Just The Ticket

Given his fondness for movies, it's not surprising that Reed Hastings thinks about the future of home entertainment in terms that sound like they're drawn straight from "Star Wars." The story line, according to the founder of the DVDs-by-mail pioneer Netflix, goes something like this: as DVDs slowly give way to online movies, consumers will face a stark choice. Will they side with the "Forces of Control" or the "Forces of Freedom"? The Forces of Control are the cable and satellite companies, which offer 50 to 500 channels of content that's chosen by network programmers.

Opposing this bunch are the Forces of Freedom, a group of companies that includes Netflix, TiVo, Apple, AOL and Yahoo. Together the freedom fighters will offer something like 5 million channels via the Internet, giving consumers the ability to watch just about anything they'd like, whenever they'd like. "Instead of an electronic program guide that viewers scroll through with a remote control, the keyboard will be your remote control and your program guide will be Google or Yahoo," says Hastings, 44.

It's no secret which team Hastings is betting on. He built his empire on the premise that people would rather have their rental movies delivered to their mailboxes than have to haul themselves to the video store. As a tech company, Netflix was a contrarian play. Even at the height of the dot-com boom, when Silicon Valley buzzed with the promise of "transformative technologies" and "fat pipes" that would allow consumers to quickly download all manner of content, Hastings built Netflix on two disarmingly retro technologies: the DVD and the United States Postal Service. For a monthly subscription fee averaging $17.99, consumers would be treated to an unlimited number of rented DVDs, most delivered within a day of being ordered online. "People were talking about beaming movies to wristwatches," Hastings says. "We tried not to get drunk on the future, but actually to predict it accurately."

So far, so good. Today Netflix has 3.5 million members, and last quarter it did $5.7 million in profits. In the imitation-is-flattery department, last year executives at rental giant Blockbuster who once sneered that Netflix would never appeal to the masses, launched a service modeled on Hastings's creation. Earlier this year Wal-Mart pulled out of a similar effort to copy Netflix, signaling that even America's biggest retailer couldn't compete with Hastings's freedom fighters. But as far as the Netflix gang have come on old-school technology, its founder doesn't dispute the notion that before long, many people will begin watching movies at home over broadband. As that era dawns, Netflix will face a tricky pivot, requiring an overhaul of its business model.

As Silicon Valley visionaries go, Hastings has an unusually diverse resume. After graduating from Bowdoin in the early 1980s, Hastings spent three years teaching math in Switzerland. He returned to California and became a computer programmer, selling his first company, Pure Software, in the mid-1990s for $750 million. He then went back to school, getting a master's in education from Stanford before teaming up with star venture capitalist John Doerr on a ballot initiative to improve school funding in California. After that Hastings served briefly as head of TechNet, the Silicon Valley lobbying group, and became president of the California Board of Education.

His career in education ended around the time he rented "Apollo 13" from a Blockbuster store. After getting dunned for $40 in late fees, Hastings began wondering why video rentals don't work like a health club, which gives members unlimited access for a flat monthly fee. His original business plan relied on mailing VHS cassettes to customers, but in 1997 he realized that DVDs, still new at that time, would be a much easier, more durable format for mailing. In 1998, he started Netflix from a warehouse in the heart of Silicon Valley.

Today there are 35 warehouses around the country. Each day they receive 100,000 new movies from Hollywood studios, and mail out 1 million DVDs to customers (their total inventory is 42 million discs). A corner of the original warehouse in Los Gatos serves as the Netflix museum, including plastic remnants of the racks that workers used to pluck DVDs from by hand. Today all of that is handled by state-of-the-art automation. Workers still open envelopes, stopping every 45 minutes to do ergonomic exercises.

They'll need to stay limber: in tech-savvy markets like San Jose, Oakland and Fremont, more than 10 percent of households subscribe to Netflix. Hastings expects to have more than 4 million subscribers at the year-end, and more than 20 million by 2010. Hastings sees downloadable movies as a long-term threat, and predicts that his snail-mail model will be around another 20 to 30 years, both because DVDs are very portable and convenient to customers, and because movie studios "want DVDs to last a long time because it's such a revenue and profit driver." He says what consumers want is only one piece of any industry's economic puzzle: the reason you have to wait a year for books to come out in cheaper paperback form is that it's in the publishing industry's economic interests to sell to you that way.

Remember, Hastings says, the big music companies didn't begin to offer downloadable songs to please consumers. That was a defensive response to free services from Napster and Kazaa, which were cutting record companies out of the revenue equation. "What really drives the market is the content owner's profitability," Hastings says. "DVD might be around for a very long time absent some cataclysmic piracy attack." And even when downloads become popular, people aren't going to suddenly throw away their DVD players, which have a huge installed base. In fact, according to projections by Fox Studios, DVDs won't hit their peak usage until 2013, suggesting the Netflix gang has room to run.

Even if DVDs eventually go the way of the eight-track tape, Netflix boosters say the company stands a reasonable chance of surviving. Marketing textbooks traditionally talk about how railroad companies stopped growing because they saw only railroads, not the wider transportation business; in contrast, analysts seem to trust Netflix's ability to think of itself more broadly as a movie company. Safa Ratschy, managing partner at Piper Jaffray, says Netflix is a lot more than a DVD-by-mail distribution system; its real asset is a strong subscriber base that has grown accustomed to ordering on the Web, and is likely to stick with Netflix as the era of downloadable movies arrives.

Hastings envisions Netflix becoming a destination Web site offering a mix of free, ad-supported content, premium pay-per-view content and subscription services. "No one has figured out what's the right economic model," he says. "We know that we can do all of those and we'll continue to evolve." And with many Americans upgrading to big-screen, high-definition TVs, Hastings is betting they won't watch this fare on their computer monitors. That is part of the rationale behind the deal announced last year between Netflix and ?TiVo, which makes personal video recorders that already connect televisions to the Internet. Although Hastings will shed little light on exactly what these partners are cooking up, outsiders say they are a smart match. "If you can deliver video to the box that's connected to the TV and not to the PC, you're way ahead of the game," says Laura Behrens, a media-industry analyst for Gartner. "This is a good move for Netflix."

In talking about Netflix's future, Hastings repeatedly brings up AOL. He acknowledges it's an odd choice, given the online pioneer's disastrous merger with Time Warner. "AOL has a mixed ending or a bad ending, so it's not like publicly we're going to say 'OK, we want to be the next AOL'," he says. Still, Hastings sees in AOL a subscription-based survivor: once a dial-up service for online newbies, today AOL acts more like an infotainment portal, and has retained many subscribers who get broadband service from another company. He also sees HBO and DirecTV as having elements of the future Netflix model, in that they are both nationwide distributors with a capacity to cater to niche tastes or local markets. Of course, if a big media conglomerate moves in to buy Netflix, a very attractive target, the future won't be Hastings's problem.

There's another, lower-tech industry that may foreshadow the challenges Netflix faces: automobiles. For years pundits have prophesied the replacement of the gasoline engine by pollution-free fuel-cell-powered cars. Those predictions inspired automakers to spend billions in R&D to prepare for this new world, which seems to be coming much more slowly than experts expected. Similarly, Netflix is preparing for the future, even though it believes the era of online movies is more distant than some believe. "We're starting to invest now, even though there's no real market for it today, so that when it comes, we're ready," Hastings says. "[But] DVD will last as long as the gasoline engine, newspaper--any of your 'obsolete' in the very long term industries." If he's wrong, those 42 million DVDs he owns will make for one heckuva yard sale.