Netflix, Inc.

Analysis of Strategy Keeping the world safe for couch potatoes

Kostadin Atanasov kostadin.atanasov@gmail.com Institute for Media and Entertainment

Netflix Analysis of Strategy 3 December 2004, New York, USA

Kostadin Atanasov

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Netflix, Inc. Analysis of Strategy

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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...............................................................................................................16 Critical 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 service and new technologies. Although this gives the company a serious first mover advantage, it also 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 Netflix is not sustainable and will become increasingly difficult. At this critical point the company must decide whether it should exit or it should stay and compete. If Netflix decides to exit, it should attract financing and expand its operations to capture quick gains and improve its valuation. If Netflix decides to stay and compete it needs to (1) keep innovating to maintain its advantage, (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 digital technologies.

Introduction
This document discusses the competitive strategy of Netflix, a US-based online subscription DVD rental company. Because of the customer service innovation and highly visible IPO, Netflix has been extensively discussed in the media, industry publications, financial analyses and business school literature. Therefore this paper only mentions high level aggregate data and facts and uses them as basis for discussion of Netflixs forward looking growth and competitive strategy. The analytical tools used as widely popular strategy concepts such as the five forces framework 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 Netflix
Excerpt from Netflixs 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 the United States] with access to a comprehensive library of titles. For a monthly subscription fee under the standard plan, subscribers can rent as many digital video discs (DVDs) as they 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 subscribers

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. The Company also provides background information on the Companys Web site (www.netflix.com) on DVD releases, including critic reviews, member reviews, online trailers, 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 sales generating 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 is expected to pick-up as the DVD establishes itself as the video format of choice.
11,000 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 Turns (Millions) 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

3,601 3,626 3,526 3,756 3,502

3,250 3,100 3,100 3,250 3,450 9,440 9,225 9,370 9,668 10,150

Spending ($ Millions) 9,655 10,099 10,227 10,259 9,911

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 marked the peak in DVD player sales, penetration will continue and DVD will establish itself as the single dominant home video format. 2003 figures indicate around 53% of US households own at least one DVD player and penetration is expected to reach around 65% by 2004 year-end with sales seeing the beginning of a downward trend.
2

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

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40 35 30 25 20 15 10 5 0 DVD Unit Sales US Market Penetration Y-o-Y Sales grow th 1997 0.305 0% 1998 0.946 1% 210% 1999 3.55 3% 275% 2000 9.877 9% 178% 2001 16.662 18% 69% 2002 25.113 33% 51%

Kostadin Atanasov
300% 250% 200% 150% 100% 50% 0% 2003 33.734 53% 34% 2004 27 69% -20% -50%

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-visual content migrates towards digital, there is a thrust for the DVD market. Increased share of TV entertainment vs. print media. Media consumption trends suggest that audience interests shift from print to visual media. This migration is favorable for 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 Netflixs customers 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 rental market since a person who purchases a film is unlikely to rent it.

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1,400 1,200 1,000 800 600 400 200 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Unit sales grow th Unit Sales (Millions) 16 59 147 294 491 670 850 1,020 1,150 1,270

300% 250% 200% 150% 100% 50% 0%

269% 149% 100% 67% 36% 27% 20% 13% 10%

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

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 video services 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 million households 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 (content creators, packagers/programmers, distributors), Netflix occupies the distribution segment (see Attachment 1 Motion Picture Value Chain). Given the nature of the industry three conclusions jump out immediately: First, many of the players in the industry are large vertically integrated conglomerates whose 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 intensifies competition 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 the upcoming technological changes. A precursor of upcoming changes is the personal recording device (PVR), TiVo being the most prominent STP/PVR brand, which slowly turns into a part of the TV set and takes on some gatekeeper functions.

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7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 PVR HH (Millions) 2001 0.40 2002 1.20 2003 2.50 2004 3.60 2005 5.00

Kostadin Atanasov

2006 6.00

2007 6.50

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

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 instead we adopt the distinction between distributors (theatres, rental and retail stores) and pipelines (free-to-air and cable channels), a distinction used by Standard & Poors analysts, 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 the launch of the same movie title over the different outlets (see figure 5.)

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Netflix, Inc. Analysis of Strategy

Motion picture release-window sequence

Kostadin Atanasov

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 film from 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 account movie theatres and hotels and airlines as well. Finally, if we insist on the on-line nature of Netflixs 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 DVDs and in consumers 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 location around the corner and therefore Netflix does not technically compete for this customer with Blockbuster for instance. (Of course we have to recognize that slowly all other DVD rental and retail players adopt on-line ordering as part of their strategy, stepping into Netflix territory.) For the purposes of this analysis, I will use Netflixs own definition of its competitors: Definition Video rental outlets Movie retail stores Subscription entertainment services Pay-per-view and VOD services Online DVD sites FilmCaddy.com or Walmart.com Page 9 of 24 Example Blockbuster, Hollywood Entertainment Best Buy, Wal-Mart, Amazon.com HBO, Showtime

Netflix, Inc. Analysis of Strategy Internet movie providers Cable providers Direct broadcast satellite providers
Source: 2003 Annual Report, Netflix, Inc.

Kostadin Atanasov Movielink, CinemaNow.com, MovieFlix Time Warner, Comcast DirecTV, Echostar

According to latest home video rental and retail data, market shares are as follows:
Circuit City 4%

Blockbuster 11% Other 32% Blockbuster 41%

Target 13% Wal-Mart 56%

Family Video 3% Movie Gallery 5% Hollyw oo d Ent. 13% Best Buy 16%

Netflix 6%

Figure 6. Market share of US home-video rental market.

Figure 7. Market share of US home-video retail market.

Although Netflix has been called the leading provider of online subscription-based DVD rental 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 the leader in the category, with a market share of 41%. Rental Chain Blockbuster Hollywood Entertainment Netflix Movie Gallery Family Video Market Share 41.1% 13.3% 5.5% 4.9% 3.2% Unit Volume (Million) 609.4 197.5 81.8 73.2 47.5 Unit Dollars (Million) $2,334 $757 $313 $280 $182

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

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Netflix, Inc. Analysis of Strategy Retail Chain Wal-Mart Best Buy Target Blockbuster Circuit City Market Share 31.0% 9.0% 7.1% 6.3% 2.2% Unit Volume (Million)

Kostadin Atanasov Unit Dollars (Million) $2,968 $866 $683 $601 $209

187.9 54.8 43.2 38.0 13.2

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 are worth mentioning since they are critical to the operations success and are provided by very strong 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 the cases Netflix deals with powerful companies in consolidated industries. (Strongly negative.) Buyers. Netflix delivers its services to the end-consumers which gives the company certain freedom. However demand for motion pictures is highly dependent on intangible and uncontrollable factors such as personal preferences, perceptions, prejudices and recommendations. 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 within the media category such as books or magazines. Specific attention must be paid to the increasing popularity of video games (the fastest growing entertainment sector) and the advent 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 place users 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 DVD Installed base 57 Million Penetration 53%

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Netflix, Inc. Analysis of Strategy Internet usage3 TV Sets 202 Million 107 Million

Kostadin Atanasov 69% 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 the end of 2004. (Strongly positive.) Competition. First, the competition in the home-video rental segment is already intensive with powerful and established players such as Blockbuster and Hollywood Entertainment controlling jointly over half of the market. Further, if we remove the word rental from the 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 an on-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 the distribution license from film studios. (Negative.) The general evaluation of the industry is somehow negative: It invites entrants and imitation; (2) competitive advantages cannot be sustained for long periods of time, and (3) technologies rapidly transform the landscape.

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

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Internal Analysis
Financial Performance Indicators
700% 600% 500% 400% 300% 200% 100% 0% 1999 2000 2001 2002 2003
Source: 2003 Annual Report, Netflix, Inc.

SG&A Marketing Technology R&D Fulfillment Cost of revenues

Figure 8. Composition of costs. Percentage-wise the gross margin of Netflixs model is in the low forties depending on intensity of service usage as well as fluctuations in shipment, payment processing and licensing fees. Trend in subscriber acquisition costs (SAC) is difficult to estimate. On one hand the brand is very powerful, which generates visibility, word-of-mouth marketing and ultimately new subscribers at very low or zero cost. On the other hand increased media advertising and expected 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 is the basis of its rich catalog. Deep and wide library. Netflix currently offers around 25,000 film titles, (arguably all feature 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 in the US. It has a well recognizable brand, which helps in marketing by decreasing customer acquisition costs. Page 13 of 24

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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, Netflix delivers 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 database contained around 300 million ratings (around 15,000 ratings per title and 150 ratings per subscriber). Thus every customer can receive a personalized computer-generated recommendation for a film. Client acquisition momentum. Netflix has a critical mass of over 2 million customers, a number expected to grow in the next 2-3 years. Low price per title. Based on their reported annual subscription revenues for 2003 and reported monthly turnover of about 18 million disks, the average rental price per DVD comes 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 the eyes of their customer the possibility to rent unlimited number of titles and thus have a home-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 a growing number of other rental businesses too.

Weaknesses
Strong suppliers. As discussed above Netflix sources its main inputs from a few and strong players. Films come from Hollywood distributors, all distribution is handled by one service 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 on uncontrollable variables such as taste, recommendation. Finally economic success is very much related to customer loyalty because of the high acquisition costs. Voluntary ratings. One of the distinctive feature of the service is the recommendation algorithm, whose performance depends on viewer ratings. Currently viewers rate the films they 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. This is a decision made by movie studios and their distributors and therefore outside the control of Netflix. As discussed above, the position along the window release continuum might affect 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-how towards digital delivery. The single most important factor in digital VOD models would be adequate recommendation (the modern version of traditional TV programming) and no other player in feature-film delivery has this expertise. DVD format dominant. Based on the analysis above and the opinion of industry experts and analysts, the DVD format will be the dominant video format in the next at least 10 years. This situation might be challenged by the new digital transmission and HD storage formats, however, this is an issue affecting the whole business model and departing from the physical nature of the medium. DVD installed base grows. With expected penetration of DVD players in 65% of US households, 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 there seems to be no short term need to finance operations.) The weighted average book-debt-tocapital ratios for the internet and movie rental industries ranges between 9% and 14.3%. Comparison universe Movie rental industry peer group (Retail special lines, SIC: 5600) (4 companies) Internet industry (SIC: 7370) (164 companies)
Source: Historical market data, www.damodaran.com

WA book debt to capital ratio 14.3709%

9.0389%

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 film studios 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 segment intensifies, studios might deem it more beneficial to form alliances with bigger players, namely Blockbuster and Wal-Mart, manifested in more advantageous conditions. This will worsen the competitive advantage of Netflix. Studios might not renegotiate revenue sharing agreements. Revenue sharing agreements which shift costs towards the variable end of the continuum might not be Page 15 of 24

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renegotiated at less advantageous terms. Although this will not necessarily worsen the economics 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 be financed 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 might lure customers away from renting and into buying DVDs. A similar tendency was observed in the period 1999 2003 and must not be discounted lightly. New channels of filmed entertainment delivery. New technological solutions and digitalization of TV will enable consumers to get access to filmed entertainment over new channels such as VOD, pay-per-view and Video over IP. Although not expected to gain market importance before 2007, these channels already witness implementation which is well accepted by consumers. Additionally, the increasing popularity of video games also claims part of consumers leisure time. New entrants into the rental market. Already competitive, the rental market is about to see 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 business operations. Successful management of this growth is a critical factor for Netflixs continued competitiveness.

Strategies Employed
Below 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 million DVDs 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 feature of the service at the beginning of Netflix operation. Its success among clients has made competitors 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 this feature of the service suggests to every individual client movie titles, which it thinks the client will enjoy based this clients past history and ratings (each client is invited to rate each film he or she sees). The recommendation algorithm takes into consideration the opinions 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 easily visible as the latest hot releases.

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On-line catalog and ordering. Netflix client can log on to the companys website and leaf through the catalog of titles. On the web-site they can build queues or wish lists, of films which are sent out on a first-in-first-out basis. There is an indication of the expected waiting 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 distributors under 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 the option 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 closest competitor Wal-Mart operating only 6 distribution centers.

Critical Assessment of Strategies

The 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; cash generation is strong, balance sheet is debt free and the number of subscribers grows steadily. Below is a discussion of individual elements of Netflixs strategy. First mover advantage. Netflix pioneered the flat-fee model in combination with on-line ordering and postal delivery. This fact makes Netflix synonymous with the business model, which gives the company visibility and credibility. The publicity momentum serves them well in attracting new customers. Title selection. The size of the selection increases the subscribers choice and the depth minimizes 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 Netflixs ability to manage its distribution center stocking policy, since the larger the number of distribution centers, the benefits of the pooling effect are lost and effective depth of copy decreases. No late fees. This component of Netflix pricing strategy helps the company achieve steady revenue 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. As competition in the rental segment grows, over-paying customers will find it more advantageous to move to services which reflect more fairly their low usage. Netflix have already 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 seemingly simple feature does three things. First it helps Netflix predict the demand several days ahead and make adjustments in shipping and stocking where benefits outweigh costs. (There is no information whether Netflix actually adjusts its shipping and stocking decisions based on queued items.) Second, Netflix makes sure that in the event of a stockout of a specific title, the client will still receive a film that he or she likes, i.e. there will be Page 17 of 24

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no dissatisfaction with the service. Finally it allows Netflix identify potential problems quickly 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 also gives 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 clients instant 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 catalog items cost less).

Latest Developments
International expansion. Netflix has announced plans to expand internationally, specifically mentioning the UK and Canada. In the first place, every international expansion has risk associated with it, especially if this is the companys first replication of its business model. Clearly the challenge is in the companys 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 licensing agreements with the distributors. Third, financial analysts predict that the companys forecasts 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 services already introduced in UK, most notably Blockbuster uses UK as its experimental territory for the online subscription model before introduction into US. Given the above circumstances, 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 press circulated news about possible partnership talks between Netflix and TiVo, the PVR manufacturer. No details were available; neither did the PR department of Netflix disclose further 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 delivery of films over IP networks (Internet).

Conclusions
Based on the analysis so far, Netflix gained its leadership position within the online subscription video-rental niche thanks to its innovation and first mover advantage. However this leadership is aggressively attacked and not sustainable even in the medium term.
4

Email correspondence with pr@netflix.com as of 2 December 2004.

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Competition will intensify in the coming 1-2 years, following the entry of powerful companies 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 not maintain 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 solid foundation for raising the necessary debt or new capital. Therefore Netflix might compete against the heavily capitalized champions either in union with 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 medium run. 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 momentum and probably consider borrowing to finance quick expansion, thus achieving appreciation and 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 the market something it has already proved it is good at. The strategy should be threepronged: keep the competition guessing while stabilizing own customer base and planting roots 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 would have caused the shake-up sooner or later, simply Netflix opened the floodgate. In these turbulent 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 has mastered. Therefore by offering new service features, either based on technological changes or improvement of service will keep Netflix ahead. An example of such a move is Netflixs 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, but their 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 company should capitalize on that trend and try to increase the number of its customers, so it gains Page 19 of 24

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

Plant roots in the deep future

It is clear, that penetration of digital technologies will be the main factor in the rearrangement 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 films not only on physical DVDs but over digital networks. Says Netflix CEO Reed Hastings, We named the company Netflix, we didnt name it DVD by Mail. It is clear that films will be delivered to subscriber homes via Internet Protocol (IP), what is still 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? Will it be TiVo, Microsofts 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 the market? Will broadband penetration, critical for the success of this plan, reach threshold levels to allow for sustainable economies5? If not for what period is Netflix prepared to take losses? For what period are Netflix shareholders prepared to take losses?

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 must consent. 2. It should try to avoid cable as key delivery infrastructure and look more towards the telecoms, 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 as Akamai, which will store the content close to consumers. 4. Finally Netflix should team up with TiVo to ensure that subscribers have a device to play the films. This will also solidify Netflixs 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, TiVos position is shaky in the light of MSOs deployment of own free STPs and is likely to embrace the opportunity. Second, TiVo is deploying its second generation STP which can connect to the Internet and would therefore look for media content provider for this channel. Finally TiVos CEO Mike Ramsay sits on the Netflix board.) It needs to be mentioned that TiVos second generation of STPs will need some time to establish itself in the market. It is unclear how fast broadband will roll-out. The good news is that with a device like TiVo, rating the films can be somehow more automated which will 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, USA Atanasov, 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 2004 Burrows, P., Next: TV Meets IP, Business Week Online, 23 November 2004 Yang, C., TVs 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) Page 21 of 24

Netflix, Inc. Analysis of Strategy World Internet Statistics, (www.internetworldstats.com), August 2004; Euro Monitor (www.euromonitor.com)

Kostadin Atanasov

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Attachment 1 Motion Picture Value Chain

S a te llite N e tw o rk s C o n te n t a c q u is it io n T V N e tw o rk s C o n te n t a c q u is it io n C o n te n t S e n d to L o c a l f r e e t o a ir p r o g r a m m in glo c a l m a r k e t sin f r a s t r u c tu r e C o n te n t B r o a d c a s t to p r o g r a m m in gc o n s u m e r s

C a b le N e tw o rk s C o n te n t a c q u is it io n C o n te n t S e n d to L o c a l c a b le p r o g r a m m in glo c a l m a r k e t sin f r a s t r u c tu r e

F ilm S t u d io s In te rn a l p r o d u c t io n D is t r ib u t o r s In d e p e n d e n t p r o d u c t io n

V O D N e tw o rk s C o n te n t a c q u is it io n C o n te n t p r o g r a m m in g STP H o u s e h o ld s

V i d e o o v Nr eI tPw or k s e C o n te n t a c q u is it io n C o n te n t p r o g r a m m in g L o c a l t e le c o m in f r a s t r u c tu r e

T h e a te r C h a in s C o n te n t a c q u is it io n R e t a ile r s C o n te n t a c q u is it io n R e n ta l C h a in s C o n te n t a c q u is it io n H o m e v id e o r e n t a ls DVD S a le s T h e a t r ic a l e x h ib it io n s

Source: the author

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Attachment 2 Before and After Digital Tectonics

Before Dedicated Transmission Channels Specialized transmitters over government allocated frequencies and over pre-designed routes. Limited Geographic Distribution Electronic media content could be delivered only at geographic locations where dedicated infrastructure exists. Programming Decisions: The Station TV stations program based on (1) stations agenda, (2) imperfect feedback and (3) aggregated and averaged figures. Network Owners Control Delivery Programming and distribution companies controlled BOTH producers access to consumer and consumers access to content. Easy Government Control & Censorship With a few critical points controlling the distribution, levers to affect programming were easily available. Linear Streaming Delivery Content is broadcast and consumed in realtime. Consumers adapt to broadcast schedules. Trading Terms Defined by Stations Content producers sold their content for what TV networks were willing to pay. TV networks were concentrated and with high negotiation power. Imperfect Market Feedback Feedback from consumers obtained through imperfect statistical measurement tools. After Least-cost Auto-routed Channels Internet networking equipment is widespread with multitude of routing options. Routes allocated dynamically. Unlimited Geographic Distribution Internet networks already reach virtually any point on the planet and are not controlled by single dedicated operator. Programming Decisions: The Consumer Consumer decides what to watch on demand model. Info of media usage on individual household level. No One Controls Delivery Content creators can publish content on universally visible servers. Thus they have direct access to consumers. On the other hand consumers have direct access to content. Virtually impossible Censorship With unlimited delivery channels, control over content is virtually impossible. 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 Market Content producers sell their content based on consumer demand. Price for content is determined by market. (Does not mean that content producers are better off.) Perfectly Precise Consumption Data Feedback from market is detailed down to individual programs and households.

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