Netflix's Spin Move

The financial media has written plenty about the online DVD-rental price war between Motley Fool Stock Advisor recommendation Netflix (Nasdaq: NFLX  ) and Blockbuster (NYSE: BBI  ) . The standard view is that Blockbuster has lower price points, while Netflix believes that its superior customer features merit an additional $3 per month.

But is this how the two companies truly appear to consumers deciding between them? The best way to test this proposition would be to map the purchasing decisions of a large focus group of consumers. Absent that, we could just wait for quarterly sales numbers and churn levels to come out. Of course, by then, the market will price in the new information.

The undecided shopper
But maybe there's another way. Consider a potential buyer who visits each company's website. What would he or she be likely to do?

www.netflix.com -- The website greets visitors with a simple design: a picture of a young couple watching a comedy, complete with popcorn, a glass of red wine, and three Netflix mailers on the table. Service highlights are spelled out clearly: 40,000 movies, no late fees, free shipping, and rental plans starting at $11.99. A click later, Netflix's four lowest-priced plans are revealed and explained. (The two companies' plans are listed in a table later in the article for comparison purposes.)

www.blockbuster.com -- The main site offers separate tabs for movies and games, and a similar picture of a happy family watching TV. A large banner announces the $14.99-per-month option, along with no return dates, no late fees, free shipping, a selection of 30,000 titles, and unlimited DVD rentals, three at a time. Since the original writing of this story, a promotion for two free in-store movie/game rentals each month has joined these features on Blockbuster's home page.

Those are the first impressions. Digging further through each website, consumers might discover some less-advertised rental plans. Some are open only to current customers, while others seem to be available only when you try to restart your membership or attempt to cancel. The table below showcases the currently offered rental plans I found:

Movies out at a time Blockbuster Netflix
1 *** $9.99
2 (limit 4/mo) *** $11.99
2 (unlimited) *** $14.99
3 $14.99 $17.99
4 *** $23.99
5 $27.49 $29.99
6 *** $35.99
7 *** $41.99
8 $37.49 $47.99


Blockbuster is bearing down.
I think there are several items to note from this table. First, it's a bit curious that Blockbuster doesn't match Netflix on the breadth of its unlimited rental plans. As a Netflix customer, I've found it very useful to switch between the two-, three-, and four-DVDs-out-at-a-time plans, depending on how much free time I have. While I am likely to be in the minority, I find it difficult to believe that providing this option is a significant added cost for Blockbuster.

Second, Blockbuster's price structure is a bit puzzling to me. For Netflix, the price progression is logical -- take the $17.99 price and add $6 for each additional movie out per month. The calculation doesn't work for the $9.99 plan or the four-movies-per-month plan, but the general gist is obvious. With Blockbuster, the five-movie plan isn't as good of a deal as the three-movie plan. But the eight-movie plan becomes an incredible bargain, offering a huge discount to what Netflix charges; it's Blockbuster's most affordable deal on per-rental basis.

At this level, I'm not exactly sure whom the companies' price plans are targeting -- perhaps the soccer mom whose kids devour Barney videos by the truckload, or the super-serious movie buff -- but why the two companies price plans so differently is beyond me. Perhaps so few people rent at these levels that the price point simply doesn't matter.

Third, and crucially, which company has the best-priced plan? While Netflix offers the least expensive plans, Blockbuster is significantly cheaper on the most popular rental option. For the same price as Netflix's two-movie plan, Blockbuster gives you three, plus two more coupons for in-store rentals. Even if you value Netflix's recommendation and friend features quite heavily, which yours truly does, Blockbuster's main plan is still the better deal for cash-conscious movie buffs.

. But Netflix tries to spin away
Look closer, though, and you'll see that the real coups here are Netflix's $9.99 and $11.99 plans. Amazon.com (Nasdaq: AMZN  ) debuted its UK DVD-rental with two very similar options, and for good reason: Plans with a capped number of total monthly rentals allow for a lower price point and higher margins, and they enable the company to capture a greater market share. For that very reason, in its latest quarterly earnings release, Netflix guided down on revenues but reiterated its earnings forecast -- the lower-priced plans bring in less cash but are more profitable. And if Netflix's guidance is any indication, their popularity seems to be growing.

The prospect of starting out easy is a powerful incentive. Two years ago, when I first raved about Netflix to my friends, their top reason for not joining was that they simply didn't watch enough movies to warrant the three-movie plan, regardless of price. Allowing customers to start slow (and cheap) with a limit of four monthly rentals, or even one movie at a time, gives Netflix a chance to let newcomers get accustomed to the service. New members can build up their queues and, in the process, decide just how many movies they actually want to see. The company hopes they'll eventually expand their membership. (Setting up long queues also makes defection to another DVD-rental service slightly more cumbersome.)

These lower-priced plans are Netflix's attempts to spin past Blockbuster's deep price cuts. More than six months after its launch, Blockbuster still does not offer a four-movies-per-month option, which shows the limits that brick-and-mortar stores still place on Blockbuster's business model. (When I originally wrote this story, Blockbuster was discounting new members' first month of service to $9.99. Though I've searched very hard for this promotion, I'm no longer able to find it. I've been told that the option is still offered to those who try to quit their membership, but I have no way of verifying the claim).

The offline-stores dilemma
This brings up the double-edged nature of offline stores. Blockbuster's fleet of brick-and-mortar stores is certainly an asset. The stores cater to customers who like to physically browse for movies and require instant gratification for their movie-watching urges. Also, once the company integrates those stores into their online subscription model, they will ideally provide for faster shipping than Netflix. If managed properly, the stores might create long-term efficiencies by maximizing inventory control and utilization.

But the stores' advantages are also limitations. Blockbuster's stores derive their revenue from those who rent a movie and return it within a few days. Currently, a Blockbuster store rental costs just over $4; undercutting Netflix would require Blockbuster to allow customers to rent four movies per month at $3 or less ($11.99 divided by plan's limit of four). Such low-priced online rentals could further cannibalize Blockbuster's store traffic or force stores to lower rental prices. Neither option looks particularly appealing -- if the company has had trouble getting all its franchisees to sign on to the current "No Late Fees" program, you can imagine how unpopular the capped online plan would be.

The mailman cometh
Like all wars, the price war must ultimately end. The U.S. Postal Service is due for a rate hike; it hasn't done so since 2002. In 2006, both companies will probably have to contend with at least a 39-cent stamp for first-class mail. While this will likely amount to no more than a 6% increase in shipping costs, it still won't be smoothly hoisted onto consumers. To its merit, Netflix is pushing heavily to develop the option of downloading movies over the Internet, presumably a quicker and less costly alternative.

So can we say that either company is winning the price war? Not yet. It's quite possible that the market for renting DVDs by mail/Internet is so large, and growing so quickly, that there's still plenty of low-hanging fruit for everyone. As such, consumers might not really comparison-shop or pick one company over the other but merely sign up for whichever service they hear about first. If that's the case, both Netflix and Blockbuster have a long way to go before they'll have to start actively stealing customers from one another.

Want more Foolishness on the BBI vs. NFLX battle? We've got plenty:

David Gardner chose Netflix for hisMotley Fool Stock Advisorrecommendations.To learn more, subscribe for six months, risk-free.

Fool contributor Marko Djuranovic owns shares of Netflix, but not Blockbuster or any other companies mentioned in this article. The Fool has a disclosure policy.


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