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Redbox DVD-Kiosks Give Netflix A Run For Their Money

June 21, 2009

With more subscribers than ever signing up for its DVD-by-mail service, Netflix Inc. is one of the few companies to prosper during the current economic slowdown.  But CEO Reed Hastings is not without his worries.  One of his former employees has launched an even lower-cost DVD rental service known as Redbox, the largest operator of DVD-rental kiosks.

Redbox has now grown to include more than 15,400 vending machines that dispense $1-per-day DVDs to budget-conscious customers in grocery and discount stores throughout the country.

The company is opening an average of one kiosk per hour, and Hastings worries the fast-growing service might ultimately challenge Netflix, whose lowest-cost mail-order service plan costs $5 for two movie rentals per month.

“By the end of the year, kiosks will likely be our No. 1 competitor,” said Hastings on a recent conference call.

“There are already more kiosks in America than video stores.”

The fight for DVD-rental loyalties is expected to heat up as Netflix, Redbox, Blockbuster Inc. and others compete for the business of frugal customers seeking inexpensive home entertainment.

Last year, Americans spent more renting DVDs from stores, kiosks and online services like Netflix than they did in purchasing the discs outright, according to data from PricewaterhouseCoopers.  It’s a trend many expect to continue this year.

Redbox got its start in 2002 as a way for McDonald’s Corp. to extend beyond its burger business.  The restaurant chain’s strategy group tested a handful of so-called  “automated retail” ideas.

“Vending sounded so last-century,” Gregg Kaplan, who led Redbox from inception until April, told the Associated Press.

He now serves as chief operating officer of Coinstar Inc., Redbox’s parent company.

McDonald also experimented with a machine that made fresh french fries and an 18-foot-wide automated convenience store, but only the DVD kiosk was a hit with consumers.

Within just three years, the team that ran Redbox grew from operating 12 of the DVD machines to about 900.   By mid-2005, Redbox was anxious to expand beyond McDonalds, so the restaurant chain agreed to allow it to pursue another partner.

Bellevue, Wash.-based Coinstar had a national sales team in place that sold machines that converted loose change into bills in drug stores, supermarkets other retailers.  It was thought those customer relationships could be leveraged for Redbox kiosks as well.  So in 2005 and 2006, Coinstar invested $37 million in Redbox, giving it a majority ownership position.  This year, Coinstar paid $25 million to buy out McDonald’s and other investors.

Last May, Oakbrook Terrace, IL-based Redbox said it intended to go public, but the plans were withdrawn amid the slowing economy.

DVD kiosks now comprise more than half of Coinstar’s sales and profit.  Coinstar, which also owns DVDXpress, a much smaller kiosk chain, saw its profit more than double during the last quarter on sales that grew to $154 million.

At the same time, Netflix grew at a slower pace, with first-quarter revenue increasing 21 percent to $394 million.

Redbox president Mitch Lowe joined the company after six years with Netflix, where he was vice president of business development.

While at Netflix, Lowe oversaw a popular system that recommended lesser-known movies to subscribers based on ratings for films they had already seen.  The system was one of Netflix’s competitive advantages, helping the company’s 10.3 million customers sort through some 100,000 movie titles.

By comparison, Redbox’s machines carry roughly 700 discs with 200 titles, primarily recent releases.  The $1 per-rental nightly rate entices people to experiment with different titles.  Indeed, some four million people have swiped a card at a Redbox kiosk in the past month alone.

Another difference between the Redbox and Netflix is the way in which their customers obtain the movies.  Since Netflix must pay for postage twice for every DVD it rents out, its best profits come from customers with high-level subscription plans who are slow to watch and return their titles.

By contrast, Redbox’s profits come from renting out each DVD as many times as possible before demand for the title dries up.  The company tracks its rentals to forecast the right combination of titles and the ideal number of copies for each kiosk location.  It also lets customers reserve a DVD online for a specific kiosk, then retrieve in person.  Although the $1 nightly rental fee may be the initial attraction, most customers ultimately pay to keep the discs for two or three days.

If Redbox becomes a serious challenger to Netflix, it will have succeeded in what Blockbuster and Wal-Mart failed to do.  Both companies attempted to take on Netflix’s DVD-by-mail business. Wal-Mart ultimately abandoned its efforts and gave all its customers to Netflix, while Blockbuster still lags behind Netflix in DVDs by mail and is closing a number of its unprofitable stores.

Redbox’s success has caused Blockbuster to pledge 10,000 DVD kiosks of its own in a deal with NCR Corp., which in April acquired TNR Holdings Corp., the second-largest movie kiosk company.

To the dismay of some Hollywood studios, Redbox kiosks sell used DVDs for $7 as soon as two weeks after their initial release.  Traditional video stores typically wait two or three months to sell the titles.

Redbox’s practice may jeopardize the $1-a-day rental model the company relies upon to attract its customers.

Last year, Universal Studios Home Entertainment, NBC Universal’s Distribution arm, pressured Redbox to limit the number of Universal DVDs its kiosks could carry, and requested the used discs be destroyed instead of sold at highly-reduced prices.

But Redbox refused, prompting Universal to order its partners to discontinue selling DVDs to Redbox at wholesale prices. The move caused Redbox to sue Universal for violation of antitrust laws and other claims.  The case is still ongoing.

Wedbush Morgan Securities analyst Michael Pachter told the Associated Press that other studios might follow Universal’s lead if Redbox loses the lawsuit.  Such action would likely encourage Redbox to either enact restrictions or purchase movies at retail prices, which might result in higher rental fees.

Entering the movie-rental industry via grocery store kiosks may seem a bit retro in the age of YouTube, Hulu and Netflix’s own streaming video services, but the market dynamics are working for Redbox.

While DVDs may ultimately become a thing of the past, about 90 percent of U.S. households currently own a DVD or Blu-Ray player.  Meanwhile, only a small percent of movie watchers download films to their computer or stream them from the Internet, according to NPD Group analyst Russ Crupnick.

Crupnick predicts streaming services will not fully gain traction until the technology is incorporated into more television sets.   And since many people only recently invested in new flat-screen TVs, it will be some time before they are replaced.

“Digital options and physical options can coexist,” Crupnick told the Associated Press.

“People think there’s this balkanization – ‘Once I get Netflix, I never go to Blockbuster. Once I go to Redbox, I don’t need Netflix.’ That’s really not the way that it works in the world.”

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