The following is part of our week-long Rule Breaker series, where we Foolishly examine several companies and ask, "Is it a Rule Breaker?" Hey, even better, we'll answer the question for you.
We've all experienced those times in life when all you can do is shrug and capitulate. You could fight the system. But it's not going to help. The system isn't listening.
I've had this experience while waiting beside the rails in Italy, where the trains are infamous for their unreliability. I feel it when I accept one of those half-day windows in which the cable guy may show up. I've also -- like so many of us -- paid obscene late fees to Blockbuster
I always held out hope that the free market would deliver us from this evil. I'd reassure myself by pondering how many pretty good restaurants in New York City went out of business because of the few dozen pretty great restaurants on the same block. Then I came across David Gardner's passage in Rule Breakers, Rule Makers: "When established industries fail to evolve. opportunities arrive for Rule Breakers."
Coincidentally, not long after I encountered this powerful idea, I started hearing whispers around the water cooler from the ultra-in-the-know cinephiles. I soon linked these guys and gals to large numbers of red envelopes in the outgoing mail bins. Then it occurred to me: whatever this was, it was breaking the rules.
Netflix: The first mover
Every so often the environment is right for someone to come along and change the way something is done: painting before and after Picasso; the electric guitar before and after Jimi Hendrix; football offense pre- and post-Bill Walsh. Companies do the same thing: Ford and the assembly line; Intel and the microprocessor; eBay and the virtual marketplace.
These massive and unprecedented shifts in process are called disruptive innovations, and they are one of, if not the, most important characteristic of a Rule Breaker. Netflix
- It delivered lower prices and better services to consumers. In the case of Netflix, there's an obvious price tipping point that relates to how quickly you turn your DVDs around. But without late fees, I'm personally making out like a bandit. So I'll assume others are as well. And that benefit.
- Spawned copycats. Heard of those pesky little companies Blockbuster, Wal-Mart
(NYSE:WMT), and Amazon.com (NASDAQ:AMZN)?
As a Netflix shareholder, the response you'd like to see from a top dog like Blockbuster is that they concede and move upmarket -- to more expensive products -- and try to hold the higher profit margin areas. The company might begin focusing on renting DVD players, Microsoft Xboxes, Sony
Think about how Compaq reacted to Dell's
But Blockbuster, much to the benefit of its shareholders, has decided not to do this. Instead of scrambling for higher ground, the company finds itself in the trenches of a pricing war. Netflix preemptively slashed prices to try to dissuade Amazon.com from entering the DVD-rental fray. Blockbuster then followed suit with even more aggressive reductions on its plan.
Netflix sits in Tweener-land
There comes a time in every Rule Breaker's life when it graduates from Rule Breaker status. At that point, it becomes a "Tweener." It enters a stage from which it will either emerge as a big boy Rule Maker, or it will not.
Netflix was able to get to 3 million members in just a few years, including 1 million alone from May 2004 to March 2005, and churn is near a historical low at 5%. The company is expecting to finish the year with roughly 4 million members. What will make or break Netflix in the years to come? In my estimation, it will be how the company comes to terms with online distribution. With increasing bandwidth and more efficient data compression, online distribution is the future. From a consumer perspective, DVDs are just plain inconvenient when compared to movies zipping around the information superhighway at the push of a button. To rent DVDs online, you have to deal with the postal service, shipping fees, and multiday waits.
However, I don't want to forget how far we've come, and I don't want to undervalue the current Netflix business model. For perspective on the attractiveness of Tweener-land, let's just think back to those trips to the local video store, with its absurdly limited inventory and those darn fees: "OK, so. what'll it be? Men in Black 2 or Spider-Man? Oh, and by the way, you owe $41.95 in late fees?"
Netflix put an end to this. We all owe the company a debt of gratitude.
Nevertheless, according to CEO Reed Hastings, video-on-demand is the greatest opportunity -- or threat -- for Netflix, depending on how you view it. "Our competitors are a bigger threat next year," Hastings told The New York Times in February of this year, "but in 10 years, digital distribution is a bigger threat." To emerge as a Rule Maker, Netflix must find a way to adapt its business model.
Shrug and capitulate. or stand and deliver?
As Netflix sits between its Rule Breaking past and the 800-pound broadband gorilla standing in the path of its Rule Making future, you may find yourself wondering: How can I find companies that right now have disruptive, rule-shattering possibilities -- companies that most investors haven't yet heard of that are poised to become tomorrow's water cooler cult brands, or companies that will drive the coming nanotech revolution?
That's where the Rule Breakers service comes in. We seek out tomorrow's great growth companies a day early. If you want to join us, take a 30-day free trial. There's no obligation to subscribe, and you may just find tomorrow's first movers a day early.
To check out our exploration of Rule Breaking companies, see:
- Searching for Rule Breakers by David Gardner
- Is Apple a Rule Breaker? by Rick Munarriz
- Is DreamWorks a Rule Breaker? by John Reeves
- Is eBay a Rule Breaker? by Alyce Lomax
- Is Dendreon a Rule Breaker? by Karl Thiel
- Is Geron a Rule Breaker? by Charly Travers
- Is IBM a Rule Breaker? by Carl Wherrett and John Yelovich
- Is Google a Rule Breaker? by Tim Beyers
Beirne White does not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy .