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Within a year, Netflix had negotiated direct revenue-sharing agreements with nearly all the major studios. Rather than pay an up-front price of $20 per DVD, the studios would reduce their unit up-front price in return for a fee based on the titles total number of rentals for a given period of time. Hastings described this transition with the companys suppliers: We spent more money, not less, with the studios but got bigger customer satisfaction. It was like paying 20% more and getting two times the number of copies. The benefit of the new relationships with the studios extended beyond lowering the acquisition costs for high-demand releases. Hastings recognized early on the number of customers who were frustrated with the poor selection offered at many video stores, where shelf space is focused on hit movies and new releases. Customers interested in exploring a much broader range of movie titles were left unsatisfied by their options. Sarandos explained: The thing that Reed and I connected on before I even joined Netflix was the promise of a business model that promoted lesser-known movies. Films outside of the top 20 are not distributed widely. If you didnt see a movie within six months of when it was in the theaters, it often disappeared forever. The use of a national inventory allowed Netflix to satisfy the diverse demands of movie watchers, serving the same number of customers as a local network of Blockbuster retail locations with far fewer copies of a given movie title. Sarandos explained the difference in economics: Half the equation of packaged media is allocationgetting the right amount of product in the right locations. This was more of a challenge for products that did not enjoy broad promotion. The trade radius of a single video store was so small that even a single copy of a lesser-known film had lousy economics. By using a national inventory, we avoid that issue. We never have overstocks on one side of town with understocks on the other side. Using the subscribers queues provides a great deal of data. By looking into the demand in the near future, we can replicate near-perfect inventory. Overall, we can satisfy demand in an area with about one-third to one-fifth of the inventory needed by a retail chain. In the summer of 2001, Netflix operated out of a single distribution center located in Sunnyvale, California. While several years of operations had allowed for improvements in this center, the majority of the country was still not able to enjoy next-day delivery of their rented movies. These extended delivery times were a barrier for Netflix in attracting and retaining customers in those regions. Hastings explained: Post Office variability was long on cross-country mail. . . . It essentially meant one-week delivery times. So in the summer of 2001, we realized that regions with overnight delivery were being disproportionately successful. We tested the theory by upgrading Sacramento. The numbers popped quickly. Netflixs Sunnyvale distribution center could serve the San Francisco Bay Area with overnight delivery. But while outbound mail from Sunnyvale could reach Sacramento overnight, returns often took several days. Netflix tested Sacramento by arranging with the Postal Service to intercept returns at a Sacramento mail-sort center and then truck them to Sunnyvale. This would shorten the turnaround dramatically. Added Hastings, As we added centers in Boston, New York, and D.C., they started performing like the Bay Area. Armed with this evidence of success, Netflix quickly opened more distribution centers across the country, and subscriber numbers continued to respond to the improved delivery service. The company promised 500,000 subscribers to its investors in its 2002 prospectus and delivered 700,000 at the time of the May 2002 IPO. These changes in Netflixs pricing and cost structure allowed the company to reach profitability for the first time in the quarter ending June 2003. After establishing the viability of this business model, Netflix continued to build its subscriber base and upgrade the customer experience by opening new centers (see Exhibit 2 for Netflixs operating statistics). The centers themselves were inexpensive investments; it cost about $60,000 to convert an existing warehouse to Netflixs needs. The company continually added centers to improve upon its nationwide coverage and reduce delivery time to its customers. With the number reaching 44 by early 2007, over 90% of subscribers could be reached within one delivery day. The improved ability for Netflix to provide next-day delivery to more regions of the country allowed it to compete more successfully with retail video stores for new customers drawn by all three of the targeted characteristics of convenience, value, and selection. Netflix considered delivery time to be the key measure of customer satisfaction and continually sought to improve the operations within each of its existing distribution centers. Much of the process of opening return envelopes and filling outgoing mailers with DVDs was still performed manually. However, with careful hiring practices and thorough time and motion studies, Netflixs employees could open and restuff an average of 800 DVDs per hour, allowing the entire distribution center network to ship over 1.6 million DVDs per day. (See Exhibit 3 for photos of the distribution center operations.) Netflixs relationship with the USPS grew. While the USPS was facing a general decline in firstclass mail, Netflix represented its fastest-growing first-class customer. Along with receiving the standard discount for presorting of its outbound envelopes by zip code, Netflix worked with the USPS to reduce the time it took to receive a movie return. Rather than deliver returns to the distribution center of origin, the USPS brought the easily recognizable red Netflix envelopes to the closest Netflix distribution center. And recently, Netflix began using multiple truck routes, supporting each distribution center to expedite returns. This shortened turnaround time for new movies and improved the overall customer experience. As the company added subscribers, content acquisition continued to grow in importance for Netflix. Sarandos explained: For a technology company like Netflix, we are the group that is most dependent on art. What we do is probably 70% science, 30% art. Our buying staff has to have their finger on the pulse of the market to make their decisions. A high box-office performer wont necessarily be a high video performer, and vice versa. The box office is an indicator, as a proxy for awareness, but not for demand. . . . If rental demand for a title is lower than we forecast, it is a tax on the overall economics of Netflixs model. Even with the benefit of profit sharing, it is a margin eroder. If we underforecast demand, the problem is correctable, but it takes time. As Netflix built its film library, it grew in importance as a distribution channel for many small and independent film studios. For lower-profile and independent films that did not enjoy the advertising support of major releases, generating customer awareness was a major priority. As Netflix became known as the best source for lesser-known movies, the studios began to look upon this partnership with increasing favor. Sarandos explained: It wasnt all about fulfilling demand for mainstream videos. We were also providing the studios large markets for their films that they were having trouble reaching. And for the independent films, Netflix can be the dominant channel, representing between 60% and 75% of the earnings for some films. At Netflix, a lesser-known film can really succeed on its merits. Hotel Rwanda, the Don Cheadle film about the genocide in Rwanda, is an excellent example. It enjoyed some box-office sales, but generally it was a difficult topic and a difficult film to market, with a low viewership. At Netflix, however, it is our fourth-most-rented film. The rest of the top 10 are movies you would expect, but there is this wonderful independent film right there at number four. More people have seen it at Netflix than at the box office. In 2006, Netflix evolved from its de facto marketing efforts and began acquiring the distribution rights to certain independent films through its Red Envelope Entertainment subsidiary. Sarandos, who led this initiative, explained the shift in strategy: Red Envelope Entertainment is 90% about content acquisition. While we do distribute films in other channels, including retail and other video stores, we did this to bring more excellent movies to DVD. Of the 100 films that are featured at a festival such as Sundance, only 10 will make it to DVD. We are looking through the other 90 films for top-tier content to bring to our customers. By helping to bring high-potential films to market, Netflix hoped to enhance its reputation as the highest-quality source of independent films, a designation that contributed to its popularity. As it was for many subscription-based services, customer churn was a critical issue for Netflix. In an average month in 2006, 3.6% of customers would cancel their subscription. In 2002, that churn rate was even higher, at 6.3%. Since customer acquisition was a major expense, retaining existing customers and reclaiming old ones who had previously unsubscribed was a key opportunity. Originally, customers wishing to unsubscribe had to deal with a salesperson by phone, who attempted to convince the customer to retain their account. In 2002, the company changed its approach completely. Customers could unsubscribe online from Netflix as easily as they had been able to join. The only request was that they complete a brief survey explaining why they left. Hastings believed that it was more fruitful to encourage departing customers to return later on than attempt to coerce unwilling customers to stay: We were on the AOL style of it being really hard to cancel our service. We realized, This is stupid. Its a false savings. We turned it off, enabling the customer to unsubscribe on the website. We had a 30-day burst of churn, but we are convinced that it led to return visitors. Instead of making Netflix a difficult service to leave, Hastings wanted to make it a service that former customers would return to. Customers appreciated the personalized aspect of Netflixs service, a dimension that continued to improve. The proprietary recommendation system grew more accurate in predicting a users taste as the number of films rated by a subscriber increased. Hastings also emphasized the role of the customers queue as a major retention tool: Our explicit strategy is to invest in things that are strategically relevant to customer satisfaction potential. The key invention behind our subscription model is the queue. Our average queue length is 50 movies. It turned out to be an amazing invention. Its our biggest switching cost. Just as importantly, a customers profile was maintained if they left Netflix. If the customer were to return, everything was already in place, as if they had never left. Hastings found that growing the business in the face of a high churn rate was easier if many lost customers eventually returned