Redbox's machines take on Netflix's red envelopes

BELLEVUE, Washington -- With more subscribers than ever flocking to its DVD-by-mail service, Netflix is one of the few companies to prosper during the worst U.S. recession in 70 years. Yet Netflix CEO Reed Hastings still has something to worry about: an even cheaper DVD rental service run by one of his former lieutenants.

Once just an incongruous experiment amid the burgers and fries at McDonald's restaurants, Redbox has emerged as the largest operator of DVD-rental kiosks, with more than 15,400 vending machines set up to dispense $1-per-day discs in supermarkets and discount stores.

With Redbox opening an average of one kiosk per hour to lure budget-conscious consumers, Hastings is concerned that this upstart might upstage Netflix, whose cheapest mail-order plan costs $5 for two movie rentals in a month.

"By the end of the year, kiosks will likely be our No. 1 competitor," Hastings said in a recent conference call. "There are already more kiosks in America than video stores."

The fight for DVD-rental loyalties figures to intensify as Netflix, Redbox, Blockbuster and others vie for the attention of frugal consumers looking for inexpensive home entertainment. According to research from PricewaterhouseCoopers, Americans last year spent less money buying DVDs and more on rentals from stores, kiosks and online services like Netflix. The trend is expected to continue this year.

Redbox began in 2002 as a way for McDonald's Corp. to expand beyond the burger business. A strategy group inside the company tested a few "automated retail" ideas, as it called them.

"Vending sounded so last-century," said Gregg Kaplan, who led Redbox from inception until April, when he became chief operating officer of its parent company, Coinstar.

McDonald's also tried a machine that made fresh french fries and an 18-foot-wide automated convenience store that sold everything from toilet paper to fancy sandwiches. Only the DVD kiosk stuck.

The group running Redbox grew from operating 12 of the DVD machines to about 900 in three years. By the middle of 2005, Redbox was itching to expand beyond burger joints, and McDonald's agreed to let it seek out another partner.