Netflix in 2011

Blockbuster:
• In 1990 Blockbuster was the market leader in U.S. home fragmented video market. They mostly
rented movies on VHS cassette from a retail location for $3 - $4/movie for max a week.
• In 2006, Blockbuster had 5,194 retail locations in U.S. and 70% of their revenue came from the
new releases. Occupancy and payroll (part-time employees) were the significant cost with each
retail location employing on an average 10 member staff. Customers liked to rent mostly new
releases in the first week of distribution and after that demand fell. As demand for a particular
title dropped, Blockbuster would sell the used copy to reduce their inventory and buy new
releases.
• Late return of the movies from the customer would attract late fee which was an additional
revenue opportunity but that also reduced customer satisfaction due to stockouts.
• Blockbuster business model depended on the maximizing the days that a movie was out. They
stocked mostly familiar movies and lesser known movies were hardly stocked as the customers
were mostly interested in the hit or familiar movies. Blockbuster operated both under purchase
model and revenue share model for DVD rentals
• In 2003, Blockbuster spent $837 million on rental library purchases, $300K in the store’s setup.
They produced $900K sales per year with an operating profit of $162K
• Consumer adoption of DVD-player increased from 24% to 37% in one year from 2001 to 2002.
Blockbuster earned record revenue and profit in 2002.
• Blockbuster opened its first online store in 2004 and waved off its late fees program. However, it
had to forego $600 million of its yearly revenue due to “no late fees” program. No late fees
programs increased the rental volume but could not make up the revenue losses. By 2009, US
news and world report described Blockbuster as one of the 15 companies that might not survive
2009.

Netflix:
• Netflix was founded in 1997, it launched its first website for online rentals in 1998. They target
customers who were the early adopters of the DVD technology. Their website had a search engine
for the movie selection on various criteria like title, actor, director. Customers could build a queue
of the movies to be received from the Netflix, based on the order of the title and the next when
the previous was returned.
• Netflix charges were $4/movie and $2 for shipping and extended rental fee if not returned timely.
Main business was DVD-by-mail service.
• Netflix’s business started taking a hit as customers were frustrated with Netflix charging rental
price similar to the retail stores, while providing slow delivery. Also, a high cost needs to build a
DVD library to support growing subscriber base. They moved to no-late-fee-subscription.
• Netflix moved to prepaid subscription service allowing them to keep three movies at a time and
exchange them frequently as they liked.

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 • Netflix developed the proprietary recommendation system that displayed the recommendation
of lesser known movies based on the customer survey thus avoiding recommending new releases
those were already in high demand. New releases represented less than 30% of total rentals in
2006.
• Netflix struck revenue sharing agreement with major studios meaning, Netflix would be charged
by the studios based on the total rentals of a title rather than $15-$18 per DVD thus reducing the
upfront unit DVD price. This also helped Netflix get bigger customer satisfaction for the high and
timely availability of the new releases that too with the reduced acquisition cost of the new
releases.
• Opened new distribution and delivery centers in various cities on U.S. Sunnyvale being the first
one followed by Sacramento and Boston. Tied up with USPS (United States Postal Services) for
the overnight delivery of DVDs. By 2009 its distribution centers count touched 58.
• Netflix continued to grow its content acquisition by successfully promoting the lesser know
movies and acquiring rights of the independent new releases and thus enhanced its reputation of
the source of highest quality independent films.
• Video over Internet i.e. video-on-demand became popular in 2007. However, it has its own
challenges like limited until hardware to connect a user’s computer to their TV. Content
availability was another limitation. Unlike buying a DVDs and renting them, for VOD firm had to
negotiate the distribution rights with the studios. Also, the online content was limited to the older
or less popular films.
• Netflix’s purpose was not to provide DVD rentals through the internet but rather to provide best
home videos for the customers that too the mass market unlike VOD to the niche customers.
Netflix transitioned to the streaming video by launching streaming service in addition to its core
DVD-by-mail offerings. Company started building its own streaming infrastructure.
• In 2010 majority of Netflix customers turned to streaming services than DVD. The company saw
success for its streaming service, including content, user, personalization, TV attachment and
streaming infrastructure. In 2009, Netflix migrated all its major applications including the
streaming to Amazon Web Services (AWS) which then became Netflix’s key infrastructure service
provider for its streaming service.

Analysis:
Netflix always kept its business strategy elastic and adaptable. Tt has been on the positive trajectory of its
growth due to its business model innovation based on the needs and mainly due to the value proposition
that helped customer solve their fundamental problem. Throughout the case it is very much evident that
Netflix tweaked its business model driven by not only customer needs but also responded to disruptions
keeping its main focus on delivering the Value Proposition in terms of effectiveness, convenience and
affordability. In line with the value proposition they aligned the resources and adjusted/formulated
relevant processes that ensured right profit margins from that value proposition. Right value proposition
ensured value to customer and right profit formula/margin ensured value delivered to Netflix itself.
Netflix did well in both business models - When the value proposition was related to product
functionality and reliability and when the value proposition was primarily related to the cost. They also
successfully responded to the technological disruption of “Streaming Video Technology” and

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transformed into profit making business model. Netflix launched innovations consistent with their own
business model as well as the change in their own business model in response to the disruption by services
from other service providers or even new technology. Blockbuster tried once to compete with Netflix by
integrating its online offering with the stores business, by launching total access and finally waved off the
late fee but in doing so Blockbuster’s revenue loss was much more as compared to increase in rental
volume they achieved.

Value proposition related to product functionality and reliability (Netflix):

• Netflix moved to prepaid subscription service and turned the disadvantage of long delivery time
on its part into advantage of having more movies at home all the time to the customer.
• They developed a proprietary recommendation system to better balance customer demand. This
feature avoided customer frustration by satisfying customers with the movies already in stock.
Netflix’s website resonated with the customers as they enjoyed the lesser known movies. This
software established relationship with customers that was no matched by part-time employees.
• Proprietary recommendation system promoted the business model that promoted lesser-known
movies.
• Tied up with major studios and video rental chain by signing revenue-sharing agreements. That
way Netflix started getting double the copied by paying 20% more and hence lowering the
acquisition costs for new releases.
• Setup distribution centers, low cost delivery centers and tied up with USPS for the over night
delivery. National inventory allowed Netflix to server customers in all regions without overstock
or understock in any region.
• Company’s signature red envelopes for content acquisition.

Value proposition primarily related to the cost:

• Transitioned to high margin streaming video services business model

• Streaming deal with Starz Entertainment in 2008, This bought 2,500 titles from Walt Disney
Studios and Sony Pictures
• Spent money in developing original contents
• Struck $1 billion deal with Paramount, MGM and Lionsgate for the movie streaming
• Built its own streaming infrastructure and finally migrated its steaming applications to reliable but
expensive Amazon Web Services.
• Netflix decided to split DVD-by-mail and streaming services as two separate business units

Problem:
Considering a continued significant growth of streaming business, Reed Hasting, founder and CEO of
Netflix decided to split DVD-by-mail and streaming services as two separate business units. In July 2011
Netflix announced that it would charge separately for the streaming service and DVD service and each
would cost $7.99 a month. The streaming service earlier was $2 add-on to the basic DVD monthly charge
of $7.99. Customers who want both would have to shell out $15.98 a month. For most new customers
who wanted only streaming service would actually see the price reduction. However, 60% price increase
for the combination of the services bought severe public criticism that resulted in Netflix’s stock fall from

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$300 to $77 in one quarter and the subscriber growth halted. DVD-by-mail service and video streaming
service were two different business units and streaming service built on higher margins. Higher pricing
for DVD services remained a major challenge, not the new name or separation of the units. By mid-
October, the company reversed the breakup plan.

Exhibit 5 shows the chronology of Netflix and Blockbuster service offerings.

Questions:
1. How to cope with the very different business model for streaming in a company built on higher
margins of DVD-by-email?
2. How could the transition from one business model to another be managed?
3. Did Netflix have the wherewithal to complete against deep-pocketed competitors like Amazon,
which was the company’s key infrastructure provider for its streaming service?

Conclusion:
Splitting the business was the move to push customers toward the higher-margin streaming business as
a long-term strategy and the price hike was needed to pay for increasingly costly content. While Netflix’s
cost of investment in the streaming infrastructure and deals to make services better was increasing, its
revenue was growing but needed fast growth to make up the investment cost. Also, streaming business
being the fastest growing, Netflix wanted to focus on both having different margins separately and the
goal was to cannibalize the low margin DVD business and promote streaming one. The resources,
processes and the profit model developed in DVD-by-mail service were completely different from the
ones developed in the streaming model so both models should be managed separately.

Higher pricing for DVD services remained a major challenge, not the new name or separation of the
business units. Considering the public outcry and the loss Netflix incurred after the breakup
announcement, in my opinion price hike should be rolled back while still keeping both the business units
separate. Market in 2011 was growing. Netflix in short term may face shortage of funds but in long run
should be able make that up by pulling profits and cash out of its DVD business to pay for building the
faster growing streaming business. This should allow Netflix to actually grow revenue, and grow profits,
while making the market transition from one platform (DVD) to another (streaming). Eventually, I think,
growing streaming business would add more new streaming customers which eventually bring down the
DVD customers. Amazon was Netflix’s key infrastructure provider for its streaming service but not its
competitor. Amazon was in retail so only threat that Netflix had from Amazon was the price hikes for its
services and not the competition. Price hikes for infrastructure services can be dealt by building in house
reliable infrastructure and current comparative revenue loss (roll back of the price hike) can be made up
by exploring the opportunities of international expansion. Partnering with Multichannel Television
Providers can also be an option to grow fast.