Main Points From Netflix Case Part I PDF

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IPOs And Venture Capital Dr. Sherman

Netflix.com, Inc., Harvard Business Case 9-201-037 Regarding Netflix Part 1, you will not have to do present value calculations. First, here are two key things that you most need to know: 1) The rationale behind the ‘library backfile freed up’ that we added for the per subscriber calculations. Why would we add that amount back in, when Netflix does not sell the disks left over from those subscribers? We did it to offset the amounts we subtracted for new subscribers when they signed up, since Netflix doesn’t need to buy disks for new subscribers if the number of new subscribers equals the number that drop. If for some reason Netflix was not expected to buy disks for new subscribers in the future (for example, because it was switching to streaming downloads), then for subscribers signing up or dropping after that future switch, we would not subtract the disk cost for new subscribers and thus would not add back the disk cost for old subscribers that dropped after that point. The only reason to add back the disk cost for those that drop is to net out that amount against what we’re subtracting for new subscribers, so the amounts should match up (i.e. it should be a wash). 2) How the studio deal would affect Netflix’s risk, relative to the effect on Blockbuster’s risk. The studio deal (lower upfront cost per disk, but a royalty each time the title was viewed) would only reduce risk IF Netflix was using the current Blockbuster model of charging per rental. Under the pay-per-rental model used by Blockbuster, the studio deal would make the costs more closely match the revenues, meaning less risk in terms of variance in net returns (costs would be high only if revenues were high). But Netflix operates under the health club model, where people pay a fixed amount per month. Netflix has fixed revenues per subscriber, so it would better match revenues and costs to have fixed and not variable costs per subscriber. Introducing variables costs with fixed revenues means more risk

– more possibility that costs will be high without a corresponding increase in revenues! Netflix is already vulnerable to heavy users, and this will increase that vulnerability. More details about the case, and the solution: Netflix business model: “health club model” – pay monthly fee, rent as many DVDs as you want How do you get them? US mail (a 37 cent stamp, at the time) How do you order them? Online account (Marquee) When you return a movie, how do you get another? It’s sent automatically. No phone operators, customers don’t have to fill out forms, no data entry on arrival. Much easier and more cost effective for both customers and company. What problem is this company trying to solve? I.e., what is the pain? Reed Hastings: The movie rental industry is about $8 billion, and $1 billion (15%) historically had been late fees. ‘That’s a lot of toothache, and if you’ve got the Novocain…’ So originally, he was trying to offer a solution for people who were sick of late fees. “What has changed in the world so that this now makes sense?” Or, “if this is such a good idea, why didn’t someone do it already?” Note that it’s not good enough to say “everyone else is stupid”. If there’s a big bag of gold just lying there, why hasn’t someone picked it up yet? How had the world changed? (why start Netflix in 1998?) 1) DVDs – this simply would not have been cost effective with VHS tapes because the mailing costs were so much higher (they spent a long time developing the technology of the mailing envelope, so that the DVDs were safe but it still took only one stamp) 2) Online Marquee – this service is so much easier because you can order online, have a queue, and the next movie comes automatically. Netflix was a paradigm shift in how movies were delivered to customers. It grew out of '90s thinking – how do you lower inventory (create the next Dell)? everyone was trying to get away from bricks and mortar.

1. When it was first started in 1998, Netflix’s business model – sending movies by mail – was very different from the ‘bricks and mortar’ approach of chains such as Blockbuster or Hollywood Video. What are some advantages and disadvantages of Netflix’s business model from the customers’ standpoint? What are some advantages and disadvantages from Netflix’s standpoint? The business model: Advantages for customers –  Don’t have to leave home  Cost effective (can rent “unlimited” movies per month; in practice, can watch 4 movies each weekend, plus perhaps one or two in week, all for $20 total)  No late fees  Huge selection (long tail)  If library done right, can search, get info. on movies (Amazon vs. bookstore) Disadvantages –  Have to wait for mail; Occasional unexpected mail delays.  Different way to shop - can’t just show up and see what you’re in the mood for, don’t have the experience of browsing; no ‘instant’ gratification. 没有进店挑选的快感  Disk may be scratched, broken, not what you wanted Advantages for Netflix –  No “bricks and mortar” costs.  Wider selection with less inventory (it’s very expensive for Blockbuster to have at least one of every title in every single bricks and mortar store; Netflix can have just one or two DVD copies of a title for the few people in the country that want to watch every year). Challenges for Netflix –  getting customers to change their habits  competing with “the big guys” (Blockbuster, Hollywood Video) 2. Given the difficult market, there's a chance that Netflix will have to cancel its 2000 IPO. Based on the information in the case (for example,

Exhibit 1), what alternatives does Netflix have if it doesn't do an IPO now? In particular, can Netflix bootstrap itself from here? Netflix had a $30 million operating loss in 1999 (and a more than $10 million loss in 1998). It needs a lot of cash even to operate at its current level, much less to grow. [Net loss of $29.1 million in 1999 and $11.1 in 1998, with an accumulated loss of $41.3 million by the end of 1999 (this last number is from the S-1 and may not be in the case; recall that their website was only launched in April, 1998).] Bootstrapping isn’t feasible for this company – it’s not making small profits it can reinvest, it’s making big losses. Even if Netflix could get the cash to go on its own at a slower pace, what would it do to Netflix’s future prospects if it slows down now? Netflix needs to grow quickly, since others could come in (either another small business similar to Netflix, but better funded, or a big competitor such as Blockbuster, Hollywood Video or Walmart). It’s only a matter of time before competitors with big pockets come in, so Netflix needs to prepare fast, because it needs that first mover advantage. It’s up or out for Netflix! 3. If Netflix signs the studio deal where they pay less up front but have to pay a royalty each time the movie is rented, what will it do to Netflix’s risk? This deal would lower Netflix’s fixed costs of acquiring disks but would increase the variable costs based on the number of times each title is chosen. This mean that Netflix would pay more only when demand is high, and only for popular movies. If a title wasn’t in demand, then it wouldn’t cost Netflix very much. Wouldn’t this reduce risk? This would reduce risk, IF Netflix was using the current Blockbuster model of charging per rental. That way, making the costs more closely match the number of viewings would help to match revenues and costs, meaning less risk or variance in returns (costs would be high only if revenues were high). But Netflix operates on the health club model, where people pay a fixed amount per month. They have fixed revenues per subscriber, so it would

better match revenues and costs to have fixed costs per subscriber. Introducing variables costs with fixed revenues means more risk – more possibility that costs will be high without a corresponding increase in revenues! The movie deal might be worthwhile, because it reduces upfront costs, but the deal would also lead to greater potential variations later, which should be taken into account. This deal would increase, not decrease, Netflix’s vulnerability to heavy users, which is one of their main risks. Decision Tree – (A few notes on the calculations shown at the end); For the remaining steps, see the decision tree at the end with numbers filled in. Note that you will not be tested in this class on present value calculations – your main goal should be to understand the reasoning behind the assumptions and calculations. Right now (early 2000), Netflix has 5.8 discs per customer. (the case writers estimated 5.6, but 5.8 is the correct number, based on information from Netflix’s 2002 Prospectus, not available in 2000) Suppose it has a great month in terms of signing up new customers, and doubles its number of subscribers! In other words, the number of new, trial month subscribers this month equals all old subscribers combined. This means that Netflix needs to immediately ship out 4 discs to each new subscriber. Can it do this? Not without increasing its library! It already has only 1.8 discs per subscriber “in the warehouse”, not enough to handle a lot of new subscribers, even assuming that people don’t want choice and will take any movie you send them. A key difference from the health club model – you don’t have those that belong but don’t use the facilities! From Netflix’s standpoint, everyone always has the full number of discs out. 每个人手上都至少有 4 个 discs (from the customer’s standpoint, the discs are in shipping part of the time; but Netflix ships out a new disc the same day that the old one comes in!) So, to expand, Netflix MUST add to the library as it attracts new customers, especially now, when their excess is slim (only 1.8 extra per customer) and they’re hoping for explosive growth.

[Of course, light users that keep their discs longer cost less in mailing; but they always have discs, so there’s no library benefit.] Assumptions, initial customers: I’ve assumed that they use/watch the same number of disks during the month as established customers! That means that they actually see more movies during the month, since they get 4 to start, so you could argue that this should be lower. But, new customers may be excited, may actually watch more. Do customers that stay for only the trial month cost Netflix more than $100? If someone signs up for a trial month, then drops, you don’t lose the library addition that was your main cost. You get it back – that part of the backfile has been freed up. The way to include this in our cash flow calculations is to add back in the amount of library “freed up”, to use instead with the next subscriber. Note: this assumes that you’re constantly adding new subscribers or at least holding steady, and thus can use any discs freed up. It also assumes that you will continue to deliver DVDs by mail, rather than streaming downloads in the future. But, you don’t fully break even for the free trial month customers who drop, in terms of the library, because you bought the discs one month earlier than you would otherwise have bought them for the next subscriber. Also, you still need new releases for the new subscriber, so the net benefit must adjust for that. [They said that about 20% of the library is new releases, and a disc is a new release for 8 weeks. So, I assumed that 10% of the library purchased for that new trial customer was new releases that no longer qualify as new, while another 10% was new releases that will count as new for the next customer.] Rental library, end of 1999 (Exhibit 5) Discs in library (p. 4):

10,882,000 620,000 Ratio = $17.55 So, their historical cost per disk has been $17.55. Assuming that they will buy 5.8 disks for each new customer: 5.8 * $17.55 = $101.79 What are we assuming about disc prices? That they’ll stay constant over time (in nominal terms)

Library backfile freed up New releases

4

101.79 (10.18)

Net effect in 1 month

$

PV:

$ 90.11

91.61

Initial discs sent: Added discs during month:

4.3

Addition to library:

101.79

Per month net:

110.09

Library freed up: 91.61 PV (pd.0) of fees: 25.61 PV, library freed up: 82.96 PV: $108.57

Prob. = 30%

Drop at end of trial month Prob. = 30%

-$110.09

Subscribe for 6 months total Prob. = 60% Become paid subscriber Prob. = 70%

5.47

Prob. = 70% * 60% = 42% Monthly fee Shipping: New releases: Per month net: PV of fees, 5 years total: PV, library backfile freed:

Become long term customer Prob. = 40%

19.95 (4.30) (10.18) $ 5.47 203.12 33.42

$236.54 Prob. = 70% * 40% = 28%

NPV = .30*90.11 + .42*108.57 + .28*236.54 – 110.09 Or NPV = .30*(90.11 – 110.09) + .42*(108.57 – 110.09) + .28*(236.54 – 110.09) = $28.77

Drop after 1st month: Probabilities: 30% PV: (19.98) Prob. Times PV: (5.99) Total if long term are forever: $ 52.95

Permanent (long term 6 months: stay forever): 42% 28% (1.52) 212.79 (0.64) 59.58 Total if long term stay 5 years:

Only 5 years, rather than permanent: 28% 126.45 35.41

$ 28.77...