Unspoken agenda

By Paul Sweeting -- Video Business, 4/21/2006

APRIL 21 | Patent enforcement actions are not for the faint of heart.

They can go on for years, they’re frighteningly expensive and they carry huge risks to both sides.

The alleged infringer can face enormous jury awards if it loses, while the patent holder risks spending many years and million of dollars in a fruitless and distracting effort.

Business method patents are particularly tricky to enforce because the validity of the patents themselves is often subject to challenge, separate from the enforcement action.

None of this is news to the folks in charge at Netflix Inc. Even as it was granted its first patent on its online DVD rental business in 2003, the company recognized the huge challenges it would face in bringing an infringement claim against Blockbuster, which was then launching its own online service.

The purpose in securing business patents, Netflix chairman Reed Hastings said at the time, is to gain negotiating leverage with potential partners and competitors, not to file lawsuits.

So it’s fair to assume that there’s something more than mere pique at being copied behind the action Netflix has now brought against its rival.

According to Blockbuster, that something more is the success of its own online rental service, which is now up to 1.2 million subscribers, compared to Netflix’s 4.1 million.

“Apparently, Netflix would prefer to take us on in the courts rather than facing us in the marketplace where the consumer is the judge,” Blockbuster Online senior VP/general manager Shane Evangelist said in response to the suit.

Netflix officials say what changed was the grant of a second, broader patent covering all aspects of its business model.

“From top to bottom, Blockbuster has deliberately and willfully copied Netflix’s business model,” a Netflix spokesman said.

It’s unlikely either of those factors is the sole reason for the lawsuit, however.

Doubtless, Blockbuster Online’s growth and the margin-eating price war it started has made the situation more urgent for Netflix. But I doubt Hastings is really looking to face anyone in court.

Likewise, while the second patent may bolster Netflix’s claims, Blockbuster isn’t copying its business model any more now than it was when Netflix had only one patent.

What’s more likely to have changed is Hastings’ sense of the end game for Netflix.

Although Netflix continues to gain subscribers, as does Blockbuster, the last of the low-hanging fruit may be near. Driving growth in the future is likely to get more expensive, as the companies have to market harder to persuade later adopters.

Price competition, meanwhile, will continue to weigh on revenue.

Given those market realities, one logical strategy for a start-up like Netflix is to make yourself a takeover target. That’s where the patent suit comes in.

If Netflix can press its claims against Blockbuster far enough, Blockbuster will have to start thinking settlement. It’s hard to envision a deal, however, that would allow Blockbuster Online to continue.

Any deal that acknowledged Netflix’s claims would likely involve ongoing royalty payments by Blockbuster. That would put Blockbuster in the position of handing control over its margins to a competitor, something no company would do.

The more logical way to settle the dispute would be for Blockbuster to simply acquire Netflix.

While that might raise eyebrows at the Justice Department, a settlement that forced Blockbuster out of the online business would have the same effect on competition. And if Netflix’s claims are upheld, no other competitor could enter the market anyway.

Alternatively, the patent enforcement action could make Netflix a more attractive meal for someone like Amazon.

Amazon may have been scared away from the online rental business—and any interest in Netflix—by the price war with Blockbuster. But if Netflix can demonstrate that it has a decent shot at shutting Blockbuster down, Amazon’s interest could be renewed.

Either way, the lawsuit is likely to raise the price, which might suit Netflix shareholders just fine.