"Netflix used to be a perfectly good horror movie. Company management swings a chainsaw; investors scream and are cut to bits; audience is titillated. Now it has become one of those avant-garde films your pseudo-intellectual friend recommends: no fun to watch, surreal and confusing . . . . The no-fun-to-watch part is the damage that Netflix's abrupt price increase has had on subscriber numbers. Subscriber growth ground to a halt in the third quarter, after the increase was announced in July. In the current quarter, as the price increase is put into effect, the company expects its physical DVD service to lose 3mabout a fifthof its subscribers. Streaming video subscribers are expected to be flat to down. Given that Netflix's strategy is designed to encourage growth in streaming, this is far worse news than the hit to DVDs.

LEX Column: Netflix, Financial Times, October 25, 2011[1]

Reed Hastings, founder and CEO of Netflix, was having a rough September. Only a few months earlier, he was on top of the world. Named Fortune magazine's businessperson of the year in 2010,[2] Hastings had built the DVD-by-mail company into an enormously popular consumer service. (See[...]"

"streaming service was formerly a $2 add-on to the basic DVD monthly charge of $7.99 for its entry-level one-DVD-at-a-time plan. Customers who wanted both would now have to pay $15.98 a month. Although most new consumers who wanted only the streaming service would actually see a price reduction, the public outcry over the 60% price increase for the combination drowned out that fact.[3]

Things got worse when Hastings announced that the company would split the DVD-by-mail into a separate business named Qwikster, and that the online streaming business would retain the Netflix name. On September 18, 2011, he announced on his blog:

It is clear from the feedback over the past two months that many members felt we lacked respect and humility in the way we announced the separation of DVD and streaming, and the price changes. That was certainly not our intent, and I offer my sincere apology. I'll try to explain how this happened."

"For the past five years, my greatest fear at Netflix has been that we wouldn't make the leap from success in DVDs to success in streaming. Most companies that are great at somethinglike AOL "

"dialup or Borders bookstoresdo not become great at new things people want (streaming for us) because they are afraid to hurt their initial business. Eventually these companies realize their error of not focusing enough on the new thing, and then the company fights desperately and hopelessly to recover. Companies rarely die from moving too fast, and they frequently die from moving too slowly.[4]

Hastings went on to explain that streaming and DVD-by mail were becoming two quite different businesses, with different cost structures and benefits that needed to be marketed differently. In addition, each business needed to be able to grow and operate independently.

Thousands of consumers criticized the plan on Netflix's website, and Netflix stock continued its slide, from $300 earlier in the year to $77 in October.[5] By mid-October, the company reversed course again, abandoning the breakup plan. Asked in a television interview about how it felt to apologize for business mistakes, Hastings was humble:

Going through marriage counseling 20 years ago was really how I moved to become a better manager and leader . . . This marriage counselor was able to get me to see that I was often lying to myself and "even if it's not necessarily what they want to hear, if it's really sincere.[6]

The bigger challenge facing Hastings and his team was how to cope with the very different business model for streaming in a company built on the higher margins of DVD-by-mail. How would they manage that transition within a single business, and more importantly, with the company's 20 million customer relationships? That was the question he now had to be honest about.

The U.S. Home Video Rental Market

In the 1990s, the U.S. home video market was a fragmented industry largely populated with "mom-and-pop" retail outlets. Customers rented movies, primarily on VHS cassette, from a retail location for a specified time period, usually between two days and one week, and paid a fee of $3 to $4 for each movie rented.

Blockbuster Inc. became the market leader with the insight that movie rentals were largely impulse decisions. To customers deciding at the last minute that a given night was "movie night," the ability to quickly obtain the newest release was a priority. Statistics showed that new releases represented over 70% of total rentals. Blockbuster's growth strategy revolved around opening new locations "4,255 were company owned and the balance franchised. Locations were chosen based on customer concentration and proximity to competition, focusing on high-visibility stores in heavily trafficked retail areas. Management often proclaimed that "70% of the U.S. population lives.

"releases during the first three weeks of the studio distribution window.[a] After that, demand fell sharply. The studios protected this window because of the increasing share of revenues that they received from sales (see Exhibit 2). As rental demand for a particular title dropped, the stores remarketed used copies to reduce their inventory and generate additional income."

"Blockbuster's business model depended on maximizing the days that a movie was out for rent. Stores were reluctant to stock large numbers of lesser-known and independent films, since the demand for these titles was inconsistent. With a relatively narrow selection of mostly familiar movies, customers could generally select a title with a limited amount of advice from the sales staff. Movies not returned to the renting location by the end of the specified rental period were subject to extended viewing fees, or "late fees." In 2004, these fees represented about 10% of revenues. Late fees also improved asset utilization by encouraging a timely return of each rented film, allowing it to be rented by another customer. Late returns led to increased levels of stockouts, costing Blockbuster incremental rental opportunities as well as reduced customer satisfaction.

The unit economics of retail video rental were straightforward. Blockbuster acquired approximately half of its rental inventory under a purchase model in which it would pay the studios $15-$18, rent it 9-10 times for $4 per rental, and then resell the DVD for an average of $8 per unit.[b] The other half was acquired under a revenue share model in "was estimated that they produced $900K sales per year with an operating profit of $162K.[11]

In 2002 Blockbuster enjoyed record levels of revenue and profitability, riding a wave of consumer DVD-player adoption, which increased from 24% to 37% of U.S. households in just one year. (Exhibit 3 shows Blockbuster's income statement through 2006.) As consumers sought content for their new players, spending for in-home movie viewing reached $22.3 billion.[12] 2002 represented Blockbuster's fifth consecutive year of same-store sales growth, and the Blockbuster brand achieved nearly 100% recognition with active movie renters. That same year Netflix went public, and some would say that is when Blockbuster's troubles really started to get serious.

Netflix History

Hastings conceived of Netflix in 1997 after he discovered an overdue rental copy of Apollo 13 in his closet. After paying the $40 late fee, Hastings, a successful entrepreneur who had already founded and sold a software business, began to consider alternative ways to provide a better home movie service. At the time, most movie rentals were VHS videocassettes, but Hastings had heard from a friend about the new DVD technology. DVDs were small and light, enabling inexpensive postal delivery.

"they would come back and what condition they would be in," he explained. "I waited for two daysand they all arrived in perfect condition. All the pieces started to fall into place after that."

Netflix's Early Days

Hastings founded Netflix in 1997, and launched the company's first website in early 1998. Netflix targeted early technology adopters who had recently purchased DVD players, offering cross-promotional programs with the manufacturers and sellers of DVD players, thus providing a source of content for customers. Hastings elaborated, "We were targeting people who just bought DVD players. At the time our goal was just to get our coupon in the box. We didn't have too much competition. The market was underserved, and stores didn't carry a wide selection of DVDs at the time."

Netflix's website included a search engine that allowed its customers to sort through its selections by title, actor, director, and genre. Using this search engine, customers built a list, called a "queue," of movies to be received from Netflix[...]

1. What are the main differences between Netflix's and Blockbuster's business model?
2. Do you think Netflix's success in streaming is sustainable for the future?
3. Did Netflix's advantage travel from DVD-by-mail to Streaming?

At least one page answers for each question and explain in your words your answers and conclusions.