TCS Daily

Wal-Mart Grows a Tail

By Dominic Basulto - May 27, 2005 12:00 AM

When Wal-Mart announced its foray into online DVD rentals more than two years ago, business analysts predicted the beginning of the end for Netflix, which launched its online DVD rental business in 1999. Wal-Mart, after all, was the 800-pound gorilla of the retail world, able to under-price and out-merchandise its smaller rivals. Netflix's announcement on May 19 that it was taking over Wal-Mart's online DVD rental business, then, came as a surprise. After all, how many small companies have taken on Wal-Mart and won?

Certainly, it makes for a great story -- a tiny Internet David takes on a brick-and-mortar Goliath and wins. The announcement that Wal-Mart was bowing out of the online DVD rental business must have been especially sweet for the company's detractors, who typically accuse the company of systematically driving small mom-and-pop operations out of business as well as a whole host of uncompetitive business practices. But is this what actually happened? If you read the headlines after the deal was announced, it certainly seems that way: "Wal-Mart Gives Up," "Wal-Mart Walks Away," and, of course, "Wal-Mart Wusses Out."

Yet, if one reads the Netflix press release carefully, it appears that the two companies are actually participating in a type of joint partnership and talking up the strategic potential of the deal. Wal-Mart is offering existing DVD rental customers the chance to continue their subscriptions with Netflix and promoting Netflix on its Web site. For its part, Netflix will encourage its customers to buy DVDs at Wal-Mart. In other words, the two companies are now partners in the online DVD business: Netflix handles the rentals, while Wal-Mart handles the sales.

What a partnership it is. Netflix boasts 3 million customers; 40,000 titles; $500 million in annual revenue and enough regional distribution centers to provide 90% of its subscribers with 1-business day delivery of DVD rentals. In comparison, Wal-Mart only had a paltry 100,000 customers and 15,000 titles and was a late entrant to a market niche that had already been explored and then fortified by Netflix. What Wal-Mart does offer, though, is an unrivalled distribution network and the ability to grow the Netflix brand. The Web site attracts 19.7 million visitors a month (nearly twice the traffic on the Netflix site), while brick-and-mortar Wal-Mart stores attract 100 million shoppers a week.

That's not the whole story, though. It's not just about driving eyeballs to the Netflix site or fusing together an Internet business with a brick-and-mortar business. It's also about unlocking the full catalog of DVD titles. By minimizing inventory carrying costs, a company like Netflix is able to stock the types of narrow-interest titles that customers want, unleashing the full power of what is now popularly known as the Long Tail. For companies like Netflix, a disproportionate share of revenue derives from rentals with niche appeal, not from rentals with mass appeal. As Chris Anderson of Wired Magazine pointed out in his "Long Tail" article, 20% of Netflix rentals are outside of the top 3,000 titles. Moreover, of the company's top 10,000 titles, 99% will be rented at least one time a month.

Wal-Mart, on the other hand, is the opposite of a Long Tail business -- a Short Tail business, if you will. In other words, 80% of its sales result from 20% of its products. It's a company based on cranking out best-sellers in best-selling categories in best-selling geographic locations. The company relies on huge volume to compensate for razor-thin margins on many products. The company needs to strip out unnecessary costs from its distribution network and sign the best deals with suppliers in order to offset the high cost of shelf space and give consumers the best prices. Considering Wal-Mart's aggressive pricing tactics, any product that sits on a shelf has to be, almost by definition, a best-seller. For example, Wal-Mart must sell 100,000 copies of a CD in order to cover its retail overhead costs and make a reasonable profit.

Under constant pressure by Wall Street analysts to increase sales, Wal-Mart only had a limited amount of time to transform its online DVD rental business into a mega-million-dollar cash cow. When this did not materialize after 24 months, it simply did not make sense to continue. But that doesn't mean that it's a bad business to be in -- only that a smaller company like Netflix can do it better. For Wal-Mart, $100 million is a rounding error; for Netflix, it's 20% of annual sales.

Viewed from this perspective, then, the deal between Wal-Mart and Netflix is actually a strategic move that leverages the strengths of two different types of businesses, thereby counteracting possible moves by rivals in the online DVD space. Given that has already launched a DVD rental service in the U.K. and that Blockbuster plans to spend nearly $170 million this year to expand its online operations, the threat is real. Blockbuster already boasts nearly 1 million online DVD rental customers and hopes to double that number within the next 12 months.

In some ways, the partnership between Netflix and Wal-Mart is similar to the decision by the New York Times to acquire for $400 million. The New York Times viewed the deal as a way to unlock the value of the Long Tail of information (i.e. niche content) and to monetize its archives. If people want news about Michael Jackson, does it still make economic sense to offer news about Uzbekistan?

If these types of deals prove successful, it is likely that more Long Tail companies will partner with Short Tail companies. Over the next six to twelve months, it will be interesting to see whether the deal between Wal-Mart and Netflix was just a short-term promotion and a face-saving measure for Wal-Mart -- or the start of a fundamental new trend in business.

The author is a TCS Contributing Writer focusing on technology, business and venture capital.


TCS Daily Archives