn't have to have online access. The titles would just keep coming as soon as viewed titles are sent back until the lengthy queue is depleted or the subscriber cancels.

This could work by phone. This could work by mail. It could even work as an extension of the online service through wired kiosks in suburban shopping malls or your local BestBuy (NYSE: BBY  ) to set up the process in person while also allowing existing subscribers the opportunity to tweak their own queues or gift others.

These Ticket packages could also naturally migrate to the online service. Why not incorporate the one-click approach to fleshing out hungry queues? Why not have a series of celebrities or notable movie critics chime in with a list of weekly or monthly DVD picks that interested users can subscribe to automatically?

Maximized mailings
Finally, how much longer will it be before Netflix maximizes the use of those red mailers? If TV networks have paid Best Buy to distribute free fall season preview DVDs, why isn't Netflix taking advantage of its captive audience and piggybacking free studio sampler discs or even demo computer software?

The days of stagnancy ended this summer when Blockbuster woke up with something to prove. So if Netflix shares have been roughed up lately, perhaps it's because the market believes that dishing out temporary DVDs is all that Netflix -- or Blockbuster or Wal-Mart -- will ever aspire to achieve. Bah! We know better. That's a naive assumption. Amazon (Nasdaq: AMZN  ) didn't stop at books. eBay (Nasdaq: EBAY  ) didn't pause at Pez dispensers.

Netflix has a highly desirable target audience. It has perfected a distribution network that is easily adaptable and scalable for other light media formats. Concerns that the emergence of video on demand or Blockbuster's respectable entry into DVD rentals by mail will trip up Netflix operate under the premise that Netflix will remain forever sedentary.

What are the chances of that? Don't just sit there and ponder that for too long. Moving targets have much more fun.

Fool co-founders David and Tom Gardner duke it out every month in the pages of their Motley Fool Stock Advisor. Each picks a stock and does his best to shoot holes in his brother's pick.Subscribe today for immediate online access to their top stocks!

Longtime Fool contributor Rick Munarriz will be joining his fellow Fools in theNetflix discussion board to discuss these and many other possibilities for Netflix and the DVD rental industry. Hehas been a Netflix customer -- and shareholder -- since 2002. The Fool has a disclosure policy.

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Rick Munarriz

Rick has been writing for Motley Fool since 1995 where he's a Consumer and Tech Stocks Specialist. Yes, that's a long time. He's been an analyst for Motley Fool Rule Breakers and a portfolio lead analyst for Motley Fool Supernova since each newsletter service's inception. He earned his BBA and MBA from the University of Miami, and he now lives a block from his alma mater.

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