THE PRISONERS DILEMMA, TIT FOR TAT or CHICKEN

I love to play games and it seems that Reed Hastings of Netflix is ready and willing to play serious games. Today my worse performing stock was NFLX. The stock dropped 7% on the news that Blockbuster has lowered its subscription price by $2.50 to $14.99 per month.

Wal-Mart was already running a $15 special with a maximum of two movies out at a time. BBI just beat the NFLX price by $3 per month and Wal-Mart with an extra movie out. For BBI to beat NFLX on price is not necessarily smart but to beat the Wal-Mart prices appears to be suicide. BBI advertises 30,000 titles, unlimited rentals and no late fees. They promise to build several distribution centers in order to match NFLX with next day deliveries.

Back in my college days, I was required to participate in "lab games" in the psychology department. All participants received course credits and we were paid an average of $3 per hour. Participants were paid on how well they played games designed by the professors and graduate students. In one three hour session, I was one of twelve participants. We all knew that we would split $108 among the 12 depending on our game skills. One fellow did really well and earned more than $9 leaving less than $99 for the rest of us. I earned $97.40 and the other players split $1.50 ten ways. Yes, I am bragging to demonstrate that there are big winners and big losers in business.

The games we played included Prisoners Dilemma, Tit for Tat and Chicken. In each of these games, the players needed to listen carefully to the rules. To be successful one typically needed to take advantage of the rules. To win, one should break the rules if the penalty for breaking a rule is low or if the probability of getting caught is low. Yes, the games were purposely designed to make each player examine the ethics of the situation and decide what is the right thing to do.

The game of life is about the same. We are called by our "moral compass" to understand the rules and play by the rules. The concept to be learned in Tit for Tat is that a business cannot make money if it participates in a price war. Unfortunately there are times when a price war is hard to avoid. Several airlines are bankrupt or close to bankruptcy as a result of players who are willing to try to steal market share by fighting a price war. Several well run airlines have just been through an all out game of Chicken.

So far, NFLX and Reed Hastings have played a good game of Tit for Tat with Wal-Mart and with Blockbuster. The winners in the game of Tit for Tat are usually those who do not try to have the lowest price.

I have watched a regional operator of convenience stores play Tit for Tat for many years. He is very successful and he keeps growing the business. Every now and then he is forced into the game. Let's say that he is selling gas for $1.75 per gallon when the store on the opposite corner unexpectedly lowers its price to $1.67. He knows $1.67 is not enough to give a fair return but he also knows that if he continues to charge $1.75 he will not sell much gas.

The vindictive player might lower the price to $1.62 and the next thing you know the other store would be at $1.52 and so on. Pretty soon both stores would be losing lots of money. Their game would become a game of Chicken. Each would desire to last longer than the other knowing that the survivor can re-price for bigger profits. The problem is that even if you win there might be a third owner down the street that knows you are weak from the battle. The cycle may start afresh and the truth is that even the customers are eventually hurt by a price war.

The smart player lowers the price to exactly $1.67 or maybe just a penny or two more at $1.68 or $1.69. Most customers will not cross the street to save a penny or two. As an alternative, the smart player may lower to exactly $1.67 for a few days and then raise the price a penny or two a few days later. The point is to send several signals. "You get no more business at the lower price because I will match you". "You and I both will sell about the same amount of gas at $1.67 or at $1.75 why not make the extra $.08. "There is enough business for both of us if we keep the price up".

When it was clear that BBI and AMZN were about ready to enter the business, Reed Hastings raised the price at NFLX by $3 per month. He let the players know that he does not want a bloody price war. When BBI jumped in at $17.49, Hastings lowered the NFLX price to $17.99; and excellent Tit for Tat move. BBI, apparently out to win at all cost or seeing the hand writing on the wall for its brick and mortar business, then threw-in two free in store movies per month.

Hastings did not reply directly but did adjust. NFLX had previously stated plans to enter the European market. NFLX withdrew those plans to stay focused on the now competitive US market. In effect, NFLX said, we are going to stay strong here in the states. You can lower the price but you can't run us out of business. More importantly, the move was a signal to AMZN and sure enough, AMZN made the smart move of starting their movie rental service in the European market only.

Today, Hastings said that NFLX has no plans to meet the $14.99 price. Clearly the plan is to continue to offer the best service. NFLX is David going up against the Goliath, Blockbuster. NFLX is trying to be smart and Blockbuster is going after a flea with a sledge hammer.

It is interesting that Blockbuster has 8,900 stores, $6 Billion in sales and a slow delivery service while NFLX has zero stores, $500 million in sales and a fast delivery system. Blockbuster's sales growth has been stagnate while NFLX has gone from $81 million to $500 million in 4 years.

Anyone who has cell phone service has probably been on more than one carrier and has experienced dropped calls and poor service. The services of all the remaining players is far better now than in prior years. Nextel did not have the backing of an established large phone company but it has survived and prospered by giving the best service. It has the lowest churn rate, the highest usage per customer and it consistently gets more than its pro-rata share of new customers. The public has paid a higher price to get the best service.

My projection is that NFLX will not survive as a separate company. Hastings is playing the game well and he has the skill to successfully battle Blockbuster, but Wal-Mart nor AMZN are going to go away. The cable companies nor the studios are ready to surrender prime content to be sent via the internet. TIVO and NFLX will offer an electronic delivery program but it is not likely that they will do it as independent companies. One would assume that one of the owners of the large movie collections would be the company to buy TIVO and NFLX. TIVO seems to be the more important piece.

AMZN has about the same sales as BBI but is growing its sales rapidly. AMZN is gearing up in Europe but eventually they will bring the service to the states. Will they buy NFLX? I would not be surprised.

Put BBI up against Wal-Mart and AMZN and one must wonder about the break up value of BBI. Hastings said yesterday that the latest pricing by BBI kills the video store! The store is committing cannibalism. BBI says half of their new subscribers have not been into a BBI store for six months. That means the other half may stop coming to the store. It may be that BBI will rapidly convert to the NFLX format and then offer the real estate for sale.

Based on the BBI bid to buy Hollywood Video, BBI believes it can operate the brick and mortar stores for some time to come. Clearly there are many customers who do not pay $15 every month for movies. If the majority of the active renters subscribe to on-line services, can the store be justified for the large numbers of infrequent renters.

Perhaps it is foolish to own a company that is operating a business model that will die in maybe five years. My brain tells me it is wise to bale out now. My heart is with NFLX. The company developed an innovative plan that would have eventually killed the video store as a business model. The company has discussed with TIVO a plan that would benefit the consumer. I believe the announcement of an on-line delivery service will be made soon. Surely TIVO and NFLX understand that the take over price would be significant if they could at least get an internet movie and TV service up and running.

The biggest remaining question is will the movie moguls allow movies to be transmitted over the internet by independent companies in exchange for a license fee? Time Warner and others have big decisions to make. The music business was destroyed when the players did not appreciate the power of the internet.

GOOG has apparently thought the situation all the way through for printed content. GOOG has stated that on-line libraries will be good for the Authors, Publishers, Libraries and Patrons. John Malone is playing hard-ball with News Corp to pry free TV-Guide as another piece of the media server dilemma. The efficiency of on-line delivery should create the same win-win situation in the movie business as seems to be developing for libraries. Until then, how about a game of Chicken?