Netflix Strategy Analysis v1.0

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Netflix, Inc.Analysis of Strategy

“Keeping the world safe for couch potatoes…”

Kostadin Atanasov

[email protected]

Institute for Media and Entertainment

mailto:[email protected]




NetflixAnalysis of Strategy Kostadin Atanasov

3 December 2004, New York, USA

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Netflix, Inc.Analysis of Strategy Kostadin Atanasov

Content

Executive Summary.................................................................................................................4

Introduction..............................................................................................................................4

About Netflix............................................................................................................................4

External Analysis.....................................................................................................................5

Overall Market Situation......................................................................................................5

Home Rental Market Drivers................................................................................................5

Home Rental Market Inhibitors............................................................................................6

Value Chain...........................................................................................................................7

Competition...........................................................................................................................8

Five Forces Analysis...........................................................................................................11

Internal Analysis.....................................................................................................................13

Financial Performance Indicators.......................................................................................13

SWOT Analysis..................................................................................................................13

Strengths..........................................................................................................................13

Weaknesses......................................................................................................................14

Opportunities...................................................................................................................15

Threats.............................................................................................................................15

Strategies Employed...............................................................................................................16Critical Assessment of Strategies...........................................................................................17

Latest Developments..............................................................................................................18

Conclusions............................................................................................................................18

Join Forces..........................................................................................................................19

Compete..............................................................................................................................19

Keep competition guessing….........................................................................................19

Stabilize own customer base….......................................................................................19

Plant roots in the deep future…......................................................................................20

Bibliography And Sources.....................................................................................................21

Attachment 1 – Motion Picture Value Chain.........................................................................23

Attachment 2 – Before and After Digital Tectonics..............................................................24

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Executive Summary Netflix reinvented the home video rental model by employing innovative customer serviceand new technologies. Although this gives the company a serious first mover advantage, italso invites a wave of competition, most importantly large players such as Blockbuster,

Wal-Mart and Amazon.

Although outlook of external market conditions is positive, the overall situation of Netflixis not sustainable and will become increasingly difficult.

At this critical point the company must decide whether it should exit or it should stay andcompete.

If Netflix decides to exit, it should attract financing and expand its operations to capturequick gains and improve its valuation.

If Netflix decides to stay and compete it needs to (1) keep innovating to maintain itsadvantage, (2) use subscriber acquisition momentum and build larger customer base and

(3) move fast to plant roots into next-generation models of content delivery based on digitaltechnologies.

IntroductionThis document discusses the competitive strategy of Netflix, a US-based onlinesubscription DVD rental company. Because of the customer service innovation and highlyvisible IPO, Netflix has been extensively discussed in the media, industry publications,financial analyses and business school literature. Therefore this paper only mentions highlevel aggregate data and facts and uses them as basis for discussion of Netflix’s forwardlooking growth and competitive strategy.

The analytical tools used as widely popular strategy concepts such as the five forcesframework and the industry value chain.

In addition the some of the conclusions are derived on the basis of a conceptual framework for media distribution – a model developed by the author, looking at value chain shifts of the audio-visual industry in the next 10 – 15 years1.

About NetflixExcerpt from Netflix’s 2003 Annual Report:

Netflix, Inc. was incorporated on August 29, 1997 and began operations on April 14, 1998.The Company is an online movie rental subscription service, providing subscribers [in theUnited States] with access to a comprehensive library of titles. For a monthly subscriptionfee under the standard plan, subscribers can rent as many digital video discs (“DVDs”) asthey want, with a number of movies out at a time, and keep them for as long as they like.There are no due dates and no late fees. DVDs are delivered directly to the subscriber’s

1 This model is not included and is available upon request.

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address by first-class mail from distribution centers throughout the United States. TheCompany also provides background information on the Company’s Web site(www.netflix.com) on DVD releases, including critic reviews, member reviews, onlinetrailers, ratings and personalized movie recommendations.

External Analysis

Overall Market Situation

The home-video rental segment in the US is a $6.8 billion market, with home-video salesgenerating another almost $12 billion. Rental and sales combined provide around 45% of film studios’ revenues, making home-video the most important business line for Hollywood2.

The home-video rental market has been in stagnation since 2000 due to consumers’migration from renting towards purchases of home-video titles. However growth isexpected to pick-up as the DVD establishes itself as the video format of choice.

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

11,000

Turns (Millions) 3,601 3,626 3,526 3,756 3,502 3,250 3,100 3,100 3,250 3,450

Spending ($ Millions) 9,655 10,099 10,227 10,259 9,911 9,440 9,225 9,370 9,668 10,150

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: Entertainment and Media Outlook: 2003 – 2007, North America, PWC

Figure 1. Home video (VHS and DVD) rental turns (units) and revenues ($, Millions) in the US.

Home Rental Market Drivers

Growth in DVD installed base. The DVD format has seen a true explosion in the US for the past 7 years since its introduction. Although industry experts agree that 2003 markedthe peak in DVD player sales, penetration will continue and DVD will establish itself as thesingle dominant home video format. 2003 figures indicate around 53% of US householdsown at least one DVD player and penetration is expected to reach around 65% by 2004year-end with sales seeing the beginning of a downward trend.

2 Markets size estimates vary greatly depending on the source. Numbers presented here are midpointsdefined by author.

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0

5

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15

20

25

30

35

40

-50%

0%

50%

100%

150%

200%

250%

300%

DVD Unit Sales 0.305 0.946 3.55 9.877 16.662 25.113 33.734 27

US Market Penetration 0% 1% 3% 9% 18% 33% 53% 69%

Y-o-Y Sales grow th 210% 275% 178% 69% 51% 34% -20%

1997 1998 1999 2000 2001 2002 2003 2004

Source: Digital Entertainment Group, (www.digitalentertainmentinfo.com)

Figure 2. Sales, penetration and growth of DVD players in the US.

Digitalization of content. Most content owners are transferring their content over to digital platforms, what is known as “digital media asset management”. Content producers today predominantly edit and produce the “master” in digital environment. As most audio-visualcontent migrates towards digital, there is a thrust for the DVD market.

Increased share of TV entertainment vs. print media. Media consumption trendssuggest that audience interests shift from print to visual media. This migration is favorablefor the DVD format in general and Netflix business in particular.

Penetration of Internet access. At the 3rd quarter of 2004 US internet connectivity

penetration is estimated at almost 69%. This fact has positive implications as Netflix’scustomers need to be online to make their order or browse the catalog.

Home Rental Market Inhibitors

Growing sell-through trend. As the retail price of DVD films decreases, customers often prefer to purchase a title for their home film library. This affects adversely the rentalmarket since a person who purchases a film is unlikely to rent it.

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http://www.digitalentertainmentinfo.com/






0

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1,400

0%

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Unit sales grow th 16 59 147 294 491 670 850 1,020 1,1501,270

Unit Sales (Millions) 269%149%100% 67% 36% 27% 20% 13% 10%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007


Figure 3. Home DVD sell-through market.

Growth of cable, and on-demand delivery. As MSOs make an effort to enrich their offering to stay competitive, subscribers will have access and use on-demand videoservices such as pay-per-view and video on demand (VOD).

PPV is expected to grow at 7.4% CAGR for the period 2003 – 2007, reaching 65 millionhouseholds in 2007 (61% of US households). Similarly VOD is expected to grow at 24.3%for the period 2004 – 2007, reaching a penetration of 19% of US households.

Value Chain

Under the standard classification of the motion picture industry value chain (“contentcreators”, “packagers/programmers”, “distributors”), Netflix occupies the distributionsegment (see Attachment 1 – Motion Picture Value Chain). Given the nature of theindustry three conclusions jump out immediately:

First, many of the players in the industry are large vertically integrated conglomerateswhose interests to protect their market share and revenues might come into conflict with Netflix. As mentioned earlier, Netflix sources its main input from a small number of suppliers with significant negotiation power.

Second, distribution is the most densely populated segment of the chain, which intensifiescompetition for clients’ time, attention and dollars. This segment is also populated by

television (free-to-air, cable and satellite), VOD, movie theaters and retailers.

Third, distribution will be the segment most dramatically affected by the tectonics of theupcoming technological changes. A precursor of upcoming changes is the personalrecording device (PVR), TiVo being the most prominent STP/PVR brand, which slowlyturns into a part of the TV set and takes on some gatekeeper functions.

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0.00

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2.00

3.00

4.00

5.00

6.00

7.00

PVR HH (Millions) 0.40 1.20 2.50 3.60 5.00 6.00 6.50

2001 2002 2003 2004 2005 2006 2007


Figure 4. Number of US households owning a personal video recorder

Competition

Definition of the market of Netflix can vary greatly based on the value of three parameters,namely:

• Where in the value chain does Netflix stand?

• Where in the release window does Netflix stand?

• Where on the “online-offline” continuum does Netflix stand?

From a value chain perspective, if we choose to define Netflix as a “distribution” player,then we have to include movie theatres and TV channels as direct competition. If insteadwe adopt the distinction between “distributors” (theatres, rental and retail stores) and“pipelines” (free-to-air and cable channels), a distinction used by Standard & Poor’sanalysts, then maybe the list of direct competitors will shrink to only a few – Blockbuster,Hollywood Entertainment, Movie Gallery and Family Video.

The “release window” in the motion picture industry is the practice of cascading thelaunch of the same movie title over the different outlets (see figure 5.)

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Movie Theaters

Hotels and airlines

Video sales & rental

Premium cable

Basic cable

debut +5 months +12 months

Source: Netflix, Inc. coverage, Wedbush Morgan Securities

Figure 5. The Motion picture release-window sequence.

This strategy allows film studios and distributors maximize the returns of the same filmfrom the different market segments by exploiting their “cascading” willingness to pay. If we choose to take the release window as a factor in the definition of the market of Netflix,then the list of direct competitors will include video-retailers, video-renters, premium and basic cable and satellite. If we take a broader perspective we will have to take into accountmovie theatres and hotels and airlines as well.

Finally, if we insist on the on-line nature of Netflix’s business then Blockbuster,Hollywood Entertainment and the other brick-and-mortar businesses will not be in the

same business. However if we choose to recognize that in fact Netflix rents physical DVDsand in consumer’s perceptions Netflix is a video-rental business with clever utilization of Internet technology, then Netflix is again in the company of the rest of the movie-rental participants. It is worth mentioning that there will always be an Internet-averse segment of the audience which will choose to rent their movies from the brick-and-mortar locationaround the corner and therefore Netflix does not technically compete for this customer withBlockbuster for instance. (Of course we have to recognize that slowly all other DVD rentaland retail players adopt on-line ordering as part of their strategy, stepping into Netflixterritory.)

For the purposes of this analysis, I will use Netflix’s own definition of its competitors:

Definition ExampleVideo rental outlets Blockbuster, Hollywood Entertainment

Movie retail stores Best Buy, Wal-Mart, Amazon.com

Subscription entertainment services HBO, Showtime

Pay-per-view and VOD services

Online DVD sites FilmCaddy.com or Walmart.com

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Internet movie providers Movielink, CinemaNow.com, MovieFlix

Cable providers Time Warner, Comcast

Direct broadcast satellite providers DirecTV, Echostar

Source: 2003 Annual Report, Netflix, Inc.

According to latest home video rental and retail data, market shares are as follows:

Hollyw oo

d Ent.

13%

Family

Video

3%

Movie

Gallery

5%

Netflix

6%

Other

32%Block-

buster

41%

Figure 6. Market share of US home-videorental market.

Best Buy

16%

Target

13%

Block-

buster

11%

Circuit

City

4%

Wal-Mart

56%

Figure 7. Market share of US home-videoretail market.

Although Netflix has been called “the leading provider of online subscription-based DVDrental service”, it still occupies only 6% of the overall rental market if we relax the“online” component and define the market perimeter more broadly. Still Blockbuster is theleader in the category, with a market share of 41%.

Rental Chain Market Share Unit Volume

(Million)

Unit Dollars

(Million)

Blockbuster 41.1% 609.4 $2,334

Hollywood Entertainment 13.3% 197.5 $757

Netflix 5.5% 81.8 $313

Movie Gallery 4.9% 73.2 $280

Family Video 3.2% 47.5 $182

Source: Alexander & Associates (www.alexassoc.com), US Rental Market 1/1/04 – 10/31/04.

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http://www.alexassoc.com/





Retail Chain Market Share Unit Volume

(Million)

Unit Dollars

(Million)

Wal-Mart 31.0% 187.9 $2,968

Best Buy 9.0% 54.8 $866

Target 7.1% 43.2 $683

Blockbuster 6.3% 38.0 $601

Circuit City 2.2% 13.2 $209

Source: Alexander & Associates (www.alexassoc.com), US Home Video Rental Market 1/1/04 – 10/31/04.

Five Forces Analysis

Suppliers. Among the number of inputs Netflix sources from external providers, three areworth mentioning since they are critical to the operation’s success and are provided by verystrong suppliers. These are:

• the film releases, delivered by major Hollywood film distributors.

• the shipment services, provided by the United States Postal Services

• the payment processing services, provided by the major card companies (Visa,MasterCard, Discover, American Express)

Any of these components is critical to the success of the business. Moreover in all of thecases Netflix deals with powerful companies in consolidated industries. (Stronglynegative.)

Buyers. Netflix delivers its services to the end-consumers which gives the company certainfreedom. However demand for motion pictures is highly dependent on intangible and

uncontrollable factors such as personal preferences, perceptions, prejudices andrecommendations. This fact introduces certain volatility in demand. (Neutral.)

Substitutes. Home video can be substituted by any other in-home leisure activity.Furthermore depending on personal preferences, users might choose other options withinthe media category such as books or magazines. Specific attention must be paid to theincreasing popularity of video games (the fastest growing entertainment sector) and theadvent of Internet browsing, which has been shown to have impact on media consumption.(Neutral negative.)

Complements. Several components complement the services of Netflix. In the first placeusers must have TV sets. Secondly, users must have a DVD reproduction device such as

DVD player or videogame console. (PCs equipped with DVD-drive serve both functions).Finally, users must have connection to Internet and must know how to use it.

US Households Penetration

DVD Installed base 57 Million 53%

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Internet usage3 202 Million 69%

TV Sets 107 Million 98%

Source: World Internet Statistics, (www.internetworldstats.com), August 2004; Digital Entertainment Group,(www.digitalentertainmentinfo.com); Euro Monitor (www.euromonitor.com)

It is expected that DVD installed base will reach almost 2/3 of the US households by theend of 2004. (Strongly positive.)

Competition. First, the competition in the home-video rental segment is already intensivewith powerful and established players such as Blockbuster and Hollywood Entertainmentcontrolling jointly over half of the market. Further, if we remove the word “rental” fromthe market definition, its boundaries expand to include the following categories as defined by Netflix:

• Movie retail stores

• Subscription entertainment services

• Pay-per-view and VOD services

• Online DVD sites

• Internet movie providers

• Cable providers

• Direct broadcast satellite providers

Probably the most important consideration however is the fact that the on-line subscription based rental segment has already attracted heavy-weigh players – motion picture studios,retail giants (Wal-Mart, Amazon) and video-rental incumbents (Blockbuster). (Strongly

negative.)Barriers to entry. Although there are several factors which are critical to the success of anon-line video rental business, technically entry in this business is not difficult or restricted.Even ambitious entrants, who want to build a large DVD library, can make their investments in small manageable portions. The only limited/uncertain resource is thedistribution license from film studios. (Negative.)

The general evaluation of the industry is somehow negative: It invites entrants andimitation; (2) competitive advantages cannot be sustained for long periods of time, and (3)technologies rapidly transform the landscape.

3 In this case Internet connection must not necessarily be broadband. Users need Internet in order to accessthe website, make a selection and place an order – even 36K modem connection would serve the purpose.

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http://www.internetworldstats.com/



http://www.euromonitor.com/









Internal Analysis

Financial Performance Indicators

0%

100%

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300%

400%

500%

600%

700%

1999 2000 2001 2002 2003

SG&A

Marketing

Technology R&D

Fulfillment

Cost of revenues

Source: 2003 Annual Report, Netflix, Inc.

Figure 8. Composition of costs.

Percentage-wise the gross margin of Netflix’s model is in the low forties depending onintensity of service usage as well as fluctuations in shipment, payment processing andlicensing fees.

Trend in subscriber acquisition costs (SAC) is difficult to estimate. On one hand the brandis very powerful, which generates visibility, word-of-mouth marketing and ultimately newsubscribers at very low or zero cost. On the other hand increased media advertising andexpected competition from Blockbuster and Wal-Mart might push SAC up.

2003 has been the first profitable year for Netflix (NI: $6.5 Million). The balance sheet of the company looks healthy with almost $90 Million in cash and virtually no debt.

SWOT Analysis

Strengths

Relationships with studios. Netflix maintains strategic relationships with studios, which isthe basis of its rich catalog.

Deep and wide library. Netflix currently offers around 25,000 film titles, (arguably allfeature films ever published on DVD) spread over 12+ Million disks. Average depth(number of copies of each film) is 480 copies.

Recognizable brand. Netflix is the largest “on-line subscription DVD rental service” inthe US. It has a well recognizable brand, which helps in marketing by decreasing customer acquisition costs.

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Logistical expertise. Launched in 1998, Netflix has developed and fine-tuned its logistical processes for 6 years with the help of internally developed logistical software.

Widest delivery network. With 30+ distribution centers spread around the US, Netflixdelivers DVDs to 85% of its subscribers the next day.

Recommendation engine “CineMatch”. Netflix utilizes recommendation technology based on user ratings of individual titles. At the end of 2003 Netflix ratings databasecontained around 300 million ratings (around 15,000 ratings per title and 150 ratings per subscriber). Thus every customer can receive a personalized computer-generatedrecommendation for a film.

Client acquisition momentum. Netflix has a critical mass of over 2 million customers, anumber expected to grow in the next 2-3 years.

Low price per title. Based on their reported annual subscription revenues for 2003 andreported monthly turnover of about 18 million disks, the average rental price per DVDcomes at $1.50 – $1.75. According to analysts’ reports, the average Netflix customer rents

between 5 and 7 titles per month. At a monthly subscription price of $17.95, the result is$3.00, which is much closer to the market average of $3.15 - $3.79 per title. Still, in theeyes of their customer the possibility to rent unlimited number of titles and thus have ahome-made low price is clearly a strength.

“Flat monthly fee, no late fees” pricing model. This was a model pioneered by Netflix,which enjoyed enormous popularity among subscribers. Today this model is followed by agrowing number of other rental businesses too.

Weaknesses

Strong suppliers. As discussed above Netflix sources its main inputs from a few andstrong players. Films come from Hollywood distributors, all distribution is handled by oneservice provider – USPS, and all payments and made online via credit card – payments processed by the four major credit card companies.

Volatility in performance. Netflix market performance depends on a number of variables(18 listed in 2003 Annual Report). Additionally demand for the product (films) depends onuncontrollable variables such as taste, recommendation. Finally economic success is verymuch related to customer loyalty because of the high acquisition costs.

Voluntary ratings. One of the distinctive feature of the service is the recommendationalgorithm, whose performance depends on viewer ratings. Currently viewers rate the filmsthey see voluntarily. A declining response rate might adversely affect the quality of recommendations.

Studios define release. Netflix can rent out the DVDs once they are out in the market. Thisis a decision made by movie studios and their distributors and therefore outside the controlof Netflix. As discussed above, the position along the window release continuum mightaffect the popularity of a title and change the competitive environment.

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Opportunities

Digital delivery. Netflix can take advantage of their knowledge of the consumer tastes(300 million film ratings over a library of 25,000+ titles) and transfer this know-howtowards digital delivery. The single most important factor in digital VOD models would beadequate recommendation (the modern version of traditional TV programming) and noother player in feature-film delivery has this expertise.

DVD format dominant. Based on the analysis above and the opinion of industry expertsand analysts, the DVD format will be the dominant video format in the next at least 10years. This situation might be challenged by the new digital transmission and HD storageformats, however, this is an issue affecting the whole business model and departing fromthe physical nature of the medium.

DVD installed base grows. With expected penetration of DVD players in 65% of UShouseholds, Netflix is positioned favourably to exploit this “infrastructural” given.

Underutilized debt capacity. Netflix’ balance sheet as of 30 September 2004 is debt free.

This gives the company an upside potential to borrow in order to finance its expansion.(Currently unit economics and cash generating potential is believed to be strong and thereseems to be no short term need to finance operations.) The weighted average book-debt-to-capital ratios for the internet and movie rental industries ranges between 9% and 14.3%.

Comparison universe WA book debt to capital ratio

Movie rental industry – peer group(Retail – special lines, SIC: 5600)

(4 companies)

14.3709%

Internet industry(SIC: 7370)

(164 companies)

9.0389%

Source: Historical market data, www.damodaran.com

In practical terms this means borrowing capacity between $13 million and $20.7 million based on 3Q2004 balance sheet data.

Threats

Prices of key inputs. As mentioned earlier Netflix is exposed to fluctuations in supplier policies, and specifically prices. USPS, card payment processing companies and filmstudios can increase their prices, which will affect dramatically the unit economics of

Netflix model.

Studios may form alliances with bigger players. As competition in the rental segmentintensifies, studios might deem it more beneficial to form alliances with bigger players,namely Blockbuster and Wal-Mart, manifested in more advantageous conditions. This willworsen the competitive advantage of Netflix.

Studios might not renegotiate revenue sharing agreements. Revenue sharingagreements which shift costs towards the variable end of the continuum might not be

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http://www.damodaran.com/







renegotiated at less advantageous terms. Although this will not necessarily worsen theeconomics of the operation, it might significantly increase the working capital requirements(more cash trapped in DVD copies). Given the short time horizon, WCR will have to befinanced by debt which will deplete the borrowing capacity at a critical moment when Netflix might need a financing cushion to ward off other adverse market developments.

DVD retail prices fall. As discussed above diminishing retail prices of DVD titles mightlure customers away from renting and into buying DVDs. A similar tendency was observedin the period 1999 – 2003 and must not be discounted lightly.

New channels of filmed entertainment delivery. New technological solutions anddigitalization of TV will enable consumers to get access to filmed entertainment over newchannels such as VOD, pay-per-view and Video over IP. Although not expected to gainmarket importance before 2007, these channels already witness implementation which iswell accepted by consumers. Additionally, the increasing popularity of video games alsoclaims part of consumers’ leisure time.

New entrants into the rental market. Already competitive, the rental market is about tosee new entrants both from the lower end (copy-cat small-capital companies) and from the big players such as the film studios. Low entry barriers combined with the high stake for film studios (currently 45% of a films revenues come form home-video rentals and sales)will be the drivers for these shifts.

Management of growth. Currently Netflix experiences growth which affects its businessoperations. Successful management of this growth is a critical factor for Netflix’scontinued competitiveness.

Strategies EmployedBelow is a brief description of some of the key strategies the company employs.

Large selection of titles. The library of Netflix is the largest in the industry. At time of preparation of this report it contained around 25,000 titles spread over more than 12 millionDVDs resulting in an average depth of 480 copies per title.

One flat-fee with no-late-fees. This element of the subscription plan was a unique featureof the service at the beginning of Netflix operation. Its success among clients has madecompetitors rethink their pricing models. As a result an increasing number of video rental businesses have chosen to chare a flat monthly fee.

Recommendation Engine “CineMatch”. Also known as “Collaborative Filtering” thisfeature of the service suggests to every individual client movie titles, which it thinks the

client will enjoy based this client’s past history and ratings (each client is invited to rateeach film he or she sees). The recommendation algorithm takes into consideration theopinions of other users in order to make the recommendation.

High utilization of back catalog. Using its proprietary recommendation technology, Netflix suggests to its subscribers titles from the back catalog, which would not be as easilyvisible as the latest hot releases.

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On-line catalog and ordering. Netflix client can log on to the company’s website and leaf through the catalog of titles. On the web-site they can build queues or “wish lists”, of filmswhich are sent out on a first-in-first-out basis. There is an indication of the expectedwaiting period for each title. Payments for the service are made with a credit card online.

Revenue Sharing. This is a contractual arrangement between Netflix and film distributorsunder which Netflix does not purchase a DVD, nor makes any upfront payments. Rather Netflix pays a percentage of the income a title generates, usually around 15% and has theoption to return the title or purchase it for continued use after one year.

Vast distribution system. Netflix has invested in a vast distribution network of 25+distribution centers around the US. This network is the largest in the industry with closestcompetitor Wal-Mart operating only 6 distribution centers.

Critical Assessment of StrategiesThe general assessment of the strategies of Netflix is positive. The brand is solid, the

business model is successful – it has led the company into its first profitable year; cashgeneration is strong, balance sheet is debt free and the number of subscribers growssteadily.

Below is a discussion of individual elements of Netflix’s strategy.

First mover advantage. Netflix pioneered the flat-fee model in combination with on-lineordering and postal delivery. This fact makes Netflix synonymous with the business model,which gives the company visibility and credibility. The publicity momentum serves themwell in attracting new customers.

Title selection. The size of the selection increases the subscribers’ choice and the depthminimizes the chance of stock-outs. This maintains customer satisfaction levels high and

fosters loyalty, which is critical to the long term success of the model as already discussed.Important here is Netflix’s ability to manage its distribution center stocking policy, sincethe larger the number of distribution centers, the benefits of the pooling effect are lost andeffective depth of copy decreases.

No late fees. This component of Netflix pricing strategy helps the company achieve steadyrevenue flows, which some observers say have been rare for the industry. At the same time,under this pricing model, subscribers with low usage subsidize the heavy users. Ascompetition in the rental segment grows, over-paying customers will find it moreadvantageous to move to services which reflect more fairly their low usage. Netflix havealready introduced different price point brackets, which is a move to remedy the situation.

Predictable demand. After looking through the catalogue, each client adds titles to his or her “wish list”, which are then served out on a FIFO and availability basis. This seeminglysimple feature does three things. First it helps Netflix predict the demand several daysahead and make adjustments in shipping and stocking where benefits outweigh costs.(There is no information whether Netflix actually adjusts its shipping and stockingdecisions based on queued items.) Second, Netflix makes sure that in the event of a stock-out of a specific title, the client will still receive a film that he or she likes, i.e. there will be

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no dissatisfaction with the service. Finally it allows Netflix identify potential problemsquickly and fix them.

On-line catalog and ordering. Choosing on-line is the better option both for clients and Netflix. First, choosing from the comfort of home (or office) makes the experience more

enjoyable. Second, it gives clients more time to leaf through the collection at their own pace, read through film descriptions and look at back catalog items. Choosing online alsogives clients 24 hour access, without the extra cost for Netflix to run a 24 hour operation.Finally, the online catalogue avoids the drawbacks of physical shelves by giving clientsinstant access to titles with a click of the mouse.

High utilization of back catalog. High utilization of the back catalog leads to smoother distribution of demand (less stock-outs and waiting) and lower costs per title (back catalogitems cost less).

Latest Developments

International expansion. Netflix has announced plans to expand internationally,specifically mentioning the UK and Canada. In the first place, every internationalexpansion has risk associated with it, especially if this is the company’s first replication of its business model. Clearly the challenge is in the company’s ability to transpose its business processes and competitive advantages in a new market where cultural,administrative, geographical and economical realities are different. Second, the nature of the movie distribution business mandates that Netflix will have to renegotiate its licensingagreements with the distributors. Third, financial analysts predict that the company’sforecasts on necessary investment are too optimistic. Furthermore, the size of the UK market is estimated at 20% of that of US. Last but not least, there are similar servicesalready introduced in UK, most notably Blockbuster uses UK as its experimental territory

for the online subscription model before introduction into US. Given the abovecircumstances, maybe the only positive aspect of investing overseas is introducing the brand in the local market, with view to future global expansion.

Partnership with TiVo. At the time when this paper was prepared, the industry presscirculated news about possible partnership talks between Netflix and TiVo, the PVR manufacturer. No details were available; neither did the PR department of Netflix disclosefurther information when approached4.

Video over IP. Currently Netflix takes subscriber orders online and delivers films on physical DVD disks. The company has made official its plans to look into digital deliveryof films over IP networks (Internet).

ConclusionsBased on the analysis so far, Netflix gained its leadership position within the onlinesubscription video-rental niche thanks to its innovation and first mover advantage.However this leadership is aggressively attacked and not sustainable even in the mediumterm.

4 Email correspondence with [email protected] as of 2 December 2004.

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Competition will intensify in the coming 1-2 years, following the entry of powerfulcompanies like Blockbuster, Wal-Mart and Amazon, to mention the most prominent.

It is difficult to predict the exact market dynamics, but it is clear that Netflix will notmaintain and grow its market position with muscle. First, the company does not have the

necessary capitalization and market share. Second its short history will not provide a solidfoundation for raising the necessary debt or new capital.

Therefore Netflix might compete against the heavily capitalized champions either in unionwith a third player or by being smarter and quicker.

Based on these two broad scenarios, Netflix could use one of the following strategic paths.

Join Forces

Under this scenario Netflix might merge with players like “Hollywood Entertainment” of “Family Video” to withstand the attacks of deep-pocketed rivals. With bigger capitalization Netflix may reverse the odds of winning the battle or balancing the powers in the mediumrun.

Joining forces might also mean acquisition by one of the big players in the market.

If they choose the “join” scenario Netflix should use its subscriber acquisition momentumand probably consider borrowing to finance quick expansion, thus achieving appreciationand more favorable evaluation for any merger deals.

Compete

If Netflix decides to compete, it has to be smarter and quicker than the big players in themarket – something it has already proved it is good at. The strategy should be three- pronged: keep the competition guessing while stabilizing own customer base and plantingroots in the deep future. How exactly can that work?

Keep competition guessing…

Netflix shook up the video rental business. In fact the wave of technological changes wouldhave caused the shake-up sooner or later, simply Netflix opened the floodgate. In theseturbulent conditions, anyone who can stay on top of the wave already has an advantage,simply because some of the competitors will not be able to keep their balance. The bigger players like Blockbuster, Wal-Mart and Amazon are only entering the phase Netflix hasmastered. Therefore by offering new service features, either based on technologicalchanges or improvement of service will keep Netflix ahead. An example of such a move is Netflix’s expansion into UK, which is not expected to bring substantial economic results.Another way to stay ahead is to keep improving the recommendation engine CineMatch.These newly created advantages in themselves will not be sustainable in the long run, buttheir goal should be to keep Netflix ahead, while more important developments take place,namely achievement of stable market footprint.

Stabilize own customer base…

Currently Netflix has a great momentum in building its subscription base. The companyshould capitalize on that trend and try to increase the number of its customers, so it gains

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critical mass in terms of market share. An immediate concern should be their high churnlevels. (It is estimated that since beginning of its operation the number of subscribers whogave up the services of Netflix is almost as large as the number of their currentsubscribers.)

Plant roots in the deep future…It is clear, that penetration of digital technologies will be the main factor in therearrangement of the value chain in the audio-visual media content delivery in the future. Netflix management has already recognized this and has announced plans to deliver filmsnot only on physical DVDs but over digital networks. Says Netflix CEO Reed Hastings,“We named the company Netflix, we didn’t name it DVD by Mail ”.

It is clear that films will be delivered to subscriber homes via Internet Protocol (IP), what isstill unclear is the exact form. Many questions are still unanswered:

• What encryption standard will be used to ensure the protection of intellectual property and how will it be integrated in hardware platforms? Will the film studios

buy it?

• As Internet is brought into households both via cable and telecom infrastructure,will cable companies try to block film delivery over their networks?

• Which piece of consumer equipment will be the “home entertainment center”? Willit be TiVo, Microsoft’s Media Center, cable STPs or something yet unseen?

• What will be the user interface for selection of content by the users?

• Will Video-over-IP gain popularity before Netflix has a chance to move into themarket?

•

Will broadband penetration, critical for the success of this plan, reach thresholdlevels to allow for sustainable economies5? If not for what period is Netflix prepared to take losses? For what period are Netflix shareholders prepared to takelosses?

The best bet of Netflix for now is to suggest a working solution and deploy it as fast as possible:

1. Netflix should develop (or adopt) a solid DRM model to which film studios mustconsent.

2. It should try to avoid cable as key delivery infrastructure and look more towards thetelecoms, which are likely to embrace the initiative since cable already chews-off

serious portions of their business.

3. Netflix should team up with companies for digital content distribution such asAkamai, which will store the content close to consumers.

4. Finally Netflix should team up with TiVo to ensure that subscribers have a deviceto play the films. This will also solidify Netflix’s position at the last mile – access

5 Currently 25% of US adults have broadband connection. Estimate for 10.3% CAGR in US & Canada for the period 2003 – 2007.

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to consumers’ homes. (Why TiVo? First, TiVo’s position is shaky in the light of MSO’s deployment of own free STPs and is likely to embrace the opportunity.Second, TiVo is deploying its second generation STP which can connect to theInternet and would therefore look for media content provider for this channel.Finally TiVo’s CEO Mike Ramsay sits on the Netflix board.)

It needs to be mentioned that TiVo’s second generation of STPs will need some time toestablish itself in the market. It is unclear how fast broadband will roll-out. The good newsis that with a device like TiVo, rating the films can be somehow more automated whichwill remove the risk of voluntary subscriber contributions for the recommendation engine Netflix already has.

Bibliography And Sources Netflix, Inc., Annual Report (for the fiscal year ended December 31st, 2003), Los Gatos,CA, USA (www.netflix.com).

Blockbuster Inc, Annual Report , Dallas, TX, USAAtanasov, Kostadin P., Technology-Driven Value Chain Shifts in the Media Sector

PriceWaterhouseCoopers, Entertainment and Media Outlook: 2003 – 2007 ( www.pwc.com/outlook

)

JP Morgan, Netflix, Inc. Coverage, 13 August 2004

Jefferies & Company, Inc., Netflix, Inc. Coverage, 24 June 2004

Wedbush Morgan Securities, Netflix, Inc. Coverage, 28 September 2004

SG Cowen & Co., Netflix, Inc. Coverage, 26 May 2004

Helm, B., Why TV Will Never Be the Same, Business Week Online, 23 November 2004Burrows, P., Next: TV Meets IP , Business Week Online, 23 November 2004

Yang, C., TV’s Spectrum Showdown, Business Week Online, 23 November 2004

Wildstrom, Stephen H., Software For The Ultimate Couch Potato, Business Week Online,25 October 2004

Stone, B., I Want a Movie! Now!, Newsweek, 13 September 2004

Consumer Electronics Association, Digital America,(http://www.ce.org/publications/books_references/digital_america)

Alexander & Associates , Rental and Sell-through DVD Market 1 Jan 2004 – 31 Oct 2004,

1 December 2004

Digital Entertainment Group,(http://www.digitalentertainmentinfo.com/News/press/010804.htm)

Yahoo Finance (finance.yahoo.com)

Damodaran, Company ratios (www.damodaran.com)

Bureau of the Census, (www.census.gov)

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http://www.netflix.com/

http://www.pwc.com/outlook

http://www.ce.org/publications/books_references/digital_america

http://www.digitalentertainmentinfo.com/News/press/010804.htm

http://finance.yahoo.com/


http://www.census.gov/

http://www.netflix.com/

http://www.pwc.com/outlook

http://www.ce.org/publications/books_references/digital_america

http://www.digitalentertainmentinfo.com/News/press/010804.htm

http://finance.yahoo.com/


http://www.census.gov/




World Internet Statistics, (www.internetworldstats.com), August 2004;

Euro Monitor (www.euromonitor.com)

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Attachment 1 – Motion Picture Value Chain

In t e r n a l

p r o d u c ti o n

I n d e p e n d e n t

p r o d u c ti o n

D i s tr ib u to r s

C o n t e n t

a c q u is iti o n

C o n te n t

p r o g ra m m in g

S e n d to

lo c a l m a rk e ts

C o n t e n t

a c q u is iti o n

C o n te n t

p r o g ra m m in g

S e n d to

lo c a l m a rk e ts

C a b l e N e t w o r k s

T V N e t w o r k s

C o n t e n t

a c q u is iti o n

C o n te n t

p r o g ra m m in g

B r o a d c a s t to

c o n s u m e rs

S a t e l l i t e N e t w o r k s

L o c a l f re e to a ir

in f r a s tr u c tu r e

L o c a l c a b le


L o c a l te l e c o m


C o n t e n t

a c q u is iti o n

C o n te n t

p r o g ra m m in g

V O D N e t w o r k s

T h e a tr ic a l

e x h ib i t io n s

D V D

S a le s

H o m e v id e o

re n ta ls

C o n t e n t

a c q u is iti o n

R e n t a l C h a i n s

C o n t e n t

a c q u is iti o n

R e t a i le r s

C o n t e n t

a c q u is iti o n

T h e a t e r C h a i n s

C o n t e n t

a c q u is iti o n

C o n te n t

p r o g ra m m in g

V i d e o o v e r I P“N e t w o r k s”

F i l m S t u d i o s

H o u s e h o ld s

S T P

Source: the author

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Attachment 2 – Before and After Digital Tectonics Before After

Dedicated Transmission ChannelsSpecialized transmitters over governmentallocated frequencies and over pre-designedroutes.

Least-cost Auto-routed ChannelsInternet networking equipment iswidespread with multitude of routingoptions. Routes allocated dynamically.

Limited Geographic Distribution

Electronic media content could be deliveredonly at geographic locations wherededicated infrastructure exists.

Unlimited Geographic Distribution

Internet networks already reach virtuallyany point on the planet and are notcontrolled by single dedicated operator.

Programming Decisions: The Station

TV stations program based on (1) station’sagenda, (2) imperfect feedback and (3)aggregated and averaged figures.

Programming Decisions: The Consumer

Consumer decides what to watch – “ondemand” model. Info of media usage onindividual household level.

Network Owners Control Delivery

Programming and distribution companiescontrolled BOTH producers’ access to

consumer and consumers’ access to

content.

No One Controls Delivery

Content creators can publish content onuniversally visible servers. Thus they havedirect access to consumers. On the other hand consumers have direct access to

content.

Easy Government Control & Censorship

With a few critical points controlling thedistribution, levers to affect programmingwere easily available.

Virtually impossible Censorship

With unlimited delivery channels, controlover content is virtually impossible.

Linear Streaming Delivery

Content is broadcast and consumed in real-time. Consumers adapt to broadcastschedules.

Non-linear Consumption

Consumer can decide when to consume – content can be recorded either at consumer end or on intermediate storage.

Trading Terms Defined by Stations

Content producers sold their content for what TV networks were willing to pay. TVnetworks were concentrated and with highnegotiation power.

Trading Terms Defined by Market

Content producers sell their content basedon consumer demand. Price for content isdetermined by market. (Does not mean thatcontent producers are better off.)

Imperfect Market Feedback

Feedback from consumers obtained throughimperfect statistical measurement tools.

Perfectly Precise Consumption Data

Feedback from market is detailed down toindividual programs and households.

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Netflix Strategy Analysis v1.0

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