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NETFLIX INC.: STREAMING AWAY FROM DVDS1

David Wesley wrote this case under the supervision of Professor Luis Alfonso Dau solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Richard Ivey School of Business Foundation is the exclusive representative of the copyright holder and prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail [email protected]. Copyright © 2012, Northeastern University, College of Business Administration

Version: 2012-04-05

The very concept of physical media is racing toward obsolescence. – Steven Levy, author of The Perfect Thing: How the iPod Shuffles Commerce, Culture, and Coolness2 On a clear summer evening in 2011, Reed Hastings, founder and chief executive officer (CEO) of Netflix Inc. (Netflix), decided to visit a friend near his home in Santa Cruz, California. During this visit, Hastings shared an idea that he had been considering for some time — splitting his company’s DVD rental business from the online streaming business. “That is awful, I don’t want to deal with two accounts,” replied the friend, who was also a Netflix subscriber.3 Unconvinced by his friend’s objections, on July 12, Hastings publicly announced his plan and a corresponding increase in fees (see Exhibit 1), both changes to take effect on September 1. The reaction was swift and brutal. Over the next quarter, Netflix lost 805,000 subscribers, its first decline in membership in more than a decade. At the same time, the company’s stock dropped by more than 50 per cent from a high of $300 per share prior to the announcement.4 In an apologetic letter to subscribers, Hastings admitted that he had “messed up.” “I owe you an explanation,” he wrote (see Exhibit 2). 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.

1

This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of Netflix Inc. or of any of its employees. 2 Steven Levy, “Young’s Frankenstein,” Wired, July 2009, p. 54. 3 Nick Wingfield, “A Juggernaut Stumbles,” The New York Times, October 25, 2011, p. B1. 4 Todd Wasserman, “Netflix Loses 800,000 Customers in Quarter,” Mashable Business, October 24, 2011, http://mashable.com/2011/10/24/netflix-loses-800000-customers-in-quarter/#314677-Netflix-Stock-Plummets-27-FollowingEarnings-Report, accessed January 11, 2012.

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Although Hastings apologized for the way the plan was executed, he continued to defend the new structure. Meanwhile, Netflix began to face new competition from a variety of video streaming services, including Apple iTunes, Amazon Video on Demand (VOD), Hulu and Google TV. Even YouTube, which had previously limited its service to amateur video sharing, began to offer advertising-supported films and television shows. In addition, cable and satellite providers started to roll out their own video streaming services at no extra cost to subscribers. Since most Netflix subscribers relied on cable and satellite to provide them with content not available on the Internet, such as sporting events and cable news programming, Netflix content was becoming increasingly redundant. Moreover, unlike the DVD rental service, the new streaming-only service did not offer recent films, due to the unwillingness of content distributors to enter into flat-fee contracts. Streaming was not the only service where Netflix faced new competition. Redbox Automated Retail, LLC (Redbox) supplied DVD kiosks in high-traffic locations across the United States. Each of the 29,000 kiosks offered as many as 200 popular movie titles,5 which could be rented for as little as $1.00 per day ($1.50 per day for Blu-ray discs and $2 per day for videogames).6 Low rental fees, convenience and availability enabled Redbox to capture 18 per cent of the DVD rental market share in 2009, which grew to 25 per cent in 2010.7 Media analyst Michael Olson believed that for Netflix to remain competitive, it needed to expand its online catalog. I understand why they’re making this move toward streaming from a long-term perspective, but the only way they will now be able to make investors believe in them, and subscribers continue to be attracted, is to have a waterfall of new content in the next few months.8 However, Hastings had always maintained that Netflix would not seek new releases from its content partners, who demanded pay-per-view rates. Instead, Hastings’ solution was simple — go to Amazon or iTunes. “Both of the services, iTunes and Amazon, are pretty comprehensive,” he said. “We’re focused on the subscription — unlimited for a flat fee.”9 On November 25, Netflix stock fell to $63 per share.10 BACKGROUND

Reed Hastings and Marc Randolph co-founded the Los Gatos, California-based company in 1997 to provide online rentals of DVDs. At a time when technology pundits saw online streaming as the future of 5

Redbook Automated Retail, LLC, “Media Center: Facts about Redbox,” https://www.redbox.com/facts, accessed March 21, 2012. 6 Redbook Automated Retail, LLC, “General Questions: Price Change,” https://www.redbox.com/pricechange, accessed March 21, 2012. 7 Erik Gruenwedel, “Analysts Downplay Redbox’s ‘Messy’ Quarter,” Home Media Magazine, July 30, 2010, http://www.homemediamagazine.com/redbox/analysts-downplay-redbox%E2%80%99s-%E2%80%98messy%E2%80%99quarter-20180, accessed March 21, 2012. 8 Ronald Grover and Cliff Edwards, “Can Netflix Find Its Future by Abandoning the Past?” Bloomberg Businessweek, September 22, 2011, http://www.businessweek.com/printer/magazine/can-netflix-find-its-future-by-abandoning-the-past09222011.html, accessed January 11, 2012. 9 Henry Blodget and Dan Frommer, “Netflix's Market Opportunity Is a Lot Bigger Than You Think,” Business Insider, April 4, 2011, http://www.businessinsider.com/netflix-ceo-reed-hastings-interview-2011-4?op=1, accessed January 11, 2012. 10 Google Finance, “Netflix Inc.” https://www.google.com/finance?client=ob&q=NASDAQ:NFLX, accessed January 11, 2012.

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content delivery, Netflix turned to a low-tech solution — the United States Postal Service. For a fee of $20 per month, members could select three movies at a time from a wide variety of available titles. Netflix mailed members the physical DVD discs and a postage-paid return envelope. Members could keep the DVDs for as long as they needed without incurring late fees. The only catch was that the DVDs needed to be returned in good condition before another movie could be rented. “Compared with other VOD schemes, Netflix is slow,” observed Peter Lewis of Fortune, shortly after

the service was launched. But once the DVDs are in house, it’s video on demand: The movies can be watched when the user wants and as many times as he or she wants. There are no due dates or late fees. And Netflix has an advantage over other VOD schemes and rental stores when it comes to obscure movies. Try finding the Hindi classic Do Ankhen Barah Haath at your local video 11 store, for example. In 2002, Netflix raised more than $82 million in a successful initial public offering (IPO) that relied largely on the company’s strong growth projections. The enthusiasm was warranted, as Netflix nearly doubled its subscriber base each year for the next several years. By 2004, Netflix had more than 4 million subscribers, compared with 600,000 in early 2002.12 In 2005, Netflix’s growth began to slow considerably. Between 2005 and 2008, U.S. per capita annual spending on DVDs fell from $60 to $43,13 as consumers increasingly turned to illegal downloads on filesharing services such as The Pirate Bay and Megaupload.14 Most viewers did not seem to mind the security risks or video quality that was often inferior to the DVDs. Netflix responded in 2007 by launching its own streaming service that provided members with unlimited movie rentals for a nominal monthly fee. It also lowered the cost of its subscription service, eventually settling on a $10 per month flat fee for both the streaming and mail-in services. Although Netflix paid a fixed cost to distributors for streaming content over the Internet,15 contracts tended to be for one or two years, after which fees were adjusted on the basis of subscriber numbers.16 Analysts hailed the new business model, which quickly returned Netflix toward a path of rapid growth. In 2010, Netflix began to expand internationally, first offering its service in Canada and later in Latin America and the Caribbean. In 2011, the California-based company had 20 million subscribers, employed more than 4,000 people and received revenues of approximately $2.2 billion (see Exhibit 3 for additional financial data).17

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Peter Lewis, “Netflix: Video on Delay,” Fortune, September 17, 2001, p. 230. Netflix Inc., “Company Timeline,” http://signup.netflix.com/MediaCenter/Timeline, accessed January 10, 2012. 13 Dominic Rushe, “DVD Sales Slump Challenges Hollywood,” The Times Online, July 4, 2009, business.timesonline.co.uk/tol/business/industry_sectors/leisure/article6639171.ece, accessed July 13, 2009. 14 File-sharing services permitted users to upload digital media to a remote server where it could be shared with other users or distributed directly through peer-to-peer networks. In the United States, approximately 40 per cent of Internet users shared music, 14 per cent shared video content and 9 per cent shared games. Source: N, Van Eijk et al., “Legal, Economic and Cultural Aspects of File Sharing,” Communications & Strategies, No. 77, 2010, pp. 35–54. 15 In 2010, Netflix had “over $1.2 billion in such contractual commitments covering payments due over the next several years. Furthermore, [Netflix planned] on increasing the level of committed content licensing” based on continued growth projections. Source: Netflix, Inc., 2010 Annual Report, Form 10-K, p. 6 16 Henry Blodget and Dan Frommer, “Netflix's Market Opportunity Is a Lot Bigger Than You Think,” Business Insider, April 4, 2011, http://www.businessinsider.com/netflix-ceo-reed-hastings-interview-2011-4?op=1, accessed January 11, 2012. 17 “Netflix, Inc.: SWOT Analysis,” Datamonitor, October 14, 2011, p. 4 12

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THE RISE (AND FALL) OF BLOCKBUSTER

Netflix’s main competitor was Blockbuster Inc. (Blockbuster), which was founded in 1985, when the video rental market was dominated by small, independently owned rental stores and convenience stores. Video stores offered VHS and Betamax tapes for a fixed nightly fee. These tapes were large, relatively expensive to produce and wore out quickly. Most stores required consumers to pay a large deposit to ensure that tapes were returned in working condition. If tapes were returned late or damaged, consumers had to pay fines, which, in some cases, could amount to more than the purchase value of the movie. Blockbuster was widely lauded as a technological innovator for its use of computer databases to optimize inventory, track consumer movie preferences and consolidate its video rental business nationally.18 Customers were issued a membership card that could be used to borrow movies at any Blockbuster location in the United States without having to complete additional registration forms or provide additional deposits. Over the next decade and a half, Blockbuster grew rapidly across the United States and internationally. By 1999, Blockbuster was the largest video rental company in the world with triple the market share of its next nearest competitor. At the time, “Blockbuster estimated that roughly 60 percent of the U.S. population lived within three miles of a Blockbuster store. The typical Blockbuster store carried 4,500 different movie titles, 500 of which were new release titles.” Approximately 78 per cent of the company’s revenues came from new release rentals.19 The introduction of DVDs in the mid-1990s radically altered the way movies were consumed. DVDs were lightweight, cheap to produce and offered significantly improved video and sound quality over VHS tapes. Also, unlike VHS tapes, DVDs could be economically mailed directly to consumers. By delivering movies directly to consumers through the mail, Netflix was able to provide its DVD rentals from a single location in San Francisco. In 2002, Netflix added 10 regional hubs to serve its rapidly growing membership, which at the time had grown to 600,000.20 When Blockbuster introduced its own DVD mail-in service in 2004, Netflix had already grown to 3 million members. However, Blockbuster’s unwillingness to eliminate late fees, which provided $300 million in annual revenues, allowed Netflix to continue to win market share.21 In 2010, Blockbuster filed for Chapter 11 bankruptcy protection after losing more than $500 million in 2009.22 ONLINE STREAMING

In 2000, Blockbuster partnered with Enron Broadband Services (Enron) to become one of the first companies to provide on-demand movie rentals. At the time, Blockbuster dominated DVD rentals with 4,800 video stores across the United States and 72,000 employees in 26 countries.23 However, after a brief trial run in four major U.S. cities, both companies abandoned the project, each blaming the other for the failure. Blockbuster argued that Enron had not been ready to provide the technology needed to reach 18

Stephen Gandel, “How Blockbuster Failed at Failing,” Time, October 11, 2010, pp. 38–40. E. Scott Mayfield, “Netflix. Com, Inc.,” Harvard Business School Case 201-037, 2000, p. 5 20 Netflix Inc., “Netflix Announces Opening of 10 Regional Distribution Centers,” Netflix press release, June 20, 2002, http://ir.netflix.com/releasedetail.cfm?ReleaseID=83066, accessed January 24, 2012. 21 Stephen Gandel, “How Blockbuster Failed at Failing,” Time, October 11, 2010, pp. 38–40. 22 David Lieberman, “Blockbuster Files for Chapter 11 Bankruptcy, Will Reorganize,” USA Today, September 23, 2010, http://www.usatoday.com/money/media/2010-09-23-blockbuster23_ST_N.htm, accessed January 24, 2012. 23 Blockbuster Inc., “About Us: The Company,” October 4, 2001, http://web.archive.org/web/20011004102053/http://www.blockbuster.com/bb/about/company/0,4440,,00.html, accessed January 10, 2012. 19

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consumers; and Enron blamed Blockbuster for not having offered content that consumers wanted. In reality, consumers were not ready for streaming services. Most Americans still did not have broadband service, and those that did were unwilling to pay $5 per rental, a price 20 per cent higher than renting a DVD from a local video outlet.24 When Blockbuster re-launched its streaming service several years later, it fared marginally better. Pricing was clearly a major issue since Blockbuster continued to require subscribers to pay for each movie download. However, technology also proved to be a barrier, despite rapid growth in broadband adoption. Customers who did not have access to personal computers or who wanted to view content on a big-screen TV had to purchase a $100 download module to attach to their television. Apple offered a similar service, known as Apple TV, which could be integrated with iTunes for an upfront cost of $229. However, like most online streaming companies, it too followed a traditional model of charging a fee for each rental. The cost to download a television episode or movie ranged from $2.00 to $6.00, depending on the length, quality and release date of the program. High rental costs, long download times and limited viewing options were cited as reasons for the lack of interest in movie download services.25 By the mid-2000s, Netflix had begun experimenting with movie downloads on personal computers (PCs) with mixed success. Most PCs at the time had small screens that were poorly suited to home viewing. To take advantage of big-screen televisions, users either had to hook their computers up to their television or obtain a physical disc through the company’s mail-in service. In 2008, Netflix began to enter into partnerships with Microsoft, Sony and others to offer direct streaming to game consoles and “smart” devices, such as web-enabled TVs.26 Since customers already had the hardware needed to stream movies directly to their television sets, they would only need to pay the additional monthly fee to access the on-demand video service. Netflix subscribers could download as much content as they wished for a flat monthly fee that started at only $10 per month. Direct streaming was not only more economical but it encouraged users to try content that they were unsure they would like. If the film wasn’t suitable, the subscriber could delete it and download something different. Online streaming to game consoles proved to be a boon to Netflix, which posted higher than expected earnings during the first quarter the service was available.27 Most viewers seemed to prefer the convenience and affordability of Netflix’s fixed-fee monthly plans. During the economic crisis of 2008, Netflix’s stock price surged 25 per cent even as the stock market as a whole fell by half. Apple shares outperformed the market on the strength of the iPhone, but its shares still experienced an overall decline of nearly 20 per cent. Over the same period, shares in Blockbuster fell by a spectacular 95 per cent on speculation that the company would soon file for bankruptcy protection. PRICING CHANGE ANNOUNCEMENT

On July 12, 2011, Netflix emailed its U.S. subscribers to announce a pricing change from $9.99 per month to $15.98 per month. The company also announced it would be separating its DVD rental and online 24

R. Thomas Umstead, “Blockbuster-Enron Deal Fades to Black,” Multichannel News, March 19, 2001, p. 32. Samantha Clark, “PlayStation Store Movie Downloads Review, Part 2,” Variety, July 17, 2008, videobusiness.com/blog/1730000173/post/1420030142.html, accessed July 12, 2009. 26 “Xbox 360 and Netflix Team Up,” Xbox.com, July 14, 2008, xbox.com/en-US/community/events/e32008/articles/0714netflixteamup.htm, accessed January 26, 2009. 27 Sue Zeidler, “Netflix says 1 Million Xbox Members Use Movie Service,” Reuters UK, February 5, 2009, uk.reuters.com/article/filmNews/idUKTRE5145SF20090205, accessed March 1, 2009. 25

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streaming services into two separate entities. The original DVD mail-in service would be renamed Qwikster, while the streaming business would continue to be...