The Netflix way

Will the success of the pioneering DVD-rental company convince a reluctant music industry to embrace its own subscription strategy?

By Damien Cave
Published June 6, 2002 8:03PM (EDT)

John Andrews first heard about Netflix when his class at Harvard Business School studied the company in 2001. But it wasn't the business model that persuaded him to sign up for the service, in which people register online and pay $20 a month for a rotating crop of DVD rentals that arrive by mail. He simply thought a Netflix subscription would make his movie-watching activities more convenient -- and he has yet to doubt his initial hunch.

"I like that I can go online when I think of a movie I want to see and I can add it to my queue," he says. "Or if I'm not sure what I want to see -- I've been trying to catch up on classics; I just returned 'A Streetcar Named Desire' -- I can go to 'genre' and search for ideas of what I'd like to watch. The service works far better than walking into a video store and looking at the new releases."

Andrews' enthusiasm seems to be contagious. In the midst of a pronounced technology slump, Netflix has become the rarest of all Silicon Valley breeds: a rising dot-com star. The Los Gatos company has netted more than 600,000 subscribers since launching in April 1998. On May 23 Netflix raised $80 million in one of the most successful initial public offerings (IPOs) of 2002.

A combination of luck and savvy is goosing the company along. Sales of DVD players began to take off just as Netflix switched to a subscription service in late 2000, and Hollywood studios signed deals with the company at about the same time, in order to balance the growing power of Blockbuster. Consumers, tired of paying late fees and enthralled with their new DVD players -- 35 million have been sold to date -- welcomed the idea of a service that lets you hold on to a movie until you watch it.

Netflix also benefited, digital media experts argue, from its uncanny ability to shift entertainment consumer behavior toward a service and away from traditional systems in which people buy or rent a single piece of entertainment for a specific period of time. Netflix, with its focus on flexibility, comprehensiveness and ease of use, has essentially persuaded consumers to accept a system of eternal borrowing. Call it faux ownership. Netflix subscribers pay about $20 a month for the right to hold on to DVDs for as long as they want; to watch movies over and over again without paying extra fees. The only limitation is that they can't hold on to more than their allotted number. To get a new DVD, they have to send back an old one.

And here's where the Netflix story could get really interesting. If Netflix's success continues, experts argue, it would be the first online entertainment company to earn both a profit and a rabid following. As such, it might offer a model that other entertainment companies could follow -- especially the music industry. If Netflix's convenience, portability and price attract millions of people and make millions of dollars, why can't the idea of faux ownership catch on in the world of digital music?

The music business already has its toes in the water, having launched several subscription services that are essentially jukebox rental systems. But fearing the cannibalization of their billion-dollar CD business, record companies have moved cautiously, bogging down their offerings with complex protection schemes that put off potential users.

Could Netflix be the catalyst that finally forces the music business to embrace real change? A runaway subscription success might persuade entertainment industry moguls to let go of copy protection, while persuading consumers to accept flexible borrowing rather than collecting. EMusic -- a subscription service offering MP3s from independent labels, without copy protection -- is already paying close attention to the Netflix model. And music lovers, particularly those who love Netflix, seem more willing than ever to embrace a flexible subscription model.

"It could work," says Andrews, who is now a consultant at DeLoitte Touche Tohmatsu. "It would have to have a substantially larger queue. But I have a ton of music that I've downloaded, mostly from Napster, and I've got this one playlist that I put on whenever I'm home. If I could always easily go in and swap out 10 or more old songs and insert new ones, and if I could take them wherever I wanted, that would definitely hold some value."

CEO Reed Hastings says he started Netflix to fix a few problems he had with the video rental business. His epiphany came in 1997. He had just sold his software company, Pure Atria, to Rational Software, and after returning a late copy of "Apollo 13," he garnered a $40 fee. There had to be a better way.

"It was my fault in some sense. The movie was about three months late," he says. "But I realized immediately that it was a poor customer experience. It was also suboptimal for the companies -- the retailers and vendors."

Hastings figured that a subscription service, without late fees, would work better. It would be cheaper and easier for both the studios and consumers because, he says, "it would take out the selling costs around the individual content items. Without having to pay as much for promotional costs, the content owner gets more money and the consumer gets a better deal."

At the time, an entertainment subscription service was unheard of, so Hastings decided to postpone the idea and start with a more traditional model: individual DVD rentals, ordered online and sent through the mail. During the first year, Netflix even charged late fees.

"We were worried that it was too radical," Hastings says. "We thought, let's first implement a more simple mode for consumers so they can get used to us." The extra time let Netflix develop a simple sign-up system and envelopes that let users send back a DVD in the same package it had arrived in. Growth, however, only started to take off after the subscription model launched in late 1999. The company signed up 85,000 subscribers by January 2000; a year later, the subscriber rolls had swelled to 300,000."

Users say that Netflix stands out because the model gives them a high level of flexibility without much hassle. Subscribers can pick DVD titles whenever they're using the Net; they can watch the movies wherever they want, for as often as they want. And when they're done with one movie, they can rely on Netflix to handle new orders with speed and efficiency. The music industry should take note.

"It's the ease of use and the convenience that make it so compelling," Andrews says. "And it's at a price that, given how much I would spend for movies anyway, is affordable."

There's a psychological force at work, Hastings suggests. Users don't mind paying because they feel they're being given a great degree of freedom and control. "Consumers enjoy and are willing to pay for an unlimited model because it gives them freedom," he says. "Some months they watch a lot of DVDs; some months they don't. But regardless, they have the freedom to decide for themselves. It's the same reason why people get the unlimited mileage when they rent a car -- they don't want to feel nickel-and-dimed."

Netflix shows what economists have known for years: that consumers think beyond simplistic value propositions such as a flat monthly fee divided by number of movies watched. They consider flexibility a value that's worth paying for, says Jim Griffin, CEO of Cherry Lane Digital, a specialist in rights management for songwriters and movie studios. "They're paying a flat fee for the anarchistic use of the content," he says. "That's an important part of the system."

For decades, businesses have enjoyed this privilege, what Griffin calls pool (in contrast to per piece) economics. Restaurants, health clubs and other public venues can all pay the music industry a flat fee for the use of whatever songs they want. Netflix simply extends the buffet model to consumers.

"Disney CEO Michael Eisner keeps saying that if we can't control all the content, we won't let it out there," Griffin says. "But that's historically incorrect. It's the lie being used to shove digital-rights management down people's throats. The truth is that with radio, television, satellite TV and webcasting, we've always let content out. This is the future, and our past."

At least one music subscription company recognized the significance of Netflix early in its trajectory. EMusic has been watching Netflix and learning from its focus on convenience and freedom since 1999.

"We spent a lot of time understanding their service before we launched our subscription service in July 2000," says Steve Grady, an EMusic general manager. "There are differing dynamics between music and DVDs, but in terms of how you communicate with the customer, the services are very similar."

Specifically, EMusic mimicked Netflix's use of the free trial and tried to follow the overall flow of its Web site.

"Netflix does a very good job of obscuring the complications," Grady says. "They focus on the main benefits of the service, then start asking, What kind of customer are you? We decided to follow that idea because, like Netflix, we were offering a new kind of service."

EMusic also maintained a similar level of portability. Just as Netflix users could take their DVDs anywhere, and order from any Internet-connected computer, so can EMusic's 50,000 members play their music however they like. Because the company's catalog uses the MP3 format, songs can be burned to a CD, shared, or copied to a portable MP3 player.

"In essence, in a broad conceptual way, EMusic is doing the same thing as Netflix," Griffin says. "They're saying [to users], Look, you don't have to account for each play. You just cut us in on the money and we'll untether this stuff for you."

But in today's music environment, flexibility has its consequences. EMusic's focus on portability looks like kryptonite to the major labels -- the kind of thing that will kill the industry. And if EMusic is the audio stepchild of Netflix, it's practically an orphan.

Most of the other music subscription services that have risen up in Napster's wake are complicated and confining. Signing up for them may be easy: PressPlay, MusicMatch, and Real's RealOne service -- the main players in the music subscription game -- all offer free trials and registration systems that take less than 10 minutes to fill out. Searching for music is relatively simple too; the interfaces for these services seem to have ripped a page right out of the Napster playbook.

But once the searching is done, these services spiral down into a Escheresque labyrinth of complications. All of the services make listening to digital music far more complicated than it needs to be. MusicMatch's Radio MX subscription service and Real's RealOne offering both prohibit burning. Even if you pay top dollar -- about $25 a month -- you can listen to the music only if you use specific software from the appropriate company.

"The files won't work where you want them to work," says Tim Bithoney, the former technology director for Radioactive Media Partners, which streams radio for Barnes and Noble and other sites. "You can't transfer them to a car or Rio. You have to constantly be connected to the Net and you have to use their products."

PressPlay offers slightly more flexibility. Users who sign up now get to burn 10 songs to a CD for $9.95 a month (after three months, the price goes up to $14.95). But not everything is available for burning. Eminem's latest singles are marked with the flame icon that signifies burnability, but others, like Pat Benatar's "You Better Run," can only be streamed and downloaded.

These services also don't let you keep what you've collected. When users stop paying subscription fees, the music expires, becoming unusable. And it's not as if the services are comprehensive. Each service is essentially its own fiefdom. PressPlay, a partnership between Sony and Universal, doesn't yet have rights to music from Warner or BMG. MusicNet, a joint venture between EMI, Warner and BMG, doesn't yet have access to music from Sony and Universal. And EMusic, with its focus on flexibility, has only licensed music from independent labels. Grady says that EMusic wants to stay away from the majors because it's aiming for a niche of hardcore fans. But Cherry Lane Digital's Griffin scoffs at his claim.

"Come on," says Griffin. "They want everything [but] their own corporate owner" -- Vivendi, owner of Universal Music -- "won't give them everything they have."

Last year, Congress looked into the music industry's licensing practices to see whether the labels were exercising illegal monopoly power. But so far, nothing has come of the inquiry and the standoff continues. The only services that contain music from all the major labels are the unauthorized peer-to-peer networks like KaZaA, which the industry is trying to sue out of existence. Meanwhile, the official services remain littered with holes. Without the kind of comprehensiveness and portability that Netflix offers, some argue, they're destined for failure.

"No one's going to use them because of the extra rules they impose and their proprietary formats that won't go onto a CD or MP3 portable," says Glenn Reynolds, a law professor at the University of Tennessee who also leads a techno band called Mobius Dick. "They'll fail like Circuit City's DivX did, not because there's anything wrong with the concept, but because people just won't want to deal with the hassle of managing when their songs 'expire' or which ones they have to delete to make room for the new 'N Sync single."

And yet, despite their flaws, the services can be seen as signs of progress, says Griffin. "Their services are the industry's first toe into the water," he says. "They're saying, OK you can pay one fee to get into the pool and then you can use kind of what you want, kind of how you want to. It's not perfect but it's not per piece economics either. It's a shift."

The labels have moved slowly. "They are engaged in Tarzan economics," Griffin says. "They're clinging to a vine that pays their salaries while they're swinging to the next vine that they don't yet have in hand."

Hastings agrees. "In the music business, none of the subscription services have been particularly compelling because the content owners are afraid of undercutting other channels of revenue," he says.

But Netflix may encourage them to accelerate the process of change. The industry claims to be working as fast as it can. PressPlay expects to have access to music from all the major labels by the end of the year, and Erik Flannigan, vice president of music programming at Real, says that RealOne members will soon be part of a "rent to own" plan.

"The real key is establishing the value of the temporary copy," Flannigan says. "The permanent copy is the underlying royalties minus the physical cost of goods. But if I keep a song for seven months and listen to it 33 times, how much is that worth?"

Flannigan says that Real will have hammered out the details within a few months. Other services might take longer. Figuring out the pricing details can be difficult, says Cary Sherman, president of the Recording Industry Association of America. "It's not as easy as flipping a switch," he says. "This is an evolving process where all the players are constantly working to make the systems more efficient, more cutting-edge and reflective of consumer tastes."

But money is the ultimate motivator. If Netflix continues its rise, some argue, the music industry might move faster. Subscription-based entertainment could proliferate once the industry realizes that "Netflix would be far less successful if it only offered films from half the major studios and if the DVDs it delivered could only be played on certain sorts of players," says Kelly Truelove, an indpendent peer-to-peer analyst. "Comprehensiveness and portability are appreciated as necessary conditions for success."

"In essence," says Griffin, "because we will find that we can't end the anarchy, and because new technology will add to the anarchy, we'll find a way to monetize the anarchy. That's what good business does."

Not every user would be interested in a massive jukebox that comes with a monthly fee. "It can't be a subscription," says Bithoney. "It has to be purchase." But there would seem to be a large and growing contingent of entertainment users who would welcome the change.

"I like looking at my CD collection but a lot of them collect dust," says Andrews. "If there's some kind of subscription playlist that's big enough, if I can have control of the queue, if I can turn things over when I want to, then I'd go for it. If you take away the temporary feeling, I'm in."

Damien Cave

Damien Cave is an associate editor at Rolling Stone and a contributing writer at Salon.

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