The Lost Weekend window display featured lyrics sung to the tune of The Buggles’ 1979 hit, “Video Killed the Radio Star.” [Link to Video]
Netflix mailed DVDs directly to customers using a distinct red envelope that also served as a pre-addressed, pre-paid return mailer.
Netflix developed a user-friendly interface that would eventually ‘revolutionize’ the video rental industry and home entertainment more generally.
Stuart Skorman launched Reel.com in 1996. Though Skorman enthusiastically embraced the power of new technology, his background as a rental retailer may have hindered his ability to fully integrate the Internet.
Reel stressed its vast selection as a key feature of the online environment.
Skorman developed movie matchmaking as a way to guide customers to less popular titles. With Reel.com, he integrated a software program that was designed to further optimize this principle.
Financial woes prompted Skorman to open a brick-and-mortar retail outlet in Berkeley, CA.
Blockbuster launched its initial website in late 1996. The site was largely used for brand publicity and Blockbuster remained slow to fully embrace the new format.
Retailers and other vendors were excited by the promise of the Internet, but unsure of how to integrate it in a way that actually enhanced their business.
The Internet provided limitless space and interactive features. Some retailers were nonetheless reluctant to make their entire catalogues available online.
This article examines the rise of Netflix, the Internet-based movie rental and subscription service founded in 1997, and its pivotal role in a rapidly transforming home entertainment market. Focusing on the period between 1998 and 2008, the article provides a history of the company and the strategic advantages that allowed it to outmaneuver various competitors. The article also considers the viability of Netflix’s business model and how the company has modified its focus throughout this period. By examining this history, the article shows that Netflix was the beneficiary of both its own fortuitous timing and glaring miscalculations by its competition. It also demonstrates the ways in which unlikely intermediaries are able to amass significant power and initiate industry-wide shifts in periods of rapid technological change.
The Internet killed the video store?
In November 2010, the writing was on the wall or, to be more precise, on a dry erase board in the display window at Lost Weekend Video in San Francisco, CA. [open endnotes in new window] The question of whether the Internet has killed the video store is accompanied by revised lyrics to a 1979 song by the British New Wave band The Buggles that seemingly answers in the affirmative. In this way, it’s not only a mournful lament about the declining state of video rental stores, but a contradictory and telling omen about our age of rapid technological change. The song, “Video Killed the Radio Star,” gained widespread attention as the first music video aired by MTV and has since served as melodic shorthand for the inexorability of media convergence. Its lyrics bemoan the inevitable casualties of technological progress. The Lost Weekend Video Store’s parody, in contrast, evokes romanticized notions of the video store that had been displaced not necessarily by technology but by rapidly expanding corporate chains in the 1990s.
In this regard, the display obscures the immense impact video rental retailers had in inaugurating a new era of home entertainment and the upheaval they themselves had ignited within the media and entertainment industries. The tragedy for video stores was simply that they had been unable to leverage their pioneering role to ensure their survival in an era of new digital media. As this video store’s “clever-but-sad commentary” drew a few fleeting headlines, it was soon evident that these retailers were not alone in facing new and unlikely forms of competition.
Approximately seventy miles south of Lost Weekend Video, the main culprit indicted in the store’s modified lyrics, Netflix, was obviously singing a very different tune. In the company’s 2010 fourth quarter letter to shareholders, CEO Reed Hastings announced that Netflix had completed one of its most successful years in what had been a largely successful first decade. Launched in the midst of the late-90s dotcom boom, Netflix was among the legions of new start-ups hoping to parlay the Internet and associated digital technologies into a lucrative business endeavor. While most of these companies failed, Netflix succeeded by adapting the brick-and-mortar video store convenience into an online environment. The company was especially noteworthy in that it combined the power of a web-based interface with the existing United States postal system to deliver DVDs directly to customers. It was with this unique, and in some ways counter-intuitive, hybrid approach that Netflix supplanted not only neighborhood video stores like Lost Weekend, but leading corporate giants such as Blockbuster Video.
Though its initial success was closely tied to the blueprint provided by rental retailers, the company’s long-term ambitions revealed the limits of that model. By 2010, Netflix was shifting its attention away from DVD-by-mail operations to focus on its new streaming service—a form of digital delivery that seemingly brought to fruition the belabored dream of video-on-demand (VOD). With the success of this new service, Netflix amassed a subscriber base of more than twenty million, with seven million joining in 2010 alone. This made it one of the largest subscriber services in the country, comparable to cable providers such as Comcast and premium cable networks such as Home Box Office (HBO). The company’s size provided it with leverage both as it prepared to expand internationally and as it worked with manufacturers to establish its streaming software as a standard feature on hundreds of consumer electronic devices. The success of the new service also had its drawbacks as Netflix had to negotiate a new and very different set of distribution rights with content producers. The major media and entertainment conglomerates were eager to embrace the benefits of Netflix’s new streaming technology, but they were also extremely wary of the company’s instrumental position at the center of a rapidly changing and increasingly competitive home entertainment market. The resulting tensions contributed to a period of general volatility and vacillating strategies for the upstart company. Thus, even amidst apparent triumph, Netflix faced many of the same liabilities that eventually pushed video stores to the brink of extinction.
Although Netflix has ignited well-publicized debates among business executives and Wall Street prognosticators, the company and its practices remain a relatively unexplored object of scholarly study. As the following study will show, Netflix provides a particularly illuminating case study because of how directly it intersects with many of the recent changes in home entertainment and because its impact underscores how new technologies and changing consumer preferences dramatically reshape the media and entertainment industry. To put it in slightly different terms, Netflix arrived at the time traditional content producers were shifting their focus to non-theatrical or secondary exhibition windows. This new approach to distribution and exhibition was accelerated by a succession of home media formats, from VHS to DVD and Blu-ray, and the different retail strategies they each involved. During this same period the widespread introduction of the Internet and, more specifically, the increased availability of higher-speed broadband and wireless services made it possible to distribute, through streaming, a growing array of media in exclusively digital formats. These changes coincided with a proliferating array of interactive consumer electronics that featured integrated Internet capabilities, including video game consoles, portable personal computers, smartphones, and high-definition television sets. While facilitating new opportunities for media convergence and exchange, these shifts also created a great deal of anxiety for traditional content producers like the major Hollywood studios, which have had to quickly adapt their core strategies in order to optimize the value of their assets and the rights they control.
At the dawn of this era, there was a great deal of excitement about the unlimited, even utopian, potential of new digital technologies. Even though movie and television producers foresaw the economic advantages of digital distribution and video-on-demand, they couldn’t or didn’t pursue those strategies in earnest or fully commit to the shifting priorities that such a transition would require. This lag allowed unlikely intermediaries like Netflix to take the lead and establish a critical ‘first-mover’ advantage in what still remains a tumultuous and perpetually changing market. The major media conglomerates, along with technology and telecommunications interests, now are attempting to regain their advantage by introducing competing services and by leveraging their access to premium content, popular Internet portals, and various distribution channels. Regardless of whether they could vanquish the likes of Netflix or not, clearly the dreams fostered by digital technologies still will remain closely tied to the material interests of the same oligopoly that has controlled media and entertainment for most of the past century.
The rise and fall of empire(s)
By the late 1990s, the Bay Area’s Silicon Valley was home to a growing number of technology-based firms. Amidst the burgeoning dotcom boom, countless entrepreneurs hoped to strike it rich by turning the still fledgling Internet and its associated digital technologies into modern day goldmines. While Netflix turned out to be one of the most successful and resilient of these early dotcom start-ups, it was not the first attempt to wed the video rental business with the new potential of the Internet. The idea in fact originated in 1984 thousands of miles away in Manchester Center, Vermont. There, Stuart Skorman purchased a small video rental store, Empire Video, which he would go on to expand into a six-store regional chain over the next decade. Despite the success of Skorman’s store, he decided to sell Empire to Blockbuster Entertainment in 1994, just as the growing rental behemoth was completing its own empire. By acquiring a number of smaller, independent chains, the company boasted 2,100 franchises and a 12% share of the overall rental market. Skorman believed that the Internet would fundamentally transform the rental industry and would even, in the not too distant future, make it possible to deliver all movies on-demand in a digital format. With the $3 million from the sale of Empire, he moved to San Francisco to build a new company that combined the power of the Internet with the principles that had made his earlier store a success. In 1996, working out of a warehouse space in the trendy South of Market area, Skorman launched Reel.com, a website that offered 80,000 titles for sale and made another 35,000 videos available for ‘rent-by-mail.’ As Netflix’s immediate precursor, Reel shared many of the same business principles and long-term ambitions. Reel also illustrated the ways in which the Internet initially flummoxed rental retailers, and it was precisely because of their inability to fully integrate the new technology that Netflix was able to subsequently trigger an industry-wide transformation.
The key feature of Empire had been its vast selection. It carried upwards of ten thousand titles when the average store in 1988 tended to offer three thousand or less. Although the video rental business was shifting toward a hit-driven model, focusing more and more on new releases, Skorman recognized the value of guiding customers to older hits, sleepers, cult favorites, and foreign films. Though the store celebrated its cachet amongst sophisticated movie buffs, to take full advantage of this principle Skorman would also need to drive average customers to the far ends of Empire’s extensive catalogue. For this very reason, he pioneered the art of what he termed movie matchmaking. In short, this meant providing various forms of information that would lead customers to movies that matched their personal tastes. As he continued to develop this service, information ranged from personal recommendations and staff reviews to generating hundreds of novel movies categories (e.g., “So Bad It’s Good”) and, at one point, giving away three thousand copies of Leonard Maltin’s Movie Guide. The Internet obviously promised to enhance these practices. And indeed, when Reel.com went live, it featured a software program called Reel Genius that offered recommendations based on customer preferences. While the site had additional information including original content generated by staff writers and user-generated ratings, the new software provided a more efficient means of customizing information on an exponentially broader scale.
Despite all of its early promise, the precocious start-up was riddled with serious problems. Like many dotcoms at the time, Reel struggled to generate cash flow. After investing millions to get the site up and running, it only generated $745,000 in revenues during its first year of business. And while revenues increased in its second year, Reel could not project making a profit for the foreseeable future. One problem was that although the website was successful in drawing traffic, the information provided by Reel did not necessarily translate into sales or rentals. Perhaps due to the unfamiliarity of the web, “only 2.5 percent of Reel.com visitors [would go on to] complete a transaction, compared to 75 to 80 percent of video store shoppers.” More serious problems loomed on the technical side of things. Despite Skorman’s wholesale belief in the power of technology, he was actually quite incompetent when it came to implementing it within his various business endeavors. Throughout its early existence, Reel.com lacked the basic e-commerce features necessary to complete online transactions. The system was not set up to store customers’ information automatically, it was prone to crashing, and, at one point, it lost thousands of orders. With all of these problems, Skorman decided to hedge his bets by going against the grain of the dotcom boom. In June 1997, he opened an eight thousand square foot video store in Berkeley, CA, that would serve as a brick-and-mortar counterpart to Reel’s virtual storefront. Based on his earlier experience, he knew that a large video store “catering to sophisticated movie buffs could be a cash cow” and that, even if anachronistic, this might temporarily provide the solvency needed to continue his otherwise failing Internet business.
The problems afflicting Reel were not, however, entirely Skorman’s doing. These problems were tied both to the immaturity of Internet-based business operations and to the changing focus of the video rental industry. As the two issues came into contact, the potential for failure was most certainly amplified. It was likely for this reason that nearly all of the major rental chains had been extremely cautious in setting up any kind of online operation. Blockbuster, for example, launched its website in 1996, but it was used strictly as a tool for promotions and brand publicity. In 1998, the chain began selling select new videos through the web, but its overall ambitions remained quite limited. Smaller and more specialized retailers also used the web to post a searchable catalog of titles, which, like Reel, might draw online traffic without necessarily adding to their bottom line. In any case, these various concerns seemed to evaporate instantly in 1998 when Hollywood Video, the second largest rental chain, announced its plans to purchase Reel.com for the staggering sum of $100 million. The promise of its business model together with the leverage that came with being an early adopter of Internet technologies made Reel a lucrative asset despite its financial woes. What’s more, Hollywood Video saw the purchase as an opportunity to leapfrog its competitors, establishing a leading online presence of its own while also incorporating Reel’s “smart” software and a rapport with serious movie connoisseurs.
Unfortunately, the alluring promise of synergy never fully materialized. One significant factor was that shortly after the deal between Hollywood and Reel was completed, Amazon.com announced that it would be entering the home video market. Founded in 1994, Amazon was one of the earliest and most aggressive online retailers, and, like Reel, it attracted endless media hype with the promise of unlimited potential even as it continually failed to turn a profit. Unlike Reel, however, Amazon had the technical proficiency and e-commerce experience to support its expanding enterprise. After failing in its own efforts to acquire Reel, Amazon purchased the Internet Movie Database (IMDB.com) to supply customers with the same kinds of information that Reel’s matchmaking services provided. Soon after its arrival, Amazon became the top video retailer on the web. Its success encouraged the arrival of additional online retailers such as Buy.com, as well as more specialized sites such as DVD Express—all of which, following an industry-wide trend, were devoted exclusively to a sell-through model rather than rentals. With Amazon discounting its VHS and DVD titles up to 30%, these competing sites focused primarily on price. Rather than provide original content or personalized recommendations, these sites offered price-comparison technologies so as to guarantee the best value. Inundated by new competition and threatened by a wholesale reorganization of the home entertainment market in which a sell-through approach that primarily benefitted the major studios took precedence, Reel terminated its online rental service less than six months after its deal with Hollywood Video. The service had accounted for only 5% of the company’s business in the previous year. Moreover, it required additional overhead costs while the increased cost and hassle of shipping rentals were a deterrent to consumers. Renting online was proving to be cumbersome, and Reel had determined that it was simply “not an ideal business model for the Internet.”
With mounting losses and little market traction, Hollywood Video shut down Reel’s entire e-commerce operation in June 2000. For Blockbuster, Reel’s failure seemed to be a clear indication that the online video rental business was not a viable threat. With this reassurance, Blockbuster remained conspicuously slow in its own attempts to develop online strategies and, instead, the company viewed the emerging sell-through approach as its main competition.
It was the combination of Reel’s spectacular demise and Blockbuster’s disinterest that led directly to Netflix’s emergence. Founded in 1997, Netflix opened for business only a year after Reel, yet its slightly later arrival made a world of difference. Netflix likely learned from some of Reel’s mistakes, but more generally it benefitted because the Internet’s overall infrastructure was then better established and the basic standards of e-commerce better understood. Whereas Reel betrayed its new business model by eventually returning to its ‘brick-and-mortar’ foundations, Netflix, conceived entirely as part of this new era, was more fully committed to developing an exclusively Internet-based service. While Netflix missed out on the on the dotcom boom’s early windfalls—it had rented a mere 2,700 DVDs by mail as Reel was on the verge of its $100 million payday—it benefitted enormously by avoiding the burden of hyperbolic expectations and over-inflated stock values. Finally, and perhaps most important, Netflix was able to grow incrementally, building a loyal customer base on the strength of its reputation as a tech-savvy trailblazer. At the same time, Blockbuster failed to recognize the fledgling service as a serious competitor until it was too late. Unlike its precursor, Netflix made the most of this good fortune and shrewdly went on to supplant what had been one of the most dominant forces in home entertainment.
As Netflix began operations, it shared several key similarities with Reel. It offered a basic rental service whereby customers used an online interface to select the movies they wanted to see. The films were then delivered through the mail and sent back with a pre-addressed, pre-paid mailer. Also like Reel, Netflix emphasized the breadth of its selection and used proprietary software—a program called CineMatch—to direct customers toward more eclectic fare, effectively downplaying new releases while appealing to more discriminating movie connoisseurs. While both companies emphasized convenience and the ability to accommodate discerning video aficionados, there were also some fairly significant differences. First, Netflix rented only DVDs. At the time VHS still dominated the market and Netflix took a risk to focus exclusively on an unproven format. The wager paid off, however, as the new technology penetrated the market faster than either television or the VCR. In another example of its good timing, Netflix avoided having to decide whether it had to duplicate an existing inventory in order to carry both formats. This problem was even more pronounced for retailers like Reel since it also carried the laserdisc format as part of its larger efforts to court more discerning movie buffs.
When Netflix first opened its catalog was limited to a paltry 900 titles. The reason for this was that the studios were hesitant to embrace the new format and had only released a limited number of titles. This small scale, however, turned out to be another blessing in disguise. While early adopters were spending $400 to $500 for new DVD players, traditional rental stores were offering only 100 to 150 titles in the new format. This provided Netflix with a relatively small, but highly dedicated segment of consumers willing to try a new service in order to access additional DVD titles. At the same time, while the smaller library was easier to manage at the outset, Netflix was in an ideal position to scale up its selection both as DVDs became more popular and as the company expanded its customer base. Finally, because DVDs were lightweight and durable, the company was able to streamline shipping and handling, maximizing both the efficiency of its distribution system and the overall convenience of its service. This convenience in shipping marked another critical departure from Reel, which, in trying to ship and receive VHS cassettes as part of its rent-by-mail service, was unable to fully align its delivery method with various changes concurrently adopted within the U.S. postal system.