caSe

Netflix
Braxton Maddox
The Uniwesity of Alabama

large customer base and promising business tled the ever-evolving channels of DVD entertain

A model seemed like a formula for success, but

for Reed Hastings, founder and CE0of on
line movierentalI pioneer Netflix, the challenges had
tbegun. As he awaited a morning meeting, Hast-
ment and accumulated a steady stream of competi
tors, including retail giant Wal-Mart and movie
rental leader Blockbuster Video. So far, Netflix had
remained ahead of the game with, among other
speculated how his company was to sustain it-
ings things, innovative technology and software to help
lf and be added to the short list of dot-com wonder manage its intricate rental system. Netflix had pio
businesses that made it through the pioneer stages. neered the online DVD rental industry when DVDs
With such large competitors holding the resources to Were rare and had developed a strong lead of cus
mount strong, enduring attacks against Netflix. tomers, revenue, and brand recognition. "No one is
along with the ever-changing movie and entertain going to out-hare Netflix," Hastings said. "Our dan
ment industry, Hastings was faced with the challenge ger is in a tortoise attack. Wal-Mart has the ability to
ofhow to sustain Netflix's growth and determine the mount such a steady, relentless attack."
best ways to respond to the competition. In June 2003. Netflix won a patent that covered
So far, Netflix had remained a few steps ahead of much of its business model and could be used to
its closest competitor, but that certainly didnt calm help stifle competition in the future or at least de
Hastings's mind. After successfully founding his first mand licensing fees for the service. Mike Schuh of
company, Pure Software, in 1991, Hastings led sev Foundation Capital, one of Netflix's earliest finan
eral acquisitions that allowed the company to become cial backers, noted that the barriers to entry in the
one of the 50 largest software companies in the world online DVD rental market were very low, but the
by 1997. Hastings then founded Netflix in 1997, barriers to profitability were extremely high. Besides
launched the online subscription service in 1999, and newentrants, Netflix also faced a more powerful
led Netflix to a subscriber base of over l million in challenge: the likelihood that DVDs would soon no
just three and a half years. (Online service AOL took longer be the medium of choice for home entertain
Six years to acquire the same number of subscribers.) ment and that customers would instead download
During the third quarter of 2003, despite a movies to their PCs or TVs.
rapidly changing industry, Netflix reported a
stronger-than-expected boost in subscribers of 74
percent. Netflix had become not only one of the very DVDs
Tew dot-com success stories but also a highly prof
Itable one, growing substantially in the face of in The digital video disc (DVD) player was one of the
Creasingly strong competition. most successful consumer electronic products of all
Ihe strong success of Netflix had not gone un time (see Exhibit 1). The DVD market was also one
noticed. Since its founding in 1997, Netflix had bat of the fastest-growing markets, experiencing un
precedented growth since its debut in 1997 (see Ex
Prepared under the supervision of Professor A. J. Strickland, The Univer- hibit 2); the growth was largely attributed to
sity of dramatically falling component prices. DVD play
Strickland.Alabama.
CCopyright ©2004 by Braxton Maddox and A. J.
back had worked its way into a number of electronic
C-33
 Case 2 Netflix C-35

devices,and DVD recording was expected to be an

essentialdriver of the DVD market. DVD recorders
Netflix prided itself on fast. free service. It could
wereforccast to surpass sales of play-only DVD reach more than half of its subscribers with next-day
playersby 2007, with an expected Icompound annual delivery and provided prepaid return envelopes for
growthrate of 126 percent. DVD sales for 2003 were
mailing back the DVDs. (See Exhibits 3 and 4 for
expectedto reach $l14 billion, up 34 percent from
Netflix income statements.)
of 2001 In a survey by Netflix, customers said they
2002 and double those
pVD movies were available through a wide va- rented twice as many movies per month as they did
prior to joining Netflix. New Netflix customers also
niety ofchannelsto the consumer: said they were immediately more satisfied with their
Physical| retail store and stand-alone outlet sales home-entertainment experience than they were prior
"
such as Wal-Mart and Best Buy. to joining Netflix. And9 out of 10 customers said
Physicalretail store rental outlets such as Movie they were so satisfied with the service that they were
Gallery and Blockbuster Video. willing to pitch it to family and friends.
Netflix's service was full of innovative technol
Weh sites of both brick-and-mortar stores and
Internet-only retailers such as Amazon.com. ogy designed to make browsing and selecting movies
as easy as possible.One such innovative service was
Online rental services such as Netflix and Wal. CineMatch, an Oracle database thatorganized Net
Mart'sonline service. flix's library of movies into clusters of similar
pr downloads from Web sites such as Movielink movies and analyzed how customers rated them after
or file-sharing programs such as Kazaa. they rented them. Those customers who rated similar
movies in similar clusters were then matched as like
minded viewers. When a customer was online, Cine
NETFLIX Match looked the clusters he or she had rented
from in the past, determined which movies the cus
Netflix was based in Los Gatos, California. As the tomer had yet to rent in that cluster, and recom
world's largest online DVD rental service, it had a li mended only those movies that had been highly rated
braryof more than 15,000movies to choose from. by matched viewers. "Over 50percent of our traffic
comes via the recommendation system" said Hast
The idea was simple: customers signed up for a sub
scription to Netflix and created a wish list"
of all ings. "It requires a lot of work in real time." Cine
be Match ran on two Sun 420 systems and could
the movies they wanted to see; the list could
changed at any time. Provided the movies were avail generate thousands of predictions each second. The
dataset of user ratingswas stored on a third system.
able in Netflix's inventory, the DVDswere shipped
"The key is the quality of the data we use" said Neil
to the customer free of charge. The unique aspect
Hunt, Netflix's vice president of e-commerce. The
about Netflix was that it provided all the benefits of more data we collect about user preferences, the bet
atypical movie rental store but without the
hassle of
ter the recommendations."
having to return the rentals at a specific time. For a
set fee each month, customers could rent as many
Also to help keep customers happy,Netflix de
veloped a sophisticated distribution system to speed
DVDs as they wanted and keep them as long as they 15 distrib
Wantedthere were no due dates or late fees. The up mailing times. It also built a system ofgoal of hay
ution centers across the country with the
catch was that customers were limited to having only allow most Netflix
ing enough distribution centers towithin
acertain number of DVDs in their possession at a customers to receive their DVDs
one day. The
time; the number allowed varied according to the decentralized distribution system allowed Netflix an
Customer's subscription level. Blockbuster, each of
advantage over Wal-Mart and
Netlix 's 2003 pricing levels were as follows: which sent their DVDs out of only
one warehouse.
used
S13.95four DVDs a month, two titles out at a Sophistication came with the software Netflix
system al
time. to keep track of its inventory. Netflix's
communicateto de
SI9.95unlimited DVDs. three out at a time. lowed the distribution centers to
to the
S29.95-unlimited DVDs. five out at a time. termine the fastest way of getting the DVDs placed
customers. For example, suppose a customer
$39 95--unlimited DVDs,eight out at a time.
 Executing Strategy
CaNee in (aing and

rt Netfix'sIncome Statements, 1999-2002(in millions)

2002 2001
$162.81 $ 75.91
2000
Net ales 78.14 49.91
$ 35.89
Coet of goods sold $ 74.67 $ 26.01 24.86
Gross prot $ 11.03
14.63 17.73
R&D expenditures 61.89 16.82
administrative expenses 39.14
Sellino. general, and 42.96
Income before depreciation and
amortization $ (1.84) $(30.87) 1A1
$(48.75)
Depreciation and amortization n/a
(8.13)
n/a
n/a S128551
Nonoperating income (5.90)
Interest expenses
11.97 1.85 (7.1.4516) na
Inoome tbefore tax $ (21.95) $(38.62) (0.382)74
S57.36)
Provision for income taxes
Minority interest
n/a
n/ay
n/a
nla
nNa
nla
S985
Investment gains (loSses) n/a na
n/a
nla na
Other income nla nla
nda
Net income before extra items $(21.95) $(38.62) nNa
$(57.36)
Extra iterms nla nla nla
S29.85)
Discontinued operations nla nla nla na
$(21.95) $(38.62) nla
Net income $(57.36)
S/29.85)
an order for a specific DVD. The system first looked from the United States. Founded in
for that DVD at the closest distribution center to the 1985. Blockbuster had grown to moreDallas, Texas im
customer. If that distribution center didn't have the than 8.S00
company-operated franchised stores worldwide
DVD in stock, the system then moved the next clos with more than 2,600 stores outside the United
est center and checked there. This continued until the States. Analysts predicted the movie/video game
DVD was found and shipped. If the DVD was un rental market to grow tO more than $30 billion by
available anywhere in the system, it was wait-listed. 2006, and Blockbuster planned to be "the complete
The system then moved to the customer's next source" for movies and games, rental and retail.
choice and the process started all over. And no mat In an increasing focus on retail, Blockbuster had
ter where the DVD was sent from, the systemn knew developed innovative programs and expanded its i
to print the return label to the distribution center store movie, DVD, and video game selection, includ
closest to the customer to reduce return mail times. ing everything from the newest releases to a wide
collection of older titles in a number of genres. One
such innovative program was developed in Septem
BLOCKBUSTER VIDEO ber of 2000, when Blockbuster began to market the
of its
pay-per-View service DIRECTV in 3,800
of the alliance,
Blockbuster Video was the world leader in the video Stores. After the initial success
July
cassette, DVD, and video game rental industry, hold Blockbuster co-branded with DIRECTV in
ing a 65 percent market share of the $8.5 billion he p
2001 and thus established its presence in payper
The Blockbuster
market. (See Exhibit 5 for the company's income per-view movie industry. selections a day t¡
statements, 1999-2002.) It had revenues of more view service offered 44 movie
than $5.5 billion in 200280 percent of which came subscribers.