Ever since Netflix launched its online video rental service in 1999, conventional wisdom has suggested that the clock was ticking on its business model. First, there were worries that Blockbuster would squash Netflix. Then it was Wal-Mart’s DVD rental service, which Netflix absorbed in a partnership arrangement last year. Today, Netflix is under fire from movie download services offered by powerhouses such as Amazon and Apple. So what’s next?

Netflix found a market niche by renting movies on DVD to customers for $5.99 to $47.99 a month based on the number of DVDs shipped. The company’s business model features a state-of-the-art distribution network — 41 shipping centers in the U.S. that can reach most customers with one-day delivery — and an online recommendation system that lets customers select from 65,000 video titles. However, industry observers say Netflix needs to start offering movie downloads or face losing its edge. Netflix, for its part, says it will detail its movie download plans in January.

Thus far, Netflix hasn’t gotten the memo about its supposed extinction. On October 23, the company reported third quarter results that beat Wall Street estimates, with net income of $12.8 million on revenues of $256 million. Netflix’s revenues were up 48% from a year earlier, and it ended the quarter with nearly 5.7 million subscribers. The company said it would finish out 2006 with 6.3 million subscribers and nearly $1 billion in annual revenue.

“People started predicting the death of Netflix as soon as it launched,” says Wharton marketing professor Peter Fader. “If it ain’t broke, there’s no need to fix it. I don’t see why the current downloading threat is any different than the others.”

Safe or Under Siege?

Opinions vary among Wharton marketing professors as to the challenges Netflix faces, both now and in the near future. For example, Leonard Lodish says Netflix has to diversify the way it delivers movie rentals. Jehoshua (Josh) Eliashberg says the company should experiment with multiple business models beyond its current one. However, Xavier Drèze says Netflix can afford to be patient in altering its business model because DVDs will remain popular for a long time. Meanwhile, numerous financial analysts are concerned about the future of Netflix because of high subscriber acquisition costs, competition from Blockbuster and the increasing presence of download services. In a research note following Netflix’s earnings, Richard Ingrassia, an analyst at Roth Capital Partners, said Netflix “has a best-in-class product, but the company’s nearly ideal competitive environment is changing, and not for the better.”

It’s unclear whether Netflix will need to dramatically overhaul its business of renting DVDs or whether it just needs to hedge its bets by also offering movie downloads. Another wild card is timing: When will downloading be the dominant mode of movie distribution? “Once a technology trend is spotted, people tend to get giddy and over-predict its adoption,” says Kendall Whitehouse, senior director of IT at Wharton. “Downloading movies is still nascent and for now it’s mostly attracting early adopters.” Indeed, Fader says Netflix should offer downloading, but not revamp its entire business around it. “It’s good to experiment, but Netflix doesn’t need a wholesale change,” says Fader. “A downloading service works as a hedge, but that’s very different than a company changing [its business model] out of necessity.”

For now, Netflix management apparently agrees with Fader. On the October 23 Netflix earnings conference call, CEO Reed Hastings noted that download-to-own movie services from Amazon and Apple aren’t direct competition for DVD rentals. “DVD rental will be minimally affected by these new entrants in the movie ownership market,” said Hastings, adding that movie rentals are an $8 billion market. “Fortunately, physical DVDs remain ubiquitous in nearly 100 million U.S. households.”

But Netflix isn’t ignoring the download market, even if the company is taking a measured approach. CFO Barry McCarthy says that the company plans to “significantly accelerate [its] spending on digital downloading in 2007 — from less than $10 million this year to more than $40 million next year.” Adds Hastings: “In 90 days, we will give a full briefing. I know it’s frustrating to dangle it out there and not complete the sentence.”

According to Whitehouse, Netflix is facing a conundrum over how to alter its business model while building on what has made the company a success. “Netflix should be exploring some kind of hybrid model [of media-based and electronic distribution],” he says. Along those lines, Fader suggests that Netflix’s distribution prowess could be used to set up a small package delivery business, much like Federal Express did. “Remember, Netflix is equal parts distribution and movie company.”

Expanding Its Footprint

So how should Hastings and company proceed? Should Netflix spend heavily on downloading and potentially undermine its current business? Could it find new markets but spread itself too thin? How much time does Netflix really have? To Whitehouse, Netflix has two core assets: a web site that tailors recommendations for customers and a distribution system that delivers DVDs quickly. “The question is, which one does Netflix see as its core competency?” he asks.

Eliashberg suggests that Netflix utilize both assets to continue its momentum. “The model is definitely a good one, but there are questions on the horizon,” he says, noting that DVD kiosks from companies like DVDXpress may be a bigger threat than downloads. DVDXpress rents movies through ATM-like kiosks at locations such as supermarkets for $12.99 a month. In a DVDXpress press release on October 3, the company touted its “Netflix-style” monthly service. Combine kiosks with video on demand and movie downloads, and Netflix faces a bevy of competitors, says Eliashberg. “Should the CEO of Netflix be worried about becoming obsolete? No. But the company isn’t likely to grow at the same rate without experimenting.” In Eliashberg’s view, Netflix should consider offering delivery via kiosks to expand its footprint, try dynamic pricing, and offer a market for previously viewed DVDs as well as deliver rentals through downloads.

No matter what extensions of its business model Netflix decides to pursue, the upcoming download service needs to be front and center, says Lodish. “If Netflix doesn’t change to offer downloads, technology will catch up with the model. With downloads, it will be a lot easier for customers to stay with the company because there will be no reason to switch.”

CEO Hastings agrees that downloads are important. “In terms of the download rental market opportunity, we have been patiently learning through prototyping and consumer research. While there may be little near-term threat to physical DVD rental, that does not change our view on the importance of Netflix leading the download rental market.”

The problem: Renting movies through downloads is more challenging, say analysts. Most current movie download businesses focus on selling, as opposed to renting, movies. Ingrassia notes that the download-to-rent model is inherently more complicated, and major movie studios may resist a Netflix service. “At least part of the reason for Netflix’s slow progress toward an electronic delivery option is the resistance of the major studios to back any download-to-rent model.”

Operating profit margins on DVD sales, Ingrassia adds, are about 50% compared to 30% for rentals. Meanwhile, most of the studios have a financial interest in movie download services, such as MovieBeam, Movielink and CinemaNow. “We therefore believe Hollywood is even more prone to discourage a download-to-rent business. In addition, our research suggests that in spite of important strides in watermarking, encryption and protected download-and-burn technologies, the studios remain wary of electronic delivery.” Ingrassia also estimates that part of the $40 million Netflix is investing in a download service in 2007 will be used to pay studios to participate in its service.

Lodish, however, says these hurdles are not insurmountable given current digital rights management software. “The key for Netflix is to make the download seamless with its existing service. Consumers could rent the movie for the week and the disk could then self destruct.”

7 Gigabytes vs. 50

In addition, Netflix must contend with a format war over the next generation of high-definition DVDs, reminiscent of the VHS-Betamax war over video cassette formats. Sony and Microsoft are the primary backers of two different DVD technologies called Blu-ray and HD DVD, respectively.

On the Netflix conference call, Hastings said the high-definition DVD format war between Sony and Microsoft was slowing adoption of the technology. And given that both rivals have turned their game machines into high-definition DVD players, neither is going to budge, he says. The solution: The movie industry should support both formats to get consumers on board. Experts at Wharton note that Hastings has more than a passing interest in the high-definition DVD war. High-definition DVDs would be more difficult to download and could preserve Netflix’s current business for years to come.

Drèze estimates that traditional DVD rentals will still dominate in five years with high definition DVDs being the norm in a decade. If that projection holds, Netflix has plenty of time to find a new model. Indeed, Drèze argues that if high-definition DVDs become the norm among consumers, Netflix will be able to deliver a rental through the mail faster than most can download it.

“A traditional DVD currently requires 7 gigabytes. That is a 10-plus hours download. The people who promise you a 2-hour download have to increase the compression rate to get it down to 2 from 10 hours. These movies will look okay on a 27″ screen, but not on a 61″ home theater,” says Drèze. “The new Blu-ray DVDs hold 50 gigabytes and promise movies in true HD quality. At current speeds, we are now talking 72-plus hours for a download. With more and more people spending money on home theater equipment, including large HD screens, I don’t see that the download model is going to work for many years — at least not for movies.”

Add it up, and it seems there is no reason for Netflix management to panic about its business model, even though it needs to dabble with new delivery mechanisms. “The future of the movie industry is still the DVD. The vast majority of movies will be on DVD,” says Fader. “I have a lot of faith in its management. Netflix will continue to do well on its own.”