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Update: Web Rental Whirlwind

19 May, 2005 By: Holly J. Wagner

Online DVD rental turned into a whirlwind last week that pulled all of the major players into a sortie of strikes and counter maneuvers.

Netflix and Wal-Mart announced they would play to each other's strengths with a deal that lets Netflix take over Wal-Mart's online DVD rental business beginning June 16, and bridge the sellthrough gap to its own customers by promoting Wal-Mart's sellthrough on the Netflix Web site and in mailers.

Blockbuster fired back just hours later with an offer to let Netflix and Walmart.com online rental subscribers switch at their existing rates for a year, according to a Blockbuster press release, get two months of online rentals free and a free DVD of their choice to keep. Switchers will also get the two coupons for free in-store rentals that Blockbuster Online subscribers receive. A Blockbuster spokesperson later amended the statement to say switchers would get service at Blockbuster's prevailing rate at the end of their two month trials. That could avert a situation in which Netflix customers who switch would actually be paying more than Blockbuster's current monthly price of $14.99 for a three-out plan.

“We remain committed to growing our online rental business and plan to continue to compete very aggressively in this space,” said Blockbuster chairman and CEO John Antioco. “Just seven months after launching Blockbuster Online, we had more than 750,000 subscribers and we remain focused on reaching our goal of 2 million online subscribers by the end of the first quarter of 2006.”

According to the latest information from The NPD Group, Blockbuster has increased its unit-share (turns) of the market from a little more than 1 percent in the first quarter of 2004 to more than 25 percent in this first-quarter 2005. At the same time, Netflix has declined from 95 percent to 72 percent. Still, the overall number of units rented by subscription has grown by 79 percent over the same time, according to NPD.

Netflix did not immediately respond to requests for a comment.

Wal-Mart's site lets renters switch to Netflix from their existing accounts, even transferring their pricing and request queues; the accounts of those who don't switch will be closed June 16.

Netflix will promote Wal-Mart's online movie sales business, including the preorder price guarantee option at Walmart.com, on the Netflix site and on mailers sent to Netflix subscribers. In a call for analysts later the day of the announcement, Netflix CFO Barry McCarthy would not to disclose many details of the deal, including whether or how much Wal-Mart will promote Netflix on other parts of the Web.

He also would not say whether Blockbuster was ever in the running in the Wal-Mart deal, but noted the pairing reflects well on the Netflix brand. He agreed with analysts' view that the deal does more for Netflix's image than its bottom line.

“Wal-Mart has never announced the number of its online subscribers but it is believed to be under 100,000,” said Dennis McAlpine, principal analyst at McAlpine Associates. “Compared to Netflix's 3 million subscribers, that amount will get lost in the shuffle and certainly will not do much for Netflix's bottom line, even assuming they all switch from Wal-Mart to Netflix.”

However, the move eliminates a competitor that some analysts perceived as a potential major player in online rentals.

Wal-Mart is the market's dominant sellthrough merchant. McAlpine suggested Blockbuster's sellthrough business made it a less likely suitor for Wal-Mart.

“We would think that Blockbuster is regarded as much more of a competitor to Wal-Mart than Netflix, since Blockbuster sells new DVDs as well as rents them,” he said. “For this reason, we doubt that Blockbuster would have been willing, as Netflix was, to promote Wal-Mart as the place to go to buy new DVDs.”

The pairing comes at a key time for Netflix, which has lately been focused on holding the line against Blockbuster and being wary of Amazon.com entering the U.S. online rental market.

The latest volley in the price war came after Blockbuster revealed it was testing several new price points, including an increase to $17.99 a month for its three-out plan.

Consumers who respond to the $17.99 test price offer, which began May 16 and is expected to run less than two weeks in select markets, would thereafter be notified their subscription price was a test and offered the $14.99 monthly rate, said Blockbuster spokesperson Jerrianne Thomas.

“We have a lot of different plans out there,” Thomas said. “We're always doing lots of tests.”

She acknowledged Big Blue is testing several price points, including a $4.99 first-month-rate for three titles out at a time that reverts to $14.99 per month on the second month.

Hastings said Blockbuster's “kamikaze pricing” finally caught up with reality.

“Someday they are likely to raise prices to try to make at least a modest profit from online,” he said.

Blockbuster dove into the space with gusto last year, launching its online business in August as its in-store rental business was sagging. Blockbuster's price for the popular three-out-at-a-time plan was $19.99, besting Netflix's $21.99-a-month price. Netflix dropped its three-out price to $17.49 a month and Blockbuster countered, promising to hold the line at $14.99 for this year.

While the move takes Wal-Mart out of the running, Amazon.com is still a wild card. It launched in the United Kingdom with a three-out plan that caps monthly rentals at six for £9.99, and the e-tailer has been widely expected to enter the U.S. online rental market.

“If they are coming, it does not appear to be as imminent as it was when we dropped our price,” McCarthy told analysts. But not everyone is convinced.

“I think this announcement is a direct challenge to Amazon on DVD sales online. Expect Amazon to respond,” said Wedbush Morgan Securities analyst Michael Pachter. “The likely response is a similar alliance between Amazon and Blockbuster.”McAlpine agreed.

“In fact, [Amazon] has said it is discussing various forms of partnerships with both Blockbuster and Netflix to enter this business. While we do not expect Netflix to take this bait, we think Blockbuster could be more receptive given its recent internal struggles about the cost of new initiatives,” McAlpine said. “While these talks may be happening, Netflix is pushing to try and build up as big a lead in the number of subscribers it has as it can before Amazon.com shows itself.”

It was not immediately clear why Amazon would take more kindly to Blockbuster's competing sellthrough business, although Amazon has noncompete deals with many of the channel partners it represents on its portal; and McCarthy told analysts Netflix's deal with Wal-Mart is not exclusive and the company is interested in partnering with Amazon.

In the short term, the market appeared to side with Netflix. Netflix stock closed up 4.06 percent, or 63 cents, to $16.13, but slipped to $15.75 in after hours trading. Blockbuster slipped a mere 4 cents to $9.74.

So far Movie Gallery, which just jumped to a solid No. 2 in the rental business with its Hollywood Entertainment Corp. acquisition, has been mum about the online turmoil. Movie Gallery chairman and CEO Joe Malugen has said repeatedly that he thinks subscription rentals are a flawed business model, but last week's acquisition of the VHQ chain puts him into the online game with VHQ online in Canada.

Additional reporting by Erik Gruenwedel.

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