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Competition heats up in online DVD rental market

Amazon changed the face of e-commerce categories like music and videos simply by entering those markets.

Now the DVD rental industry is shifting course on just the rumor that Amazon will offer a competing service. And although some investors have not been thrilled at that prospect, more consumers will probably be pleased enough to join the market.

Netflix, the leading online DVD service, recently dropped its prices 18 percent, to $18 a month for unlimited rentals, after its chief executive said he learned that Amazon would soon offer a competing service. (Amazon refused to confirm the rumor last week.) Blockbuster quickly followed suit, cutting its price to $17.50 from $20.

The other key player in the market,, the online service from Wal-Mart Stores, said last week that the company was evaluating its own pricing strategy, having gone from offering the lowest to the highest price in a matter of about 10 days.

Amazon offered no details on when or even if it might offer movie rental service. But the company's chief financial officer, Tom Szkutak, said in a conference call with journalists on Thursday that DVD rental is "a business we're well positioned to do."

"We can afford to offer low prices," Szkutak said. "Our customer acquisition costs would be low to none, given Amazon's traffic."

To match the services of competitors, though, Amazon would likely have to open distribution centers throughout the United States — a strategy it has largely eschewed since early 2001, when it began shutting huge warehouses filled with goods it owned and started relying more on retailers and distributors to ship products on its behalf. The company maintains six regional shipping warehouses.

Szkutak said the company did not expect to open any new distribution centers in the coming months. Still, Amazon could rely on a network of vendors for DVD distribution, much as Wal-Mart has done to supplement its 14 DVD warehouses.

The cost of building a movie rental library alone could daunt some investors, said Mark S. Mahaney, an analyst with American Technology Research, a San Francisco investment firm. Mahaney noted that Netflix spent $80 million in the first nine months of this year simply acquiring DVDs — $10 million more than Amazon's capital expenditures for the past year. Netflix has about 25,000 movie titles. Neither Mahaney nor his firm own shares in either company.

"If you're talking about doubling Amazon's capital expenditures, that's something I'd have to think about," Mahaney said when asked if he thought the idea made sense for Amazon. "It'd obviously benefit them from a gross margin perspective, though."

Amazon's gross profit margins have decreased steadily in recent years, to about 24 percent, as the company has cut shipping costs and dropped prices. By contrast, Mahaney said, gross margins for online DVD rentals are 40 percent to 50 percent.

While Amazon's entry into the market, let alone its success, is far from certain, rumors of the move stunned Netflix investors, who have already seen their shares drop from a one-year high of nearly $40 in February to about $17 this month. That decline was partly in response to Blockbuster's DVD rental service, which made its debut in August.

But when Reed Hastings, Netflix's chief executive, announced the price cut and exposed Amazon's putative DVD rental initiative, his company's shares dropped again, to just more than $10. (Netflix closed at $9.80 on Friday.)

Hastings remains composed — outwardly at least — at the prospect of simultaneously competing against the world's most powerful retailer, the world's most successful movie rental company and the Internet's most vaunted merchant. "It's going to be a much more competitive market than we ever expected," he said. "But the competition will improve consumer value, which will mean more consumers renting movies online."

Netflix is in a good position to compete, Hastings said, because it is profitable, it has $175 million in the bank and it has 2.2 million subscribers, by far the most in the market. The company's revenue reached $142 million in the most recent quarter, 93 percent more than the same period a year earlier.

Despite its lower prices, Hastings said, Netflix will remain profitable because it can continue to add subscribers and thereby make more efficient use of existing inventory. It is a position that some analysts openly doubted when downgrading the company's shares.

Even if Amazon enters the market, however, Netflix may have time to add customers. Hastings said one crucial aspect of the online DVD rental business was widespread distribution of warehouses, which makes overnight delivery possible.

It has taken Netflix six years to build 29 distribution centers — enough to offer overnight delivery to nearly 90 percent of the country's prospective customers.

But Blockbuster has thrived even without such broad capability for overnight delivery. The company has 10 distribution centers, covering about half of the nation for overnight shipment, yet it says it is on track to reach 500,000 rental subscribers by the end of the year. Netflix took more than three years to reach that number of customers.

Shane Evangelist, senior vice president of Blockbuster Online, said that like Netflix, his operation could remain profitable at the lower price, particularly next year when Blockbuster stores begin shipping videos to customers who rent online.

"We've got 'Top Gun' in 6,000 stores," Evangelist said. "We bought it, we've rented it, it's fully amortized, but it's not sold out every week. We can ship it from the store, but also rent it online."

Evangelist said the company would be able to route the customer's online order to a store in a given region that has the requested title available. "So you start to see how this becomes pretty big in optimizing our inventory," he said. has been quietly building its DVD rental service since its debut in June 2003. Kevin Swint,'s director of entertainment and photo, would not disclose the number of DVD rental subscribers the company has, but he said that business had "grown beyond our expectations."

And despite the price cuts from Blockbuster and Netflix,'s service remains the least expensive in at least one regard, Swint said. It offers a program in which subscribers can rent an unlimited number of movies over the course of the month for $15.54, while keeping only two at a time. (Other services allow customers to keep three at a time.)

That offering, Swint said, is the site's most popular DVD rental option. "We're really bullish about this service," he said, "and our customers are enthusiastic."