Netflix Tech Strategy

Strategic Analysis SGMT 6800 S - Group Project Schulich School of Business

Kevin Andrews Ebube Anizor Nasir Gondal John Selvakumar

Appendices

2

CONTENTS Company Overview ......................................................................................................3 Products & Services ...................................................................................................3 Technology ...............................................................................................................4 Current Strategy ..........................................................................................................7 Business Strategy ......................................................................................................7 Technology Strategy .................................................................................................8 Innovation Strategy .................................................................................................10 Investment Priorities ...............................................................................................12 Summary ................................................................................................................12 Environmental Analysis ..............................................................................................14 Forces Analysis .......................................................................................................14 Opportunities .........................................................................................................15 Licensing and Regulatory Issues .............................................................................16 Competitive Analysis .................................................................................................19 Competitors ............................................................................................................19 New Entrants ..........................................................................................................22 Netflix Positioning ..................................................................................................22 Competitive Advantage ..............................................................................................23 Intellectual Property ................................................................................................23 Complementary Assets ...........................................................................................24 Industry Outlook ........................................................................................................28 Studio Revenue .......................................................................................................28 Recommendations .....................................................................................................31 Short and Medium term Recommendations .............................................................31 Long Term Recommendations .................................................................................33 The Bet ...................................................................................................................33 Appendices ................................................................................................................36 Appendix A: Movie Releases ...................................................................................36 Appendix B: Industry ..............................................................................................37 Appendix C: Competition ........................................................................................40 Appendix D: Technologies ......................................................................................43

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COMPANY OVERVIEW Netflix was founded in Scotts Valley, California, in August of 1997 by Reed Hastings and Marc Randolph.

The idea for the “DVD-by-Mail” business was

born out of Hastings’ own personal frustration from paying $40 in late fees for a video he had forgotten to return to Blockbuster. Hastings’ was compelled to figure out a better way for consumers to experience what was then the new video format – DVDs - and began his quest to disrupt the traditional movie rental market and create a new industry. In just over a decade Netflix has developed into the world's leading DVD rentby-mail and video streaming company. With over 14 million subscribers in the US and growing, more than 10% of US households currently subscribe to either Netflix’s mail or streaming services. Netflix employs 1,700 staff and reported revenues of US $1.67 billion in 2009. Projections for 2010 include revenues nearing $2.5 billion and a subscriber base approaching 17 million. PRODUCTS & SERVICES Netflix’s DVD-by-Mail service straddles the end of one particular technology cycle (traditional DVD rental service) and the beginning of another (on-line streaming).

Though Netflix’s early attempts at streaming technology (see

Streaming below) were met with failure their foresight and “big bet” into this technology has led to their dominant status in the movie streaming market, and

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has provided them with significant power in the industry. Figure 1 depicts how the mail and streaming services operate.

Figure 1: Neflix’s Mail and Streaming Offering

While plans for geographical expansion are underway Netflix currently only operates in the United States; offering one of four subscription choices: •

3 DVDs at-a-time/Unlimited Streaming - $17/month

•

2 DVDs at-a-time/Unlimited Streaming - $14/month

•

1 DVDs at-a-time/Unlimited Streaming - $9/month

•

2 DVDs /2 hours streaming - $5/month

TECHNOLOGY Netflix’s attempts to move from a solely mail-based service faced challenges. In 2000, engineers developed a streaming service that took 16 hours to download a two hour movie – needless to say the project the scrapped.

Noticeable

improvements were made in 2003 when using a TV connected to Linux PC at a Netflix

Appendices

5

cost of $300 it took two hours to download a two hour film.1 However, the technology was still not yet ready to be commercialized. Improvements in broadband speeds and Netflix’s technology were required to make streaming a viable offering. Progress in both regards will continue to affect growth in the Internet delivered video (IDV) industry and Netflix’s fortunes. Adoption Netflix’s service offerings reside in distinct stages in the technology life cycle DVD-by-Mail

(Figure 2).

Streaming

Figure 2: Technology Adoption Curve

DVD-by-Mail DVD-by-Mail lies somewhere between the “Early Majority” and “Late Majority” stages. The service is still growing; however the entire model as a means of distributing movie content is changing, foreshadowing the decline of the model. Ultimately delivery will be replaced as streaming improves, optimization

1

“Netflix Inside” (Wired), October 2009

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of the delivery chain peaks and the cost of shipping DVDs becomes too high relative to revenue in a competitive market. Streaming The “Streaming” model however, would have still be considered to be in the “Early Adopters” stage, however that is being driven full steam ahead into the “Early Majority” as an increasing number of devices support the Netflix platform.

Televisions, Blu-Ray players, gaming consoles, mobile phones,

tablets, PCs, and just about any device that can connect you to the internet are all becoming “Netflix enabled” devices that will likely catapult the Netflix streaming service into majority adoption. Evolution Several factors including technological improvements and customer behaviour foretell the gradual dominance online delivery.

That being said, Netflix

anticipates the continued growth of the DVD-by-Mail business into 2013 (see Figure 3) driven by the growing closures of video stores and Netflix’s delivery excellence. Clearly what is being witnessed is the saturation of the shipment business as the streaming business emerges and approaches a breakthrough in market acceptance. See Figure C4 is Appendix C for a

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Figure 3: DVD-by-Mail Shipments (Source: Netflix)

perspective on

the attractiveness of service delivery models. While the

technology Netflix employs in delivering a movie via mail or via streaming can be classified as key; providing Netflix with short term advantage, they are imitable in the longer term. See Appendix D for details on Netflix’s technology life cycle and evolution.

CURRENT STRATEGY BUSINESS STRATEGY The core business objective of Netflix is to grow a large subscription business consisting of streaming and DVD-by-mail content.

In order to achieve this

objective and differentiate itself in the marketplace, Netflix uses a customer intimacy strategy heavily rooted in innovation to make it simple, fast and easy for subscribers to access a wide selection of content on a wide selection of devices. Subscribers are offered a choice of delivery method and platform that Netflix

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is most convenient to them, all at one low price. This strategy has proven to be a highly effective strategy as it helps grow and entrench the company’s greatest resource: its loyal subscriber base.

Through its focus on customer service and

user experience, Netflix has built itself into one of the leading brands in home entertainment. TECHNOLOGY STRATEGY At the genesis of Netflix in 1997, its founder Reed Hastings was said to have envisioned a future for online streaming content – thus the name “Netflix” - but knew the timing was not right. It was obviously too early in the technology cycle (or “S-curve”) for online streaming content and the technology had not yet reached its breakthrough point2.

When the company sensed that the

incumbents in the traditional video rental business such as Blockbuster were beginning to catch up and that streaming had become more pervasive, the company quickly changed its business model to include streaming content through its ‘watch now’ online streaming feature. 3 Creating, Delivering and Capturing Value Technology strategy and innovation are at the heart of Netflix’s ability to deliver a compelling customer experience and its ability to sustain competitive advantage.

At the technology strategy level, Netflix operates as a leader by

Wolf, Michael (2010, July 1, 2010). How Netflix Shaped Skype’s Platform Strategy. Message posted to Gigaom archived at http://www.gigaom.com 2

3

Bulik, Beth Snyder (2010). How Netflix Stays Ahead of Shifting Consumer Behaviour. Advertising Age, 81(8), 28

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investing in new technologies to enhance the “subscriber experience” and “operate efficiently”4. •

Netflix creates value by continuously adding to its extensive inventory of content, by building a recommendation engine which allows the company to maximize its library utilization and by leveraging its customer database

and

online

merchandising

experience

to

digitize

the

relationship with the customer5. •

The company delivers value to customers through its recommendation and merchandising technology by providing a quick and personalized way to enjoy and experience content and through its pricing strategy which entails charging one price for quick delivery of DVDs through mail or via online streaming.6

•

Netflix then captures value through fees charged to its large installed base of 14 million users. By charging a minimum fee of $8.99 per month to its membership, In 2009 Netflix earned a $116 million profit on $1.67 billion in revenue.

Platform Strategy In addition, the company’s platform agnostic approach to spread its software across multiple platforms is proving to be a strong source of subscriber growth,

4

Netflix Annual Report (2009) Retrieved from www.netflix.com

5

Bulik, Beth Snyder (2010). How Netflix Stays Ahead of Shifting Consumer Behaviour. Advertising Age, 81(8), 28

6

Netflix Annual Report (2009) Retrieved from www.netflix.com

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guided by the company’s goal “to be ubiquitous on whatever device gets the Internet to the TV”7. By attempting to establish its online streaming technology as the standard service for getting internet content connected to electronic devices, Netflix has positioned itself to benefit from network effects and capture more value in the form of subscription fees and loyal customers. This strategy also helps the company defend its position against other competing technologies and services that are quickly emerging in the market. INNOVATION STRATEGY Disruptive innovation has been the hallmark of Netflix since its inception in 1997. It was one of the first companies to offer DVD by mail ordered over the internet. This service provided a cheaper, more convenient way for customers to enjoy DVD movies and television shows compared to the traditional brick and mortar video rental store, with the added convenience of no late fees. Netflix perfected the fulfillment of its DVD rental by mail business by investing in technology and developing processes to make it fast and efficient for customers to receive and easily return DVDs by mail. 8 Faced with competition from kiosks and other mail based rental companies, improving broadband penetration, and increased customer acceptance of online video Netflix is gradually shifting its innovation focus from DVD by mail to growing its library

Anonymous. (2010, Jan 23). Netflix Announces Multiple Partners to Instantly Stream Movies and TV Episodes from Netflix to the TV [Electronic version]. Leisure & Travel Week, p. 34 7

8

http://www.inc.com/magazine/20071001/netflix-vs-blockbuster-what-would-you-do.html (July 4)

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of online movie offering and from a technology perspective, perfecting its online recommendation engine and expanding its presence across multiple platforms. Open Innovation Netflix

has

taken

an

open

innovation

approach

to

improving

its

recommendation technology and executing on its platform strategy to expand across multiple platforms.

In one of its most well known initiatives, Netflix

engaged the general public and open source community by offering $1 million to the person(s) who could “use Netflix movie-ratings data to build a recommendation engine 10% better than Netflix’s current tool” 9.

In another

example, open innovation supported its platform strategy as Netflix saw hundreds of new apps built when it opened up its API including apps to queue movies for a mobile phone. According to a November 2009 Forbes magazine article, the $1 million competition illustrated how Moore’s law may not be applicable to innovation in the software industry. As opposed to Moore’s law which states that hardware power will double within approximately two years, the author contends that the ‘Netflix law’ illustrated by this competition suggests that you will only realize a 2-3% improvement rate and only for a short period of time.10

In addition to cost and time savings, this example

Klaassen, Abbey. (2009) Brands get boost by opening up APIs to outside developers. [digital version] Advertising Age. 80 (40), 17 9

10

Gomes, Lee. (2009) Netflix’s Law: The Future of Software. [electronic version] Forbes Magazine

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highlights the rationale for Netflix utilizing an open approach to speed up innovation and the challenges in terms of making further improvements to its recommendation software given that it took approximately three years for a winning team to emerge. INVESTMENT PRIORITIES In terms of investment priorities, Netflix has applied significant resources in web based strategic technology assets (STAs) such as subscription account signup

and

management,

personalized

optimization and streaming software11.

movie

merchandising,

inventory

These investments were made to

optimize subscriber satisfaction and management of the company’s library of content by promoting the right movies to customers and ensuring correct inventory levels.

The other important STAs in which Netflix invests is in

technology to manage the processing and distribution of DVDs and streaming content, including third party delivery networks.12 SUMMARY Overall Netflix has made well timed adjustments in strategy according to both consumer behaviour readiness and technology maturity.

Its technology

strategy has supported its business strategy of consumer intimacy.

This

involves a well tuned DVD distribution system, excellent streaming technology

11

Netflix Annual Report (2009) Retrieved from www.netflix.com

12

IBID

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and effective recommendation engine. This “intimacy” is likely how Netflix will differentiate itself in the broader and to-be-hotly contested IDV industry. See Competitive Analysis on below.

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ENVIRONMENTAL ANALYSIS In what is expected to be a US$80 billion dollar business, the subscription segment of the IDV industry exhibits growing rivalry, the existence of many substitutes and the threat of powerful entrants. Table 1 summarizes the Five Forces analysis. Appendix B provides full details. FORCES ANALYSIS Force Competitors

Suppliers

Buyers

Substitutes

New Entrants

Strength Medium/High • Market rapidly growing. Estimated at US$13B by 2011 • Online based services lowers entrance costs High • Several distribution avenues • Threat of forward integration (i.e. providing Internet delivery services) • Flexibility in licensing content High • Demand < Supply • No switching costs Medium/High • IPTV, Download Services (e.g. iTunes) • Traditional Cable and Satellite TV Medium • Potential for M&A among Major Players • Strength could be high if content providers forward integrate Table 1: Forces Analysis Summary

The environmental analysis provided below examines the opportunities that can be exploited by Netflix to grow and strengthen its market position, and the regulatory issues that can weaken its competitive advantage.

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OPPORTUNITIES Game Consoles With a high speed connection, Netflix content can be streamed via a game console. There are over 60 million game consoles in the US13 ; representing a potential asset that Netflix can exploit to expand its customer base. In April 2010, the firm signed a contract with Nintendo whereby Netflix subscribers can stream video on the Wii at no additional cost. At the end of first quarter of 2009, 55% of Netflix subscribers had watched at least 15 minutes of streaming video; but this still accounts for only 30 percent of Netflix-enabled devices14. Mobile Devices As of June 2010, or 80 days after product launch, Apple has already sold 3 million iPads15 . Netflix has launched an iPad app that allows existing subscribers to stream for free. The increasing penetration and capabilities of smartphones and tablet devices will enhance the complementary asset base for Netflix and provide further incentive for the new customers to sign up and reduce churn when competition escalates. International Expansion

13NPD

sales figure analysis. Accessed from http://www.digital-digest.com/blog/DVDGuy/2010/07/02/game-consolesmay-2010-npd-sales-figure-analysis/ 14

http://www.zdnet.com/blog/btl/netflix-55-percent-of-subscribers-now-streaming-movies/33415

15

http://www.apple.com/pr/library/2010/06/22ipad.html

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Currently, Netflix streaming is available only in the United States. However, the increasing penetration of broadband connection especially in developed countries presents a significant opportunity for Netflix to expand its offering beyond the US. According to research by Morgan Stanley16 there are 124 million households in the top 10 countries that meet key criteria for Netflix such as broadband usage rate, GDP, and affinity for Western culture. By gradually expanding its services into these countries Netflix can further leverage its digital content library and build on its brand recognition in the US to become a firm with international scope and reach.

Naturally obtaining the content

licensing for new markets will be a separate challenge. LICENSING AND REGULATORY ISSUES Content Licensing New films are released by studios in a process called windowing whereby film is first released at different times in different distribution channels. Thus a new film is initially available only in theatres, then hospitality channels, followed by release on DVD, and then pay-per-view TV (See Figure A1 in Appendix A). As a result, streaming on Netflix and other players in the digital streaming is controlled through licensing by film studios.

16

Morgan Stanley (2010). NetFlix Inc. Accessed from http://research.thomsonib.com/gaportal/ga.asp

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For Netflix, only 25% of the content represents new releases17. However, with the focus of the company shifting to digital streaming, the company might have to rely more on library or older content. Netflix’s reliance on an older catalogue will be disadvantageous especially if its competitors obtain licensing deals that allow for better access to new content. Content access will be a key challenge going forward in light of a recent agreement Netflix has signed. Realizing that the firm needed to improve its relationship with movie studios to gain access to wider variety of new content, Netflix signed an agreement with Warner Brothers Home Entertainment whereby Netflix will not sell new releases until 28 days after they go on sale. In return, Netflix will be “able to extend the range of choices available to be streamed to [its] members”18. Net Neutrality and Managed Services In 2009, the Federal Communication Commission (FCC) introduced its proposed rule changes whereby certain “managed services” will be exempt from net neutrality rule. Managed services are those services for which network carriers can reserve certain bandwidth on priority basis so that network data is transferred more quickly. Since many of the US network carriers are affiliated with subscription TV or video content providers, these carriers might use managed services rules to reserve high bandwidth for their affiliated content providers. For example, Comcast (who recently acquired NBC) might provide 17

Cannaccord (2010).” Netflix”. Accessed form http://research.thomsonib.com/gaportal/ga.asp

18 CNET (2010). “netflix, warner 8301-31001_3-10426792-261.html

bros.

Rejigger

movie

renting”.

Accessed

form

http://news.cnet.com/

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priority access to bandwidth for its own content. Thus if subscription video streaming becomes part of managed services, then companies like Netflix which don’t have an affiliation with any network carrier may be at a competitive disadvantage.

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COMPETITIVE ANALYSIS When Netflix launched in 1998 it effectively disrupted the video store industry. In exchange for the delayed gratification of receiving a DVD by mail instead of heading to the store Netflix offered quick turnaround and no late fees. By 2007 the company soared to nearly a billion dollars in revenue. Naturally Blockbuster fought back toying with no-late-fee schemes and launching its own cheaper DVD mailing service (with the option of pick ups at one of its 5000 retail locations). Blockbuster’s resurgence seemed effective – for a while – as Netflix dropped prices to compete.

19

Today Blockbuster is flirting with bankruptcy; its

stock value has dropped 79% in 2010 to under 20 cents and is no longer listed on the New York Stock Exchange. As Blockbuster struggles to transform itself into a digital and mail-based operation; Netflix can by no means declare victory. Netflix’s move into the IDV business has multiplied its challenges and garnered it a new roster of wealthy and powerful competitors. COMPETITORS Outside of traditional video stores Netflix now competes with Kiosk/Vending Machine services, Television Stations, Cable/Distribution Service Providers and likely soon to be the content providers (primarily movie studios) themselves. Currently the market for Internet delivered video consists of three segments:

19

http://www.inc.com/magazine/20071001/netflix-vs-blockbuster-what-would-you-do.html

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video-on-demand (VOD), ad supported, and subscription. Table 2 details the key competitive firms and their positioning. Service Type/Area Key Firms K i o s k s / V e n d i n g • Redbox Machines Ad Supported Video • YouTube

• • Pay-Per-View

•

•

Positioning/Offering • Last-minute movie renter’s best friend • cheap • User loaded video (not professional) • Channels for professional / studio content • No movie distribution • Content from TV stations Hulu TV stations • 24 hours after air date • Deep Archives • Movies are downloaded. Purchased Apple content is owned, rented content expires after 24 hours • Amazon on Wide variety of content is available for Demand streaming

(Microsoft, Best Buy, Wal-mart)

Set-Top TV’s

Boxes

/• •

Traditional Cable • and Satellite • • Providers

Free (with “cable” subscription)

•

TiVo DVR’s

• • • • HBO Showtime • Roger’s on • Demand etc. R o g e r s ,• Comcast, T V Everywhere, etc.

Current content – immediately available HD video on large screens Partnerships with Amazon and Netflix HD video on large screens Large install base Complementary assets in online distribution of traditional content Existing subscribers have access to “home” channels on-line and on mobile devices

Table 2: Competitive Offerings

Competitive Factor: Access to Content The key competitive factor is access to content or the film release windows (See Figure A1 in Appendix A). This is the mechanism that rights holders use to lock Netflix

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in early profits from DVD releases (the most lucrative) and through other distribution channels over time. Blockbuster in business.

This factor alone may be enough to keep

Blockbuster is a place where consumers still

congregate to buy DVDs; and while rentals remain 75% of its business, sales of DVDs are far more profitable for studios. Studios earn up to $18 on each DVD sold compared to around $4 for a rental. In March 2010, Warner Bros. signed a deal permitting Blockbuster to rent DVDs online and through mail order the same day they are released for sale; Netflix and Redbox are held to 28 day wait period. Competitive Factor: Pricing / Ownership Model This primary delivery model is a streaming service (with no ownership) as employed by most firms.

The other, less prevalent, model is a purchase

download model primarily deployed by Apple iTunes and Blockbuster. Netflix’s “all you can eat” in a month model has brought it early success and has been acceptable by studios for the DVD-based product because Netflix purchases the DVD’s in cash up front. With the streaming model lucrative DVD sales are lost and Netflix (because of its market strength) becomes increasingly more of a threat than customer. Competitive Factor: Existing Business Cable companies, satellite providers and similar entities with established businesses and customer bases have both an advantage and disadvantage in Netflix

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the emerging IDV industry. The existing customer base gives the companies access to customers and eases the transition to complementary streaming services. However these businesses also have existing revenue streams and investments to protect. In the long term, IP based television and delivery may threaten margins and protected revenue made on its traditional business (e.g. hardware). Netflix, and the like, don’t have this conflict. NEW ENTRANTS Interestingly enough as online and on-demand video threatens to wither the high margin DVD business that studio the biggest threat from new entrants to Netflix are the studios themselves; should they choose to forward integrate – either directly or via exclusive partnership agreements. As will be discussed in the Industry Outlook section, the future success of the company will rely heavily upon its agreements with movie studios and what part the studios themselves want to play in the IDV value chain. As a whole the comparatively low margins IDV earns mitigates against aggressive entry from large players. NETFLIX POSITIONING Netflix augments, rather than replaces, the standard video or television package that consumers use. Its success is based on clearly defining where and how it competes: •

Segment. Netflix defines its segment as consumer-paid streaming subscription of movies and TV shows. Netflix

Appendices •

Content.

23

Focus on extensive catalogue of archived and relatively new

content. Other content (user-generated, news, sports, music videos, adult & instructional) is not in scope. Pay-per-View and DVD will likely always offer better content. •

Revenue Model.

Single, simple subscription based revenue model.

Difficult for existing providers to mimic because it cannibalizes existing revenue streams.

COMPETITIVE ADVANTAGE Netflix’s disruption of the traditional movie rental industry has not only garnered the company financial success but several assets that can be leveraged to also lead in the online streaming business. INTELLECTUAL PROPERTY Netflix use a combination of patent, trademark, copyright and trade secrets to protect its intellectual property both in the U.S. and abroad. The company uses patented in-house video streaming technology that uses an Adobe flash interface (in addition to standard protocols) to be compatible with the majority of desktop and mobile devices. In 20006 Netflix was granted a patent describing its mailing DVD rental business model20. Just hours after receiving the patent, Netflix filed a patent

http://patft.uspto.gov/netacgi/nph-Parser?Sect1=PTO2&Sect2=HITOFF&p=1&u=/netahtml/searchbool.html&r=1&f=G&l=50&co1=AND&d=ptxt&s1=netflix&OS=netflix&RS=netflix 20

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infringement lawsuit against Blockbuster seeking damages and the halting of their online rental operation.

The suit was settled in 2007 – with terms

undisclosed. Blockbuster did indicate that the settlement materially affected its ability compete. While patents are an important element of Netflix’s business, its operation is not materially dependent on any one or a combination of patents21 . COMPLEMENTARY ASSETS Installed Base Netflix’s published subscriber count increased from 1 million in 2002, to just under than 6 million at the end 2006, to 14 million by the spring of 2010 22. The company’s large install base and high level of customer satisfaction is arguably its most valuable complementary asset. Distribution When Netflix first launched the business didn't seem to require cutting-edge technical know-how. All the company needed to do is “stick discs in mailers and get those mailers to customers”23 . But keeping customer high did in fact require some heavyweight technology. Netflix has sped up mailing times by building a network of 15 distribution centers across the country. The objective has always been building enough centers so that most Netflix subscribers

21

Netflix company 2009 annual report < http://ir.netflix.com/secfiling.cfm?filingID=1193125-10-36181>

22

http://ir.netflix.com/

23

PC Magazine website 2003

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receive their movies within a day of shipping. The centers also give Netflix a competitive advantage over Wal-Mart and Blockbuster, each of which sends out discs from only one warehouse24. Customer Service Now that Netflix has settled into the leader in DVD rentals, they have decided to focus on another aspect of business, customer service. One might find this odd due to the fact they do not have a physical store and are online only business, but they have eliminated e-mail based customer service inquiries, thus forcing all complaints, questions, and suggestions to their call center. Unlike other companies where it sometimes feels impossible to locate a telephone number to contact customer service, they have made it very simple and easy to find on their main page. And unlike the increasing trend of many other companies, they have chosen not to outsource their call center. Their call center is located in Oregon and along with being local is open 24 hours a day. 25 License Agreements The company has license agreement with large content providers such as Warner Bros. and various studios and distributors granting Netflix the right to provide its subscribers with movies and TV shows on DVDs and Blue-ray discs. On the other hand, streaming content over the Internet involves the licensing of rights which are separate from and independent of the rights that the company

24

PC Magazine website 2003

25

Netflix, Victory for Voices Over Keystrokes http://www.socialtext.net/ism4300/index.cgi?netflix_strategic_advantage

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acquires when obtaining DVD content26 . Unlike DVD, streaming content is not subject to the First Sale Doctrine (Netflix’s right to do whatever it desires with a physical disc). As such, Netflix is completely dependent on the studios, content providers and distributor providing the company with additional licenses in order to access and stream content. Nonetheless, having strong relationship with those studios and content providers, Netflix is in a very strong position in to acquire the most popular movies and TV shows available for streaming over the net27. Netflix Ready Devices Roughly 50 percent of Netflix members are now instantly watching movies and TV episodes without commercial interruption, on computers, televisions, and via game consoles, Blu-ray disc players and other devices that have been on the market since 2008 28. The viewing experience is enabled by Netflix controlled software that can run on a variety of consumer electronics devices (“Netflix Ready Devices”). These Netflix Ready Devices currently include Blu-ray disc players manufactured by LG, Panasonic, Philips, Samsung, Sony and may more. Also customers can stream the content via Internet-connected TVs, digital video players and game consoles such as Xbox 360, Nintendo Wii, PlayStation 3. Even Home Theatre systems that are “Netflix Ready” enable users to have

26

Netflix company 2009 annual report < http://ir.netflix.com/secfiling.cfm?filingID=1193125-10-36181>

27

Netflix company 2009 annual report < http://ir.netflix.com/secfiling.cfm?filingID=1193125-10-36181>

28

http://blog.netflix.com/2010/03/friends-update.html

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access to the streaming content only if they have internet feed available

29 .

Thus, users do not need to acquire any hardware as long as they have one the mentioned devices. Netflix elegantly offers convenient and practicality for any type of customer who may be comfortable using only one of those devices.

29

http://www.netflix.com/NetflixReadyDevices

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INDUSTRY OUTLOOK The now infamous failure of the music industry to adapt to the digitization and online distribution of music – and eventual dominance of Apple’s iTunes has many in the movie business contemplating their future in light of the success of Netflix. The aforementioned “28 day agreement” that studios have negotiated with Netflix can only be interpreted as an offensive move to protect future revenues. While the measures that studios put in place to not commoditize its business is key to industry outlook, activity in other areas will also shape the outcome. STUDIO REVENUE Historically, studio revenue comes from the distribution of their movies through a chain of different channels and the importance and value of second rights (see Figure A2 in Appendix A) has grown over time to produce the kind of revenues and splits seen in Figure 4 below. Consequently studios will tread lightly in addressing IDV given the revenues other competing channels provide to the industry.

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Appendices

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Figure 4: US Movie Revenues (2009)

The movie industry has been wrestling with where online fits into the distribution window. Online could follow theatre releases, or alongside DVDs, or even after TV. With all traditional providers of services for each of these windows capable of offering online, many models are possible and have been tried. Placement is key to not only maximizing revenues from the new format but to minimizing losses from existing ones.30 For example VOD, with its payper-view model and revenue share for studios, makes a far more appealing proposition for studios than Netflix subscription model and therefore VOD services are getting access to movie releases earlier.  According to Telco 2.0, an initiative designed to catalyze change in the Telecoms-Media-Technology sector, “the problem for studios though is that once they release a film for rental, any purchaser of a licensed rental copy can rent it out for whatever price they choose and the same goes for online. Studios

30

Telco 2.0 http://www.telco2research.com/articles/AN_Netflix-v-Hollywood-telcos-help_Summary

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30

have no control over pricing, just license conditions, such as time, geography and revenue share.” 31 So what can studios do? Should they try and starve Netflix and the likes of content, compete directly with them by setting up their own online distribution channels? Needless to say the answers to these questions are of keen interest to Netflix.

31

Ibid

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31

RECOMMENDATIONS The biggest strategic challenge facing Netflix will be the content agreements put in place. They key for Netflix will be to reduce the “blackout period” from when they can release new titles. This is currently difficult given the desire for the studios to generate revenue from DVD and Blu-Ray disc media sales for several weeks before releasing their titles to Netflix.

However as Netflix’s

subscriber base expands as more customers are exposed to streaming media from an increasing amount of technology “touchpoints” (TVs, Blu-Ray Players, laptops, netbooks, tablets, etc), the pressure for the studios to fairly negotiate will mount.

Due to Netflix’s first mover advantage, library, user experience,

wide install base and existing relationships, Netflix is positioned well to maintain transition from gorilla status in DVDs to the same in the streaming. SHORT AND MEDIUM TERM RECOMMENDATIONS Focus on Negotiated Favourable Long Term Content Agreements •

Some acceptance of less desirable terms will likely be required. Because the content providers could start their own offerings and have several firms willing to take Netflix’s place, this will be a challenge. Acquisition or partnership with studios is an option if access to attractive content grows more difficult.

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Become Compatible with as Many Devices as Possible •

Large install base (e.g. Windows) can be an effective barrier to entry and spur retention

•

This does increase Netflix risk as it becomes more reliant on partners to deliver the Netflix experience. This can be a challenge and have brand image consequences if experience degrades.

Geographic Expansion •

Use current strength to move ahead in new markets leveraging existing model.

Building physical distribution in other markets may be cost

prohibitive – so focus should be on online streaming. Local partners (i.e. joint ventures) may be a route to market entry if regulations or other barriers prohibit expansion. Expand Complementary Assets •

Develop further features / reasons to make leaving Netflix for other service providers more challenging. Apple has accomplished this through proprietary file formats for its iPod, iPhone and iPad.

Netflix can

accomplish this through existing mechanisms like rental histories, reviews, recommendations – but may need something more compelling. Leverage DVD/Streaming Hybrid model in USA •

Mailing current comprise 25% of operating costs this is likely to increase as shipping fees get more expensive.

With margins on content Netflix

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squeezed, phasing out some distribution (perhaps in exchange for longer delivery times) may be necessary as more users get access to films via streaming. This will have to be timed properly. Speed of delivery is a differentiator for Netflix so changes should be considered carefully. Other competitors cannot imitate delivery efficiency – so Netflix should not exit the business too soon. LONG TERM RECOMMENDATIONS Key to long term growth when subscription growth flattens will be leveraging the installed based – both in terms of subscriber population and devices - to enter other business. This strategy may provide attractive growth prospects for Netflix.

Netflix’s core-competencies and complementary assets may provide

the path for extension into other physical / digital mediums that may work on a subscription basis; the most notable being video games, books and even music. THE BET In the 5 years heading into 2010 Netflix has experienced great growth with subscribers tripling, revenues up 20% on a compounded annual basis, profit 23% and a market cap of US$6.2 billion32 .

Even those that invested in the

company as recent as January 2010 would have doubled their money by July 2010. So what room is left future investors? Netflix’s prospects for growth are high for the following reasons:

32

On July 12, 2010

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They have not expanded geographically (Canada, Europe, Brazil, Russia, India, China)

•

Smartphone and tablet sales projected to increase as legitimate platforms for consumption of video

•

Mobile network speeds improving for mobile devices (4G networks, etc)

•

Increased number of Netflix-enabled devices being released by various device manufacturers

•

Entry into complementary business (books, video games) a possibility

Investment The recommendation is a “medium” size investment in Netflix with funds ideally distributed as depicted in Figure 5. Because of the high number of competing firms and potential content challenges in the IDV industry a “large” investment cannot be recommended.

Figure 5: Distribution of Investment Funds

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APPENDICES APPENDIX A: MOVIE RELEASES

Figure A1: Film Release Windows (Source: www.flatworldknowledge.com/pub/gallaugher/ 41141)

Figure A2: Film Release Model (Source: Telco 2.0)

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APPENDIX B: INDUSTRY

Figure B1: US Subscription Home Entertainment Market Size (Source: PWC 2009)

Porters – Video on Demand Buyer Power – In this case, the buyer would be the end-user utilizing the Netflix service (either the “DVD by Mail” model or “Streaming model”).

The

buyer does have a significant amount of power in this relationship, as there are many other digital alternatives for them to consume the same media that Netflix provides, meaning there are very low switching costs for the end consumer to try “other” DVD rental services (i.e. Blockbuster, or another streaming service, i.e. Blockbuster Online, Amazon Online, Vudu, etc). Threat of Substitutes – The threat of substitutes is increasingly growing, as more and more people are realizing the future of broadband media. While the Netflix

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“DVD by mail” business model that served as the foundation of Netflix in the early years slowly fades, Netflix has successfully transitioned into the streaming media model, and by doing so first has established a first-mover advantage that makes it difficult for pure substitutes to compete. Technically speaking, many substitutes exist to both their business models.

In Canada, Zip.ca

replicates Netflix’s “DVD by Mail” model to Canadian consumers. In terms of media streaming, many companies in the US are also offering streaming media services similar to Netflix, making anyone of them a substitute threat for Netflix. Supplier Power – In this case, the suppliers for Netflix would be the movie studios granting them the rights to stream their content via their service. Of course, there is the imminent fear from these studios that by providing their content to Netflix, they are cannibalizing their own DVD/Blu-Ray title sales through regular distribution channels. This would lead one to believe that the Hollywood studios do carry much of the power in this relationship, which is true to some extent. Don’t forget that the “DVD by Mail” business is profitable for the studios as well, so even while the model is transitioning, there are still positive relationships between Netflix and many of the Hollywood movie studios. Overall, this “upper hand” that the movie studios perceive to have is slowly eroding and shifting into the hands of Netflix for the following two reasons:

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1. Lessons learned from the “Apple iTunes model” – whether the studios like it or not, movie and television content is being consumed online in a big way, growing more and more as each day passes. Some could say that they days of fixed disc content like DVD, and even Blu-Ray are numbered. After seeing the challenges that their big music label neighbours fell victim to in the music industry, many Hollywood movie houses like Warner Brothers are much more willing to get ahead of this inevitable trend and work with Netflix on this streaming service. Just as iTunes proved to the world that there was a market for legally downloadable music for a fair price, Netflix seems to feel the same way for streaming TV & movie content, and so far their business growth is proving them right. 2. The Gorilla That is Netflix – At some point, even those movie studios that first resisted the “streaming” model cannot ignore the impact and power that Netflix has in the video streaming market. By the nature of sheer “industry peer pressure” combined with not wanting to be the few that have not joined Netflix’s streaming vision, the transition of “Buyer Power” is slowly but surely transitioning for the big movie studios and into the hands of Netflix as a pure result of their “Gorilla” status in the “DVD by mail” and “Streaming” markets. Threat of New Entrants – As the streaming video market heats up, it will inevitably draw a crowd of competitors.

The big competitors to date in the

streaming business have been Blockbuster, Vudu (which is now owned by WalMart), Cinema Now, Hulu and Hulu+, and Amazon.com.

While this list of

competitors is formidable in both brand reputation and size, none of the competitors combined end-user base matches the total number of end-users (12.3 million) that Netflix currently has on record. (Netflix, 2010). Netflix’s first move advantage, combined with their proprietary streaming technology, wide platform base, and user-friendly interface have all created a substantial competitive advantage that has served to suppress its nearest competitors..

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They currently offer over 15,000 titles for the rent-by-mail side of the business, and over 30,000 titles available for their streaming business.

APPENDIX C: COMPETITION

Figure C1: Video-on-demand Competitive Map (Source: Netflix 2.0, Slideshare)

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Figure C2: Video-on-demand Product Comparison (Source: Netflix 2.0, Slideshare)

Figure C3: Netflix video-on-demand offering (Source: Netflix 2.0, Slideshare)

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Figure C4: Product Portfolio / BCG Matrix (Source: Netflix 2.0, Slideshare)

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APPENDIX D: TECHNOLOGIES Technology Life Cycle Stage Notes Emerging/Pacing N/A • Streaming technology (e.g. codecs) Key • Recommendation and merchandising algorithms • Base High Speed Internet Table D1: Technology Life Cycle

Evolution and Adoption

Figure D1: Technology Evolution (“S” Curves”) and Adoption

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Figure D2: Netflix Product Evolution (“Bowling Alley”)

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