Blockbuster and Netflix: Let the games begin

About a year ago I wrote here about the Netflix business model and other entrants into the market (Blockbuster and Wal-Mart). I got a lot of feedback about that article, most of which telling me (some of which was polite) that I was off my rocker. The paragraph that seemed to draw the most response was this one:

"Simply put, I don't believe this business model is sustainable as it currently operates. I believe the market potential for the service is near saturation, and there's no true way to differentiate the service offered. Wal-Mart is forcing Netflix to compete now on price, making this a commodity offering. The service will have to evolve to the next level to build a larger customer base and still provide profits for their respective companies. Let's watch and see what happens. I give the current model 18 months or less. "

You can imagine my interest as I've watched the evolution of this market over the past 12 months or so, for example: Netflix 2nd Qtr 2004 profits down, and; Netflix customer churn up with price increase. (By the way, Wal-Mart has quietly built a nice business and maintained its lower price points.)

Today's announcement by Blockbuster that they are taking their on-price in-store program, online in direct competition with Netflix is just icing on the cake. Blockbuster's online monthly fee mirrors their in-store model and at $19.95 per month (with no late fees and 2-free in-store rentals per month) bests Netflix by $2 per month, and adds a bit less than $10 in additional value to customers through the in-store rentals (plus there are some special on-off offers at $17.99 and $15.99 per month for defined periods). On top of this, Blockbuster signed a deal with MSN and AOL to provide the online service as featured part of those services. Folks, as predicted, we have a commodity on our hands.

Interestingly, Netflix is reporting customer acquisition costs have risen from $30/per to $35/per, with estimates of reaching as high as $39/per by year's end. Now consider that Netflix reports that customers renting 5+ movies a month actually cost them money (in postage), and the 2nd quarter 2004 reports of increased revenue but decreases in profits, it would seem that Netflix has a problem or two. I couldn't even begin to guess what their payback period is for customer acquisition, but if they're signing up new folks and many of those are heavy users (5+ a month), revenue goes up, profitability goes down, and payback stretches over a longer period. I don't buy that MM customers will make them profitable. I still think heavy users will sink them because those users will always have significant postage costs--a cost that Netflix has little control over.

I still think Blockbuster is foolish to follow this path for short term gains. Of course, maybe they're thinking more long term and are just going to use their deep pockets to put some pressure on an already troubled Netflix, while moving quietly into video-on-demand. Let's continue to wait and watch.

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