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ESSEC G 183-1

Netflix: Disrupting Digital Streaming

This case was researched and prepared by Siddharth Rawat, while on his M.Sc. exchange program under the supervision of Ashok Som, Professor, Management Department at ESSEC Business School. This case was developed as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. © 2017 ESSEC, Ashok Som

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ESSEC Business Cases

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Netflix: Disrupting Digital Streaming

“Most entrepreneurial ideas will sound crazy, stupid and uneconomic, and then they’ll turn out to be right.” – Reed Hastings, CEO, Netflix On 20 January, 2015, 54-year old Reed Hastings sat in his office in Los Gatos, California and pondered over the challenges which lay ahead for Netflix. A couple of hours ago, he had made an announcement that had taken the Wall Street by surprise. In the quarterly letter to shareholders, he had set an aggressive target for the firm – expansion of global footprint to a whopping 200 countries, essentially the entire globe, within the next two years. This announcement had been accompanied by an even bolder claim of maintaining profitability amidst the rapid expansion. As the Chief Executive Officer (CEO) of a company that had redefined television st viewing experience in the 21 century, Hastings was well aware that in the digital age, the next revolution was always lurking around the corner. In order to survive, a firm had to continuously adapt to suit the evolving needs of the consumer. The art of adaptation had been skillfully mastered by Netflix over the past eighteen years. Under the leadership of Hastings, Netflix transformed from a DVD retailer based on a unique customer-focused business model to a video-on-demand (VoD) streaming service provider in the US that disrupted the previously existing model of entertainment content distribution. It challenged firmly entrenched competitors such as Blockbuster in the process. As growth in subscriber base in its home market began to saturate, international expansion became vital to the survival of Netflix. The company made its first global foray in 2010, when it launched operations in Canada. Over the next five years, Netflix grew continuously and by the beginning of 2015, it had attained coverage across 50 countries. To stay ahead of its competition, Netflix also started creating original content based on insights gained from customer analytics data. Its first original series, House of Cards, premiered in 2013 and got an extremely warm reception by both viewers and critics. However, the $7 billion global internet entertainment network headed by Reed Hastings faced some critical challenges as it continued on its growth trajectory. Netflix’s international streaming business had been losing money (see Exhibit 1 and 2). Although the company predicted that it would generate profits from its international operations by 2017, failure to achieve the same would inevitably lead to questions from Wall Street regarding its ambitious expansion plans. Moreover, with several new countries on the horizon, including complex ones such as China and India, Netflix would have to be prepared to tackle a host of regulatory, cultural and infrastructural barriers, besides competing with local content providers.

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Introduction

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History The Beginnings

“Once you have hitchhiked across Africa with ten bucks in your pocket, starting a business doesn't seem too intimidating.” On his return from the Peace Corps, Hastings went to Stanford University where he graduated with a Master’s Degree in Computer Science in 1988. Hastings left his job at a technology firm in 1991 in an attempt to start his own venture Pure Software, a company which produced troubleshooting software. As the company began to grow very rapidly, Hastings found running the business extremely challenging owing to lack of managerial experience. As his confidence weakened,he expressed the desire to resign. The company’s board, however, declined the request and he eventually learnt the ropes of being an effective CEO. Pure Software merged with Atria Software in 1996 and integration issues soon emerged between the two companies. At this point, Hastings decided to leave his new position of ‘Chief Technical Officer’ and spend some time thinking about his managerial style so as to avoid the problems he had faced in Pure Software during his next entrepreneurial endeavor. In 1997, Hastings co-founded Netflix along with his former colleague, Marc Randolph. The Netflix website was launched in April 1998 with only 30 employees and 925 DVDs available for rent through a traditional pay-per-rental model with late fees. Netflix introduced the concept of monthly subscription in September 1999 and subsequently, dropped the singlerental model by early 2000. Since that time, the company has built its reputation on flat-fee unlimited rentals without due dates, late fees, shipping and handling fees and per title rental fees.

Gaining Foothold in the Video Rental Industry The video rental market had begun to flourish in the mid-80s, paralleling the explosion in VHS player sales. By the time Netflix started in 1997, the video rental market was dominated by Blockbuster, which since its founding in 1985 had grown to capture an overwhelming 40% share of the market. The remaining market was split among a few other national players and hundreds of local mom-and-pop rental shops. The basic model for these businesses was to hold a physical inventory of movies at individual retail stores, with a large selection of new releases and a more limited selection of old movies. Blockbuster’s holdings were about 70% new releases and 30% other films. It charged a movie rental fee ranging from $3 to $4 and late returns attracted further penalty. The company’s commanding success was tied in part to its large geographic distribution network of over 5,000 locations in key areas with high customer concentration in high-visibility, hightraffic placements. Though individual stores were fairly limited in their choice of inventory, Blockbuster’s late fee policy allowed stores to maintain high video turnover and thus control inventory levels.

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Born in Boston, Massachusetts, Reed Hastings joined the Peace Corps after graduating in Mathematics. A feeling of adventure and a yearning to serve motivated him to join the volunteer program. He also taught high school mathematics in Swaziland for two years as part of his work. Such varied experiences emboldened Hastings and helped him discover the entrepreneur within himself. In a later interview to the Fortune Magazine, he commented:

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Although Netflix started with a pricing strategy which closely resembled that of the traditional retail model, it quickly changed tracks by implementing a simple idea – charge people a reasonable, flat monthly subscription fee with no late return penalty and mail DVDs to them as often as they want. The Netflix model provided flexibility to the customer to watch a movie at leisure and not incur a fee for the holding period. Its mail-order service enabled the company to develop a scalable distribution model with low capital requirements that increased inventory efficiency while adding value for customers through increased selection. In a nutshell, Netflix differentiated itself by tackling two major customer grievances in the traditional retail model: the frustration of late fees and a limited selection of older films. While developing his innovation, Hastings relied on the organizational structure of the United States Postal Service (USPS) while betting heavily on the widespread adoption of DVDs. He was fully aware that the company’s success would depend on the success of the entire DVD market. By 1997, major manufacturers had begun shipping DVD players in the U.S. and studios had started selling titles in that format. The new format offered significant advantages over VHS cassettes – higher quality, increased storage capacity, and the ability to quickly skip to selected scenes. One of the Netflix’s key decisions in its introduction phase was to partner with DVD manufacturers. As per the terms of these partnerships, the manufacturers were supposed to include coupons in the boxes that contained the DVD players. These coupons entitled customers to ten free rentals from Netflix. Netflix’s first approached Sony, but the offer was rebuffed. Subsequently, it found willing partners in Toshiba, and, eventually, Sony. Netflix also extended these partnerships to include computer makers Apple and Hewlett-Packard, which had begun manufacturing computers that included built-in DVD players. These promotional efforts were critical drivers of early traffic to the Netflix website. Netflix was able to secure 1 these deals since its small but growing library of titles limited the adoption chain risk that manufacturers faced in selling DVDs. In 1999, only 5% of households had DVD players but by 2002 this number had increased to 37%. Clearly, Hastings’ bet on the DVD market had paid off. However, more critically for Hastings, DVDs were small and difficult to damage. Due to this reason, the process of delivering DVDs to the customers by mail became easy and cheap – the discs could be shipped by normal USPS delivery. The company worked closely with the USPS to ensure DVD delivery was prompt and improved Netflix’s customer experience. While the convenience of home delivery would be of less use to customers who did not mind visiting the video store, the company stood to gain significant advantages in terms of inventory. By using a centralized rather than local distribution model, Netflix could smooth out local fluctuations in demand and carry a significantly broader selection of films. Netflix developed queue functionality on its website that enabled it to reliably predict future demand. Aside from the clear value it provided to customers, the system also allowed Netflix to obtain invaluable insight into customer preferences and create what Hastings referred to as “our biggest switching cost”. Compared to the 2,500 titles held at most of the brick-and-mortar video stores, Netflix boasted 15,000 titles by 2003 and over 70,000 titles by 2006, all the while carrying 1/3 to 1/5 the inventory of its retail competitors. 1

Adoption chain risk: The extent to which partners would need to adopt an innovation before end consumers have a chance to assess the full value proposition

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Customers preferred video rentals over other modes of watching films because rentals offered them some convenience. They could choose the time and location for their movie viewing experience. Such flexibility was not offered by cinema theatres and television channels. However, the late fee charged by the rental stores was a hindrance to this flexibility. While some customers planned specific movie watching events, others rented films they wanted to see in the hope of making time for viewing. While the Blockbuster model worked well for the former set of impulse renters, requiring customers to watch their rentals within a short time period proved less practical for the latter set, those customers who knew what they wanted to watch but did not know when they would have time to do it. Hastings was able to identify this gap in the market and realized that a movie rental company could offer more value, more convenience and more selection and availability to its customer.

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Competitive Response by Blockbuster

In 2004, Blockbuster responded by opening its own online retail store. Blockbuster largely duplicated Netflix’s model, but it offered a few differentiating features which it believed would prevail in the long-term. Firstly, it offered free in-store rentals in addition to online rentals for more or less the same price as Netflix (and later lowered their prices below Netflix’s). Secondly, it attempted to create a seamless omni-channel experience for the customers through the integration of the online component into its retail business by allowing returns at its physical retail locations. Blockbuster also abandoned its late fee policy. Blockbuster’s foray into the online space was fairly successful in terms of customer acquisition. By 2007, it had managed to register 3.1 million subscribers, possibly taking a major portion out of Netflix’s 7.5 million customer base and retaining a number of customers who might have later abandoned Blockbuster’s in-store model for the online model of Netflix. Financially, the picture was much less brighter for Blockbuster. The cost of marketing the new online store, integrating it with the retail model and undercutting Netflix’s subscription model took a heavy toll and the company was unable to make the venture as financially successful as Netflix’s.

Transitioning to VoD Streaming A technology enthusiast himself, Hastings knew that sooner than later, it would become feasible to stream movies and videos online. But he was also aware that the switch from DVD rentals to digital streaming had to be timed to perfection. Taking the risk a few years too early would have invariably led to failure because of poor acceptance among the customers. On the other hand, being late would allow competitors to seize the opportunity. Having proven the mail-order doubters wrong with its growth in the early 2000s, Netflix did not hesitate to acknowledge that the days of physically delivering movies could be numbered. While incumbent video rental providers such as Netflix and Blockbuster continued to exist, several new firms in the digital streaming space were springing up. Some industry observers went as far as to suggest that the emergence of online VoD streaming would mean the end of Netflix. Hastings, however, made his company’s strategy very clear in a comment to a journalist in 2007: “We named the company Netflix for a reason; we didn't name it DVDs-by -mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device. We're working to make this a reality in 2008, investing $40 million in instant viewing this year alone.” In early 2007, Netflix started rolling out its online video streaming to its subscribers. Quite similar to the way in which Netflix’s inception in 1997 had coincided with the rising DVD wave, the timing of the company’s new move coincided with an upsurge in broadband penetration and the introduction of high speed 3G wireless networks. The period was also marked by the advent of high quality graphic streaming capabilities on laptops and other multimedia devices such as gaming consoles. Netflix’s flourishing DVD-by-mail business was a critical asset which enabled the company to take this giant leap into the video streaming market. Ten years of rich experience had given sufficient time to its engineers for developing one of the

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By the early mid-2000s, Netflix had clearly proven that its market niche was real and its business model highly sustainable. Its subscriber growth rates exceeded 50% for five straight years, and it ended the year with 2.6 million subscribers serving up $22 million in profit. It was apparent that Netflix’s growing subscription base had begun to hurt Blockbuster’s retail sales, and it was high time for it to take some action.

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most sophisticated recommendations engines that existed on the internet, and to its marketing team for refining their pages continuously to elevate the level of user satisfaction.

Initially, the duration for which subscribers could stream online content was restricted to only one hour per dollar spent on the monthly subscription package (for example, a $16.99 plan would allow a viewer to stream 17 hours of content in a given month). However, by early 2008, Netflix had raised this limit, allowing unlimited online streaming to nearly all its subscribers. While some observers considered this move as a reaction to the growth of its competitor Hulu and to Apple’s entry into the movie rental industry, others viewed it as Netflix’s strategy to consolidate its market leadership in online streaming. A team of engineers at Netflix had been working for long on a TV box that would stream movies. However, Hastings strongly believed that developing a “box” was too limiting, and that an open-source approach would allow Netflix to distribute movies on TVs, DVD players, desk-top computers, mobile phones or in fact, almost any device. Consequently, Netflix continued to make significant investments in relationships with device manufacturers, with the goal of gaining streaming video access to as many homes as possible. Rather than betting on any single technology, Netflix streaming video was made accessible through PCs as well as Xbox 360, PS3 and certain set-top boxes, TiVos, and Blu-Ray players. By the end of 214, Netflix had been able to maintain its supremacy, having built a global subscriber base of over 57 million and with its revenue exceeding $5 billion. Its erstwhile rival Blockbuster failed to adapt to the evolving landscape of digital technology and was unable to remain an industry leader. It filed for bankruptcy in 2010 and had closed all brick-and-mortar locations in the U.S by the end of that year. The continued growth of Netflix could be attributed to its ability to adapt to the changing environment of both the video streaming and the cable industries. As new competitors such as Hulu, Amazon Prime Instant Video and HBO Go entered the VoD internet streaming space, Netflix differentiated its service by offering access to original Netflix programs. Award-winning series, including “House of Cards” and “Orange is the New Black,” mark Netflix's efforts to differentiate and innovate from traditional video streaming.

On-Demand Internet Streaming: Industry Growth and Development Netflix entered the horizon in the late 1990s as a disruptor of the traditional retail model in the DVD rental industry by delivering DVDs via mail and years later, created another disruptive innovation by delivering the same product through online streaming. The rapid growth in the subscriber base of Netflix ...