|STAR-MAKING MACHINERY: Hastings thinks that with enough subscribers, Netflix can "democratize distribution" in ways that let a wider variety of shows find success.|
The Henkels don't run into friends at the local video rental shop anymore. Netflix ships the Henkels DVDs every week based on a list of requests that they keep current on the Netflix website. Their movie tastes are quite catholic: favorites include Legally Blonde and Terminator 2, but they're also fond of DVD collections of British television programs. Lately, Bob and Bobbi have been working their way through 90 episodes of All Creatures Great and Small, a 25-year-old series about the adventures of a Yorkshire veterinarian.
That Netflix, based in Los Gatos, Calif., can offer a choice of 50,000 DVDs on a day or two's notice to this land's-end spot is a marvel of logistics. The company has 37 distribution hubs around the country, and every morning the company puts more than 1 million flat red envelopes containing DVDs in the mail.
THE FLIGHT OF THE DVD : How Netflix and the mail put movies at a customer's fingertips.|
Diagram By Nigel Holmes
But the fact that Netflix also is amassing a database that knows all about a Maine volunteer fireman's love of British comedies—and exquisitely specific film preferences of the rest of its 3.6 million subscribers—is what really excites Hastings. He believes that database will arm Netflix not only to reshape the physical distribution of movies, but also broaden the creativity and variety of movies made. That's a lofty goal—but one worth taking seriously given Hastings's success with this dark-horse survivor of the dot-com boom.
Between every charming, low-budget hit like Sideways and monster successes like Titanic, there are hundreds of movies and documentaries that would be deeply appreciated by select, but still large, numbers of people—if only they knew such movies existed. "The inefficiency in the movie industry is audience-finding," Hastings explains. Only a small fraction of movies made annually, perhaps two to three dozen, enjoy big-budget promotion. "We want to democratize distribution," Hastings says. "If you can look at any film and find the 3 million people who want to see it, that's the big, big prize. To do that takes great scale. It's like eBay providing a sweater-knitter in the Sierras with cost-effective distribution. If we have 20 million subscribers, we can do that."
CHANGING THE WORLD of entertainment might be a surprising goal for an entrepreneur who made his first fortune with a company so nerdy that it made software for other software companies. But investors, colleagues and friends of Hastings, 45, say they would never bet against his combination of long-term vision and nitty-gritty technical acumen. "Reed is one of the very few CEOs I would hand my checkbook to and say: 'Tell us what you're doing and please let us invest,'?" says Jay Hoag of Technology Crossover Ventures. Hoag was an early investor in Netflix and today sits on its board. Leslie Kilgore, MBA '92, left Amazon in 1999 to join Netflix as chief marketing officer. Her faith in Hastings's strategy and leadership is such that, "I tell people today that I am unrecruitable."
Hastings grew up on the East Coast. A math whiz at Bowdoin College in Maine, he graduated in 1983 and then served as a Peace Corps volunteer, teaching math in Swaziland for two years. In the late 1980s, he returned to the States and to the vibrant computer science department at Stanford.
There he got his first look at high-tech entrepreneurs. The example set by the founders of Sun Microsystems and other start-ups, plus Stanford's willingness to teach engineers both the business and the science of their field, "was like having a license to dream," Hastings recalls.
His first job was working at Adaptive Technology, a networking switch company, for Audrey MacLean, its founder and CEO. (She is now an angel investor who also teaches in the School of Engineering's Technology Ventures Program.) At Adaptive, Hastings invented a tool for debugging software that he could see would be snapped up by the rapidly expanding software industry. He left his job (with MacLean's blessing, and some of her personal investment money) in 1991 and formed Pure Software (later Pure Atria). Pure was one of the nation's 50 largest public software companies when Rational Software bought it out in 1997 for $750 million.
IN HIS MID-30s, Hastings says he found himself a bit adrift. "I was so ego-identified with [Pure] that I felt like a failure," he says. Armed with a fortune but without a target, Hastings felt his public-service side stir. He contacted Michael Kirst, a professor of education, to discuss educational reform and ended up enrolling in Stanford's School of Education. According to Kirst, who became a friend, "So many people in business get interested in education or criticize education, but very few are like Reed, who said, 'I've got to spend some time and study the field in depth.'?"
Hastings became excited about charter schools and other reform efforts. In 2000, Gov. Gray Davis, '64, appointed him to the State Board of Education, and the next year, Hastings became its president. He also served as the CEO of TechNet, a lobbying effort by Silicon Valley executives that focuses in part on education reform. Hastings was a rare figure on the political scene: an individual willing to donate personal time and energy as well as millions of his personal fortune.
His activism advanced California's charter school movement, and he was instrumental in the passage of Proposition 39 in November 2000. That ballot measure lowered—from 66 to 55 percent—the level of voter approval that local schools must garner to pass construction bond issues. "He is absolutely driven to improve the level of education in this country," says his friend Nick McKeown, an associate professor of electrical engineering and computer science. Hastings set an example "that it's OK to be a geek with a conscience."
A conscience perhaps, but not infinite patience for the machinations of politics. Hastings, a Democrat, ran afoul of some powerful Democratic legislators who challenged Hastings's advocacy of more English instruction and language testing for non-English-speaking students. A majority of the California Senate Rules Committee refused to confirm him as the State Board of Education president in early 2005. Hastings had enjoyed support on both sides of the aisle, and the vote prompted Gov. Arnold Schwarzenegger, who had reappointed Hastings to the board after his first term, to issue a statement saying he was "disappointed" in the committee's action. Hastings resigned.
These days, Hastings says that while he found his education reform work satisfying and he continues to support political candidates and reform efforts, he is just as happy to give most of his attention to Netflix. "I just didn't like politics enough," he says. "I love business."
DURING THE LATE 1990s, Hastings, who lives in Santa Cruz, Calif., with his wife and two children, had one of those "aha!" moments that has launched a thousand start-ups. Like many an American dad, Hastings went to Blockbuster one day and discovered that his family had been late in returning a videotape. The overdue Apollo 13 cost him a whopping $40 in fees. There had to be a way to make money renting movies without gouging customers on late fees, he reasoned.
Hastings, who likes movies but is not particularly a movie buff, started analyzing the rental business. He could see that customers hated long lines and coming home empty-handed when the selection was poor. And then there was the hassle of returning the tapes: it was easy to misplace or forget or damage them, and the return penalties quickly added up.
Hastings saw that the Internet ultimately could provide a way for customers to order and download movies right into their homes. "I've always wanted to do that. We didn't name the company 'DVDs by Mail,'?" he says, because he foresaw digital distribution. But such systems would require far more storage capacity and network bandwidth inside homes than existed in the late 1990s. Plus, there was the even more daunting issue of cracking the complex, long-term contracts between studios and broadcasters and cable channels that continue to lock up television rights to most films.
Hastings saw an opportunity in the relatively new DVDs, which were durable, convenient and fairly inexpensive to mail. Even though in 2000 only about 10 percent of American households had DVD players, growth soon took off. (Today more than 70 percent of homes have DVD players.)
Hastings's idea faced naysayers. For one thing, "Netflix is an enormous behavior change," for customers used to jumping in the car, browsing store shelves, and coming home half an hour later with two movies in hand, Kilgore notes. Making DVDs available by mail meant designing a complex distribution system that would reliably deliver movies in a day or two.
From the earliest days, Hastings used his technological savvy and relentless customer-service exhortations of employees to fuel impressive growth. After a surprisingly successful stock offering in 2002, Netflix's path has been mostly onward and upward. The number of subscribers grew 61 percent last year and is expected to reach 5.65 million by the end of 2006. The company had revenues of nearly half a billion dollars in the first nine months of 2005. "Netflix has really made renting movies convenient," says Cliff Edwards, who covers consumer electronics for BusinessWeek. "Because of Netflix, it's easier to rent a DVD than buy one now."
There have, of course, been snags along the way. Chat rooms bubble with complaints from some hardcore users that the company deliberately slows down their "unlimited" access to films. Netflix recently settled a class action suit charging, among other things, that its initial promise of a one-day turnaround was false advertising. Nonetheless, the company's stock has performed well, and in 2005 more than doubled to close the year at around $27.35.
To hit Hastings's target of 20 million subscribers, Netflix plans to increase advertising and marketing efforts and invest in still more distribution centers. One intriguing advantage: the company's prospects don't seem to depend on Hollywood's churning out a stream of attention-getting hits. Only a small percentage of Netflix rentals are new films. More and more customers are like Sharon Winnike of Menlo Park, who is as likely to rent old television shows as new movies. "I watched no TV for years when my kids were small because I could never count on sitting down at the time a program was on," she says, exemplifying a market segment of DVD renter that Netflix has fostered.
And therein lies the data gold mine that Netflix exploits every time a customer rents and then rates a DVD. Those who thought Netflix was just a delivery service did not appreciate the marketing relationship it would create with customers or the way that relationship would get stronger with every interaction. Netflix offers customers constant recommendations based on their previous rentals—recommendations based on preferred genre, or actor, or subject matter. In this personal-shopper role, Hastings believes Netflix is one of a handful of Silicon Valley companies orchestrating a "seismic shift" in the media business. Apple in music, TiVo in digital video recording, and Electronic Arts in the game business, not to mention more broad-based Internet media companies like Yahoo! and Google, are using technology to create increasingly convenient, satisfying, personal entertainment experiences. "These businesses are all growing—one is not replacing another," Hastings says. "For 100 years, media has been dominated by New York and L.A. Where are the big things happening now?"
So far, not at the companies once predicted to trounce Netflix in DVD rental. Wal-Mart pulled the plug on its two-year DVD rental business in May, after Hastings orchestrated a deal in which the giant retailer agreed to send rental customers to Netflix, in exchange for Netflix's directing DVD sales leads to Wal-Mart. Blockbuster, meanwhile, is staggering under more than $1 billion in debt and heavy losses as it struggles to build its own online rental business. It has long been rumored that Amazon intends to enter the American DVD rental business, but its efforts overseas have not been terribly successful.
It seems the systems Netflix developed to process and track its inventory and shipments, not to mention those that watch customer preferences, have proven much harder for competitors to copy than first thought. (Blockbuster reportedly has invested more than $300 million so far but is struggling to add subscribers.) At Netflix's largest distribution center, a 115,000-square-foot facility in Sunnyvale, there is a curious mix of high and low tech. Rows of employees rip open the huge postal crates of red envelopes carrying customer returns each morning. DVDs are immediately scanned to generate an e-mail to customers assuring them Netflix has received the DVD and soon will ship their next selection. The rest of the disk's journey, however, involves a highly proprietary, software-controlled whiz around the facility for sorting, stuffing and either restocking in vast racks of DVDs or reshipping to the next customer.
"The question now is, can we grow into the world's most innovative entertainment distribution company?" Hastings says of Netflix's future. Getting there will involve not only solid execution, but also experimentation. Netflix has introduced a "Friends" feature that further refines audience preferences and encourages people seeking their next selection to browse what films their friends have viewed and rated. And Netflix is investing in the actual production of certain movies, in exchange for exclusive DVD rental rights. It hit something of a jackpot when it helped fund the documentary Born into Brothels, about the children of prostitutes in Calcutta: the film won the 2005 Academy Award for best documentary. This is the kind of film, Hastings explains, that might not otherwise get made, but Netflix was confident that a large group of customers who enjoyed documentaries would want to see it.
WITH SUCH POWERFUL COMPETITORS as Amazon still lurking and cable companies trying to build the market for on-demand movies, Hastings thinks Netflix must increase its customer base in the next five years, to a size that will represent a true force in the industry: the 20-million figure is something of a grail. It represents the clout of a player such as HBO, which has 30 million subscribers. Netflix continues to invest in the technology that someday will make downloading of movies to homes easy, although the company suspended a much-anticipated direct-download trial in late 2005. The trial was stopped because Netflix still could not obtain the rights to enough sufficiently compelling content from the studios. "It will happen," Hastings says, but the complicated landscape of the industry makes it more difficult than, say, copying the model of downloaded music. "If the movie business wanted to do [the equivalent of Apple's] iTunes tomorrow, they can't. The content is already sold in five- to 10-year contracts" to cable providers and television broadcasters. As a result, Hastings predicts, DVDs "will be stronger longer than anyone would have expected."
One of the most interesting big-picture questions ahead for all entertainment companies is just where, in an era of burgeoning hardware options (think wall-sized televisions down to tiny video iPods), consumers are going to gravitate. Hastings says Baby Boomers like him may be the last of what he calls the "Bose speaker ad" generation of media consumers. Recall the image of the guy sitting in an armchair facing a stereo whose speakers are blowing his hair back. Baby Boomers' use of media tends to be focused, one-thing-at-a-time enjoyment, and it translates into a demand for ever-larger and -crisper television sets, elaborate sound systems and media rooms. As the parent of any teen can attest, however, younger generations are media multitaskers. They think nothing of listening to an iPod while playing a game on the computer while text-messaging on a cell phone. "Will younger people want a large screen in their house or not?" Hastings asks. "Will we be seeing a lot more laptop-based entertainment?" Those answers will be part of the calculus for just how long DVDs are likely to be a mainstay of film distribution. It might remain more practical to pop a DVD into a laptop because video content can be slow to transfer and a full library of movies would be a memory hog.
One of the big lessons Hastings says he learned when he first dove into education reform was that "Focus is an underappreciated virtue. It will take a couple of decades to transform entertainment. That's okay. That's what everything great takes." In the meantime, should a studio be wondering if it should take a chance on producing a charming British comedy, Hastings grows more confident every day that he can figure out just how many Bob and Bobbi Henkels are likely to want to watch it.