Netflix in 2011
Netflix used to be a perfectly good horror movie. Company management swings a chainsaw; investors scream and are cut to bits; audience is titillated. Now it has become one of those avant-garde films your pseudo-intellectual friend recommends: no fun to watch, surreal and confusing . . . . The no-fun-to-watch part is the damage that Netflix's abrupt price increase has had on subscriber numbers. Subscriber growth ground to a halt in the third quarter, after the increase was announced in July. In the current quarter, as the price increase is put into effect, the company expects its physical DVD service to lose 3m - about a fifth—of its subscribers. Streaming video subscribers are expected to be flat to down. Given that Netflix's strategy is designed to encourage growth in streaming, this is far worse news than the hit to DVDs. —LEX Column: Netflix, Financial Times, October 25, 2011
Reed Hastings, founder and CEO of Netflix, was having a rough September. Only a few months earlier, he was on top of the world. Named Fortune magazine’s businessperson of the year in 2010,Hastings had built the DVD-by-mail company into an enormously popular consumer service. (See Exhibit 1for a Netflix income statement.) In July 2011 Netflix announced that it would start charging separately for its streaming video service and its DVD service—and that each service would cost $7.99 a month. The streaming service was formerly a $2 add-on to the basic DVD monthly charge of $7.99 for its entry-level one-DVD-at-a-time plan. Customers who wanted both would now have to pay $15.98 a month. Although most new consumers who wanted only the streaming service would actually see a price reduction, the public outcry over the 60% price increase for the combination drowned out that fact.
3 Things got worse when Hastings announced that the company would split the DVD-
by-mail into a separate business named Qwikster, and that the online streaming business would retain the Netflix name. On September 18, 2011, he announced on his blog: It is clear from the feedback over the past two months that many members felt we lacked respect and humility in the way we announced the separation of DVD and streaming, and the price changes. That was certainly not our intent, and I offer my sincere apology. I’ll try to explain how this happened.
For the past five years, my greatest fear at Netflix has been that we wouldn't make the leap from success in DVDs to success in streaming. Most companies that are great at something—like AOL dialup or Borders bookstores—do not become great at new things people want (streaming for us) because they are afraid to hurt their initial business. Eventually these companies realize their error of not focusing enough on the new thing, and then the company fights desperately and hopelessly to recover. Companies rarely die from moving too fast, and they frequently die from moving too slowly. Hastings went on to explain that streaming and DVD-by mail were becoming two quite different businesses, with different cost structures and benefits that needed to be marketed differently. In addition, each business needed to be able to grow and operate independently. Thousands of consumers criticized the plan on Netflix’s website, and Netflix stock continued its slide, from $300 earlier in the year to $77in October. By mid-October, the company reversed course again, abandoning the breakup plan. Asked in a television interview about how it felt to apologize for business mistakes, Hastings was humble: Going through marriage counseling 20 years ago was really how I moved to become a better manager and leader.
This marriage counselor was able to get me to see that I was often lying to myself and my wife. and that the value of honesty is that people can take honesty, even if it’s not necessarily what they want to hear, if it’s really sincere. The bigger challenge facing Hastings and his team was how to cope with the very different business model for streaming in a company built on the higher margins of DVD-by-mail.
How would they manage that transition within a single business, and more importantly, with the company’s20 million customer relationships? That was the question he now had to be honest about.
The U.S. Home Video Rental Market
In the 1990s, the U.S. home video market was a fragmented industry largely populated with “mom-and-pop” retail outlets. Customers rented movies, primarily on VHS cassette, from a retail location for a specified time period, usually between two days and one week, and paid a fee of $3 to $4 for each movie rented. Blockbuster Inc. became the market leader with the insight that movie rentals were largely impulse decisions. To customers deciding at the last minute that a given night was “movie night,” the ability to quickly obtain the newest release was a priority. Statistics showed that new releases represented over 70% of total rentals. Blockbuster’s growth strategy revolved around opening new locations, both to expand geographic coverage and to increase penetration and share in existing markets. By2006, Blockbuster had 5,194 U.S. locations, of which 4,255 were company owned and the balance franchised. Locations were chosen based on customer concentration and proximity to competition, focusing on high-visibility stores in heavily trafficked retail areas. Management often proclaimed that “70% of the U.S. population lives within a 10-minute drive of a Blockbuster.” Stores were staffed primarily with part-time employees, averaging 10 staff members per store plus one manager. Occupancy and payroll represented a significant percentage of total costs. Blockbuster outlets carried about 2,500 different titles per store. A substantial portion of the shelf space in a store was dedicated to hit movies, with the newest releases receiving the most prominent display. Locations typically acquired 100 copies of a new release, and they made up an estimated 5%–80% of demand compared to 20%–25% for catalog releases. Consumers liked to rent new releases during the first three weeks of the studio distribution window. After that, demand fell sharply. The studios protected this window because of the increasing share of revenues that they received from sales (see Exhibit 2). As rental demand for a particular title dropped, the stores remarketed used copies to reduce their inventory and generate additional income. Blockbuster’s business model depended on maximizing the days that a movie was out for rent. Stores were reluctant to stock large numbers of lesser-known and independent films, since the demand for these titles was inconsistent. With a relatively narrow selection of mostly familiar movies, customers could generally select a title with a limited amount of advice from the sales staff. Movies not returned to the renting location by the end of the specified rental period were subject to extended viewing fees, or “late fees.” In 2004, these fees represented about 10% of revenues. Late fees also improved asset utilization by encouraging a timely return of each rented film, allowing it to be rented by another customer. Late returns led to increased levels of stockouts, costing Blockbuster incremental rental opportunities as well as reduced customer satisfaction. The unit economics of retail video rental were straightforward. Blockbuster acquired approximately half of its rental inventory under a purchase model in which it would pay the studios $15–$18, rent it 9–10 times for $4 per rental, and then resell the DVD for an average of $8per unit. The other half was acquired under a revenue share model in which Blockbuster paid the studio about $5 per copy, rented it 9times, and resold it for an average of $8, sharing 30% of the revenue with the studios. The mix shifted to 81.8% revenue share by 2006. One analyst estimated that Blockbuster spent $837 million on rental library purchases in 2003. Retail stores cost approximately $300K to set up, and it was estimated that they produced $900K sales per year with an operating profit of $162K. In 2002Blockbuster enjoyed record levels of revenue and profitability, riding a wave of consumer DVD-player adoption, which increased from 24% to 37% of U.S. households in just one year. (Exhibit 3showsBlockbuster’s income statement through 2006.)As consumers sought content for their new players, spending for in-home movie viewing reached $22.3 billion.2002 represented Blockbuster’s fifth consecutive year of same-store sales growth, and the Blockbuster brand achieved nearly 100% recognition with active movie renters. That same year Netflix went public, and some would say that is when Blockbuster’s troubles really started to get serious.
Netflix History
Hastings conceived of Netflix in 1997 after he discovered an overdue rental copy of Apollo 13in his closet. After paying the $40 late fee, Hastings, a successful entrepreneur who had already founded and sold a software business, began to consider alternative ways to provide a better home movie service. At the time, most movie rentals were VHS video cassettes, but Hastings had heard from a friend about the new DVD technology. DVDs were small and light, enabling inexpensive postal delivery. “I went out, bought a whole bunch of CDs and started mailing them to myself to see how quickly they would come back and what condition they would be in,” he explained. “I waited for two days—and they all arrived in perfect condition. All the pieces started to fall into place after that.
Netflix’s Early Days
Hastings founded Netflix in 1997, and launched the company’s first website in early 1998.Netflix targeted early technology adopters who had recently purchased DVD players ,offering cross-promotional programs with the manufacturers and sellers of DVD players, thus providing a source of content for customers. Hastings elaborated, “We were targeting people who just bought DVD players. At the time our goal was just to get our coupon in the box. We didn’t have too much competition. The market was underserved, and stores didn’t carry a wide selection of DVDs at the time.” Netflix’s website included a search engine that allowed its customers to sort through its selections by title, actor, director, and genre. Using this search engine, customers built a list, called a “queue,”of movies to be received from Netflix. Netflix sent movies to its subscribers based on the order of titles in the queue, with subscribers receiving a new movie as soon as the previous one was returned. The company initially used a pricing model similar to that offered by traditional video stores. Customers chose their films using the company’s website, were charged $4 per movie rented plus a $2 shipping and handling charge, and were expected to return films by a specific due date or be charged extended rental fees. Netflix’s early strategy went beyond DVD rentals. While marketing a 2000 IPO, management described the company as the ultimate online destination for movie enthusiasts. Along with the DVD-by-mail service, Netflix was offering its recommendation system to everyone, including nonsubscribers, creating a Web portal rather than simply a subscription service. Hastings described this early strategy: “Our2000 prospectus was spun towards things that were hot. it reflected a tension in our strategy. We would offer price comparisons, theater tickets. That strategic tension didn’t resolve itself until the bubble crashed. That summer we realized we weren’t going to make it unless we did it on rentals. It was a cash-induced strategic focusing.” This focus was pushed along by the rapid adoption rate of DVD players among U.S. households, which followed the fastest technology adoption curve in history. U.S. household penetration, at 5% in 1999, leapt to 13% by 2000, 37% by 2002, and 65% by 2004, a pace that attracted the attention of channels like Best Buy and Wal-Mart, which discounted them extensively to drive store traffic. DVDs also began replacing VHS cassettes on the shelves of traditional video rental outlets. As DVDs became more widely available both for purchase and for rental, Netflix’s value proposition to new DVD-player owners diminished. The company shelved its plans for an IPO and struggled through a large layoff as it began to adjust its business model in an effort to reach profitability. Chief among Hastings’s concerns were the general customer dissatisfaction with Netflix’s value proposition and the high cost of building a DVD library to support its growing subscriber base. Feedback from early customers revealed a frustration with Netflix charging rental prices similar to competing retail locations, while providing slower delivery. Neil Hunt, the company’s chief product officer, described Netflix’s motivation for shifting to its popular no-late-fee subscription model in 1999: Pricing had been a discussion point for a long time. Our original model didn’t work—we needed to overcome the shipping delay. It just wasn’t a high-enough-value product to overcome the delivery waiting time. We spent a lot of money to market to and attract new customers, and they wouldn’t be repeat renters. We were spending $100 to $200 to bring in a customer, and they would make one $4 rental. There was no residual value.
Moving to a Prepaid Subscription Service
Hastings believed that moving to a prepaid subscription service could provide better value to Netflix’s customers and also turn Its longer delivery times into an advantage. The first iteration of the subscription model allowed customers to have four movies in their possession at once and receive up to four new films each month. Hunt explained the effectiveness of the new pricing model: “We turned the disadvantage of delivery time into having a movie at home all the time. The value to
Netflix of having our movies in the customers’ homes at all times was our key insight.” Netflix soon changed its pricing system again, offering unlimited rentals for the first time. Subscribers could now keep three movies at a time and exchange them as frequently as they liked. Hunt explained the reasons behind this quick change: We made the observation that this change would dramatically simplify the program and make it easier to explain the service. It also allowed us to market a more compelling value proposition. The term “unlimited” is great marketing.. We had some vigorous debates about this, but in the end it was a leap of faith. The dot-com boom was still in full growth mode, and everyone around us was growing fast. It wasn’t the time to do months of testing and analysis. We had to make some bets and not worry about getting it wrong. At that time, the ones who got it right would succeed, and the ones who got it wrong wouldn’t be around. With this change the company added a new group of fans for whom movie rentals were a regular part of their daily entertainment. Many of these customers were turned off by the high cost of paying for each movie rented, yet they still chose to rent from video stores because of limited alternatives. Others were dissatisfied with high late fees, which inhibited their ability to view movies at the times most convenient to them. If “movie night” was not an event but an ordinary form of entertainment, the option to hold movies beyond a two-day rental period was important. For these frequent viewers,
Netflix’s “all you can eat” model was an attractive alternative to the traditional per-day fee structure. Subscription costs—the expense of acquiring movies for rent—were still a major burden. Hunt explained the impact that customer demand had on managing the cost of building their film library: We began struggling with a new problem. Half of the DVDs we were shipping out were brand new. We realized that we had to fix that. Top new releases received a lot of external marketing support and as a result had strong customer awareness and demand. Of course, those movies were the most expensive to acquire. We couldn’t just blindly promote movies that already had external demand generation. We needed to stimulate demand on the older and less-known movies and things already in our catalog. By marketing from the rest of the “tail” we could drive the average price down of building our catalog.
Developing The Proprietary Recommendation System
Netflix initially relied on traditional merchandising to complement its search engine and connect subscribers to the company’s library of titles. A small number of employees highlighted different films on the website’s homepage each week, effectively providing the same recommendations to all subscribers. Hunt explained the consequence of this marketing technique: We started with a system that relied heavily on editorial content, but we realized that an editor could only write so many web pages. Five movies would be highlighted on the website, then everything that was promoted was instantly rented out. That changed to a different five movies each day of the week, and they were all still instantly rented out. We tried to improve the system to ensure that subscribers weren’t referred to movies they had already rented. Eventually, we realized that the promotional value of writing the editorial blurbs was zero. Realizing the inadequacy of the traditional merchandising system, Netflix engineers developed a proprietary recommendation system to better balance customer demand. Upon establishing a new account for the first time, customers took a short survey to identify their favorite movie genres and rates pecific movie titles from one to five. Netflix’s proprietary algorithm then used these survey results and the respective ratings of millions of similar customers to recommend films to its subscribers. The recommendations page not only included a list of titles with a ranking of how closely they matched the customer’s preferences but also a synopsis of the film, a description of why the film was being recommended, and a collection of reviews from other subscribers. As customers rated each movie they saw, Netflix’s software refined its understanding of customers’ preferences and more accurately recommended movies that would appeal to each customer. Key to the success of Netflix’s inventory management was a filter placed between the output of the recommendation system and the results shown to the subscriber, screening for those movies that were out of stock. The intent was to avoid frustrating a customer by recommending a title that was not immediately available, but a side benefit was that new releases were rarely on recommendation lists, as they were the most likely films to be in short supply. The system increased the utilization of Netflix’s library of films by satisfying customers with movies already acquired and in stock, rather than requiring the purchase of more copies of newer films. Compared to traditional video rental outlets, where new releases would make up over 70% of total rentals, new releases represented less than 30% of Netflix’s total rentals in 2006. Hunt explained the power of Netflix’s recommendations: The recommendation system will pick the best movie for a customer, period. But it has to be something that can ship overnight. High-demand new releases are less visible because they are less frequently in stock. However, the customer benefits from this system. We have recognized improved customer satisfaction by eliminating the “bait and switch” perception. Most revealing about the value of the recommendations is that ratings are three-fourths of a star higher on recommended movies compared to new releases. While the investment in software engineering was modest, this shift marked a cultural battle within the company with those who remained loyal to the traditional merchandising system.
Hastings described his insistence on this change by highlighting another benefit: “A personalized experience is the benefit of the Internet. If you can otherwise do it offline, people won’t pay for it online. If our Internet offering was going to be better than stores, we had to find something stores couldn’t do well.” Movies were a taste-based product, for which many titles were consumed only once. As such, consumers needed to make a series of purchases without knowing for sure whether they would like the product. Netflix’s website resonated with subscribers because they so frequently enjoyed the lesser
-known films recommended to them that they might not have otherwise seen. The recommendation software established a relationship with customers that was not matched by part-time employees at a retail video store, nor easily replaceable if a customer switched to a competitor’s service. Netflix’s size and growth rate also enhanced the value of its collaborative filtering system, with its rapid growth in customer-generated ratings. Because it had the largest collection of movie ratings in the world, customers recognized that they were more likely to have their tastes and preferences accurately reflected in recommendations from Netflix’s site than any other offered by a competitor.
Building the Movie Library
Even with the increased customer awareness of lower-profile films that Netflix’s recommendation system generated, building the company’s movie library still represented a major use of cash. As a small player in the video rental market, Netflix had no direct relationships with the major studios. It filled its film library through relationships with a small number of movie distributors, at prices that reflected minimal discounts. Up-front costs forced Netflix to choose carefully when stocking new films and often resulted in fewer than the desired number of copies of a title being acquired. As a result, one of the major sources of customer dissatisfaction was the inability to rent new releases in a timely manner. Netflix took steps to address this by hiring Ted Sarandos as chief content officer to manage content acquisition. Sarandos, who had been with Video City, a major U.S. video rental chain, joined Netflix in May 2000 and led the company’s transition to revenue-sharing agreements with the major studios. He recalled: We were handicapped with vendors when I first arrived because other Internet vendors at the time had not been successful. As a pure rental business that was 100% subscription-based and 100% Internet-based, we were reinventing the wheel on three dimensions for the studios. However, it is very much a relationship business, working with the studios, and I had worked with those people all of my career, so I managed to bring my relationships with me from my prior company. Within a year, Netflix had negotiated direct revenue-sharing agreements with nearly all the major studios. Rather than pay an up-front price of $18 – $20 per DVD, the studios would reduce their unit up-front price in return for a fee based on the title’s total number of rentals for a given period of time. Hastings described this transition with the company’s suppliers: “We spent more money, not less, with the studios but got bigger customer satisfaction. It was like paying 20% more and getting two times the number of copies.” The benefit of the new relationships with the studios extended beyond lowering the acquisition costs for new releases. Early on Hastings had recognized the number of customers who were frustrated with the poor selection offered at many video stores, where shelf space was focused on hit movies and new releases. Customers interested in exploring a broader range of movie titles were left unsatisfied by their options. Sarandos explained: “The thing that Reed and I connected on before I even joined Netflix was the promise of a business model that promoted lesser-known movies. Films outside of the top 20 are not distributed widely. If you didn’t see a movie within six months of when it was in the theaters, it often disappeared forever. ”The use of a national inventory allowed Netflix to satisfy the diverse demands of movie watchers, serving the same number of customers as a local network of Blockbuster retail locations with far fewer copies of a given movie title. Sarandos explained the difference in economics: Half the equation of packaged media is allocation—getting the right amount of product in the right locations.
1. Identify three strategic choices through which Netflix successfully overcame Blockbuster’s existing competitive advantages. Be specific about which choice overcame which advantage and why.