As told to Patrick J. Sauer
Every day, a million red envelopes, carrying a million DVDs, circulate through the veins of the United States Postal Service, spreading cinematic joy. (Fargo to Fairbanks! Bustin' Loose to Tuscaloosa! The Onion Field to Vidalia! The Battle of Algiers to Kennebunkport!) It's all thanks to Netflix, brainchild of Reed Hastings, who in 1997 saw a way to combine Americans' love of movies with their love of not getting off the sofa even to go to the video store. Netflix launched its Internet-based subscription service in 1999 and signed up 239,000 movie lovers in the first year. Today it has nearly four million subscribers who choose from 50,000 titles. The company, which went public in 2002, expects to report $687 million in revenue for 2005.
Hastings survived a serious challenge from Wal-Mart in 2005--the giant blinked first, or yawned--and now his focus is Blockbuster. Hastings likes to point out that Netflix is already four times bigger than Blockbuster in the online segment and is continually investing in marketing. You may have noticed the ubiquitous Netflix pop-under advertisement; it's the reason the company was second in online advertising dollars spent last year.
Netflix was originally a single rental service, but the subscription model was one of a few ideas we had--so there was no Aha! moment. Having unlimited due dates and no late fees has worked in a powerful way and now seems obvious, but at that time we had no idea if consumers would even build and use an online queue. It was still a dial-up, VHS world and most video stores didn't carry DVDs, so we were able to sign up early adapters. By the time there were enough DVD owners, we had gotten better and better and broadband had grown.
I founded Pure Software in 1991 around a debugging tool for engineers; I was an engineer myself. We doubled our revenue every year, but my transformation from engineer to CEO was when Morgan Stanley took the company public in 1995. We went from one great niche item to a broad portfolio of products, significantly improving the quality of software. We were then acquired by Rational Software in 1997 for $750 million, which gave me the means to start Netflix.
Management was my biggest challenge; every year there were twice as many people and it was trial by fire. I was underprepared for the complexities and personalities.
I didn't see the dot-com crash coming. It's hard to know when you're inside the bubble.
For some people, high school graduation is the peak of their life and that's unfortunate. It's the same thing for taking a company public-- sometimes that is the peak of its life, which is unfortunate because the real promise lies ahead. It's gotten substantially harder and more expensive since Sarbanes-Oxley, but I find running a public company to be a lot more fun and exciting. What you do matters more to the world, there are more stakeholders, and management performance is more visible. The only negative is that we now get sued once a quarter. You become a magnet for frivolous lawsuits, but they get dismissed and it's a fairly minor tax.
There are three types of customers at Netflix. One group likes the convenience of free home delivery, the movie buffs want access to the widest selection of, say, French New Wave or Bollywood films, and the bargain hunters want to watch 10 or more movies for 18 bucks a month. We need to keep all the audiences happy because the more someone uses Netflix, the more likely they are to stay with us.
At this point, our movie buyers are very good. We constantly invest in and improve our technology. Using all of our measurements, we know within a 10% range whether a movie will be a hit with a subscriber. We recently added a component called Friends, which allows fellow movie buffs to share reviews and recommendations, and we are always expanding our search capabilities. Movies can be looked up in more than 200 specific genres ranging from British humor to 15 varieties of anime to steamy romance.
The average subscriber cost is $3 to $4, so we're significantly ahead on the cost curve. Netflix has to be the leader in technological advancements to maintain our annual retention rate of 97%.
Look at the all-time Netflix Top 100 list of rentals and you'll see it's not just the studio blockbuster movies. Mystic River was No. 1 for a long stretch. Oscar winners do very well for us. We approached the producers of Born Into Brothels at the Sundance Film Festival and they signed an exclusive deal with Netflix. The movie went on to win an Academy Award. Born Into Brothels is a rough digital-video documentary, but it's a great story. It's been a big winner.
When Wal-Mart started a DVD subscription service in November 2002, Netflix stock dropped to $2.50. I was surprised they entered the market, but I knew that they wouldn't be as focused as we are. We competed in 2003 and 2004, but last spring, Wal-Mart realized it had such a huge opportunity to sell DVDs that a rental service didn't make much sense. I had dinner with the CEO of Walmart.com, and eventually we came to an arrangement where basically the companies promoted one another. We're not celebrating victory at Netflix, though, because Wal-Mart never gave its best shot. Whereas Blockbuster is spending hundreds of millions of dollars, so when we beat them, it will be celebratory.
One mistake I made was waiting until 2002 to open regional warehouses for local distribution centers. Overnight delivery is so exciting to our customers and we were getting way too many complaints from subscribers that they had to wait too long. I learned from our mistake. We now have 36 warehouses spread out around the country.
Our focus is on getting to five million, 10 million, 20 million subscribers and becoming a company like HBO that transforms the entertainment industry. We want producers and directors to be able to find the right audience, to change the experience of helping people find movies they love. Netflix has customer loyalty; it's a passion brand. I've always thought trying to change consumer behavior is scary, and most companies that promote that fail. But when it works, like iPod, it works big.
"We want to be ready when video-on-demand happens. That's why the company is Netflix, not DVD-by-mail."
DVDs will continue to generate big profits in the near future. Netflix has at least another decade of dominance ahead of it. But movies over the Internet are coming, and at some point it will become big business. We started investing 1% to 2% of revenue every year in downloading, and I think it's tremendously exciting because it will fundamentally lower our mailing costs. We want to be ready when video-on-demand happens. That's why the company is called Netflix, not DVD-by-Mail.
I joined the Peace Corps after graduate school and went to teach high school math in Swaziland, out of a combination of service and adventure. It was an extremely satisfying experience. Taking smart risks can be very gratifying. Guessing right is a skill developed over time. Not all smart risks work out, but many of them do.
I got back into education after leaving Pure Software, helping the passage of California Proposition 39, which lowered the threshold for voters to pass a school bond from two-thirds to a 55% majority. I also spent three years as president of the state board of education. I'm currently funding a study at Stanford of 300 schools, examining why there are so many variants in similar student demographics. It's not a level playing field in K through 12 and we have to make it more equitable and successful to enhance what should be the strength of society, public education. I am an active supporter of the charter school movement. California is steadily adding 60 to 80 a year, which is healthy.
I have a home theater and watch a lot of movies, but my wife and I still go to the theater a couple of times a month because I like to get the popcorn and sit in the dark with an audience.
I don't want to get into production. There are passionate, talented filmmakers out there and I would pollute the craft.
I'm happy where I am. It's been eight years at Netflix and I feel it's just beginning. I have no need or desire to be acquired. We're making money, haven't used cash for three years, and have no problem with scale sufficiency. Being an entrepreneur is about patience and persistence, not the quick buck, and everything great is hard and takes a long time. If we can transform the movie biz by making it easier for people to discover movies they will love and for producers and directors to find the right audience through Netflix, and can transform public education through charter schools, that's enough for me.