Netflix Case Study: David Becomes Goliath

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Last modified: Sept. 13, 2008

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INTRODUCTION
Entrepreneurs are supposed to want to go public. When a firm sells stock for the first time, the
company gains a ton of cash to fuel expansion and its founders get rich. Going public is the
dream in the back of the mind of every tech entrepreneur. But in 2007, Netflix founder and
CEO Reed Hastings told Fortune Magazine that if he could change one strategic decision, it
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would have been to delay the firms initial public stock offering (IPO) . If we had stayed
private for another two to four years, not as many people would have understood how big a
business this could be. Once Netflix was a public company, disclosure rules forced the firm to
reveal just how profitable the firm was. Unfortunately for Hastings, others got wind that Netflix
was on a money-minting growth tear, and these guys wanted in.
Hollywoods best couldnt have scripted a more menacing group of rivals for Hastings to face.
First in line with its own DVD-by-mail offering was Blockbuster, a name synonymous with
video rental. Some 40 million US families were already card-carrying Blockbuster customers,
and the firms efforts promised to link DVD-by-mail with the nations largest network of video
stores. Alongside them was Wal-Mart. Not just a big Fortune 500 company, the biggest.
Fortune 1. The largest firm in the United States ranked by sales. In Netflix, Hastings had built a
great firm, but lets face it, his was a dot-com, an internet pure-play without a storefront and with
an overall customer base that seemed microscopic compared to these behemoths.
Before all this, Netflix was feeling so confident that it had actually raised prices. Customers
loved the service, the company was dominating its niche, and it seemed like the firm could take
advantage of its position through a modest price hike, pull in more revenue, and use this to
improve and expand the business. But the firm was surprised by how quickly the newcomers
mimicked Netflix with cheaper rival efforts. This new competition forced Netflix to cut prices
even lower than they had been before the price increase. To keep pace, Netflix also upped
advertising at a time when online ad rates were increasing. Big competitors, a price war,
spending on the rise: how could Netflix possibly withstand this onslaught? Some Wall Street
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analysts had even taken to referring to Netflixs survival prospects as The Last Picture Show .
Fast forward a year later and Wal-Mart had cut and run, dumping their experiment in DVD-bymail. Blockbuster had been mortally wounded, hemorrhaging billions of dollars in a string of
quarterly losses. And Netflix? Not only had the firm held customers, it grew bigger, recording
record profits. The dot-com did it. Hastings, a man who prior to Netflix had already built and
sold one of the 50 largest public software firms in the US, had clearly established himself as one
of Americas most capable and innovative technology leaders. In fact, at roughly the same time
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Boyle, 2007
Conlin, 2007

Netflix Case

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that Blockbuster CEO John Antioco resigned, Reed Hastings accepted an appointment to the
Board of Directors of none other than the worlds largest software firm, Microsoft. Like the final
scene in so many movies where the heros face is splashed across the news, Time magazine
named Hastings as one of the 100 most influential global citizens.
WHY STUDY NETFLIX?
Studying Netflix gives us a chance to examine how technology helps firms craft and reinforce a
competitive advantage. Well pick apart the components of the firms strategy and learn how
technology played a starring role in placing the firm atop its industry. We also realize that while
Netflix emerged the victorious underdog at the end of the first show, there will be at least one
sequel, with the final scene yet to be determined. Well finish the case with a look at the very
significant challenges the firm faces as new technology continues to shift the competitive
landscape.
How Netflix Works

Reed Hastings, a former Peace Corp volunteer with a Masters in Computer Science, got the idea for Netflix
when he was late in returning the movie Apollo 13 to his local video store. The $40 late fee was enough to have
bought the disc outright with money left over. Hastings felt ripped off, and out of this initial outrage, Netflix was
born. The model the firm eventually settled on was a DVD-by-mail service that charged a flat-rate monthly
subscription
rather than a per-disc rental fee. Customers dont pay a cent in mailing expenses, and there are no late
fees.
Netflix offers nine different subscription plans, starting at less than $5. The most popular is a $16.99 option that
offers customers three movies at a time, and unlimited returns each month. Videos arrive in red Mylar envelopes.
After tearing off the cover to remove the DVD, customers reveal a pre-paid return address. When done watching
videos, consumers just slip the DVD back into the envelope, reseal it with a peel-back sticky-strip, and drop the
disc in the mail. Users make their video choices in their request queue at Netflix.com.
If a title isnt available, Netflix simply moves to the next title in the queue. Consumers use the website to rate
videos theyve seen, specify their movie preferences, get video recommendations, check out DVD details, and
even share their viewing habits and reviews. In 2007, the firm added a Watch Now button next to those videos
that could be automatically streamed to a PC. Any customer paying at least $8.99 for a DVD-by-mail subscription
plan can stream an unlimited number of videos each month at no extra cost.

TECH AND TIMING: CREATING KILLER ASSETS

Graphic from the NetFlix PR Kit, online at www.netflix.com

To understand Netflix strengths, its important to view the firm as its customers see it. And for
the most part, what they see they like a lot! Netflix customers are rabidly loyal and rave about
the service. The firm repeatedly ranks at the top of customer satisfaction surveys. Ratings
agency Forsee has, for seven times in a row, named Netflix the number one e-commerce site in
terms of customer satisfaction (placing it ahead of Apple and Amazon, among others). Netflix
has also been cited as the best at satisfying customers by Nielsen and FastCompany, and in
January 2007 the firm was named the Retail Innovator of the Year by the National Retail
Federation.
Building a great brand, especially one online, starts with offering exceptional value to the
customer. Dont confuse branding with advertising. During the dot-com era, firms thought
brands could be built through Super Bowl ads and expensive television promotion. Advertising
can build awareness, but brands are built through customer experience. This is a particularly
important lesson for online firms. Have a bad experience at a burger joint and you might avoid
that location, but try another of the firms outlets a few blocks away. Have a bad experience
online and youre turned off by the firms one and only virtual storefront. If you click over to an
online rival, the offending firm may have lost you forever. But if a firm can, through quality
experience, get you to stay, switching costs and data-driven value might keep you there for a
long, long time, even when new entrants try to court you away.
If brand is built through customer experience, consider what this means for the Netflix
subscriber. They expect the firm to offer a huge selection, to be able to find what they want, for
it to arrive on time, for all of this to occur with no-brainer ease-of-use and convenience, and at a
fair price. Technology drives all of these capabilities, so its at the center of brand building
efforts. Lets look at how the firm does it.
Selection: The Long Tail in Action
Customers have flocked to Netflix in part because of the firms staggering selection. A
traditional video store (and Blockbuster has some 7,800 of them) stocks roughly 3,000 DVD
titles on its shelves. For comparison, Netflix is able to offer its customers a selection of over
100,000 DVDs, and rising! At traditional brick and mortar retailers, shelf space is the biggest
constraint limiting a firms ability to offer customers what they want when they want it. Just
which films, documentaries, concerts, cartoons, TV shows, and other fare make it inside the four
walls of a Blockbuster store is dictated by what the average consumer is most likely to be
interested in. To put it simply, Blockbuster stocks blockbusters.
Finding the right product mix and store size can be tricky. Offer too many titles in a bigger
storefront and there may not be enough paying customers to justify stocking less popular titles
(remember, its not just the cost of the DVD firms also pay for the real-estate of a larger store,
the workers, the energy to power the facility, etc.). You get the picture theres a breakeven
point that is arrived at by considering the geographic constraint of the number of customers that
can reach a location, factored in with store size, store inventory, the payback from that inventory,
and the cost to own and operate the store. Anyone who has visited a video store only to find a
title out-of-stock has run up against the limits of the physical store model.

But many online businesses are able to run around these limits of geography and shelf space.
Internet firms that ship products can get away with having just a few highly-automated
warehouses, each stocking just about all the products in a particular category. And for firms that
distribute products digitally (think songs on iTunes), the efficiencies are even greater because
theres no warehouse or physical product at all (more on that later).
Offer a nearly limitless selection and something interesting happens: theres actually more money
to be made selling the obscure stuff than the hits. Music service Rhapsody makes more from
songs outside of the top 10,000 than it does from songs ranked 10,000 and above. At
Amazon.com, roughly 60 percent of books sold are titles that arent available in even the biggest
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Borders or Barnes & Noble Superstores . And at Netflix, over two-thirds of DVDs shipped are
from back-catalog titles, not new releases (Blockbuster outlets do about 70 percent of their
business in new releases). Consider that Netflix sends out 45,000 different titles each day. Thats
fifteen times the selection available at your average video store! Each quarter, roughly 95
percent of titles are viewed that means that every few weeks Netflix is able to find a customer
for nearly every DVD that has ever been commercially released.
This phenomenon whereby firms can make money by selling a near-limitless selection of lesspopular products is known as The Long Tail. The term was coined by Chris Anderson, an editor
at Wired magazine, who also wrote a best-selling business book by the same name. The tail
(see figure below) refers to the demand for less popular items that arent offered by traditional
brick and mortar shops. While most stores make money from the area under the curve from the
left axis to the dotted line, long tail firms can also sell the less popular stuff. Each item under the
right part of the curve may experience less demand than the most popular products, but someone
somewhere likely wants it. And as demonstrated from the examples above, the total demand for
the obscure stuff is often much larger than what can be sold through traditional stores alone.

The Long Tail

The long tail works because the cost of production and distribution drop to a point where it
becomes economically viable to offer a huge selection. For Netflix, the cost to stock and ship an
obscure foreign film is the same as sending out the latest Will Smith mega-hit. The long tail
gives the firm a selection advantage (read one based on scale), that traditional stores simply
cannot match.
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Anderson, 2004

For more evidence that there is demand for the obscure stuff, consider Bollywood cinema a
term referring to films produced in India. When ranked by the number of movies produced each
year, Bollywood is actually bigger than Hollywood, but in terms of U.S. demand, even the topgrossing Hindi film might open in only one or two American theaters, and few video stores carry
many Bollywood DVDs. Again, we see the limits that geography and shelf space impose on
traditional stores. As Anderson puts it, when it comes to traditional methods of distribution an
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audience too thinly spread is the same as no audience at all . While there are roughly 1.7
million South Asians living in the US, Bollywood fans are geographically disbursed, making it
difficult to offer content at a physical storefront. Fans of foreign films would often find the
biggest selection at an ethnic grocery store, but even then, that wouldnt be much. Enter Netflix.
The firm has found the U.S. fans of South Asian cinema, sending out roughly 100,000
Bollywood DVDs a month. As geographic constraints go away, untapped markets open up!
The power of Netflix can revive even well-regarded work by some of Hollywoods biggest
names. In between the Godfather and Godfather Part II, director Francis Ford Coppola made
The Conversation, a film starring Gene Hackman that, in 1975, was nominated for a Best
Picture Academy Award. Coppola has called The Conversation the finest film he has ever
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made , but it was headed for obscurity as the ever-growing pipeline of new releases pushed the
film off of video store shelves. Netflix was happy to pick up The Conversation and put it in the
long tail. Since then, the number of customers viewing the film has tripled, and on Netflix, this
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once under-appreciated gem became the 13 most watched film from its time period.
Netflix has used the long tail to its advantage, crafting a business model that creates close ties
with film studios. Studios love Netflix because they earn a percentage of the subscription
revenue for every disk sent out to a Netflix customer. In exchange, Netflix gets to buy the
studios DVDs at cost. The movie business is characterized by large fixed costs up front. Studio
marketing budgets are concentrated on films when they first appear in theaters, and when theyre
first offered on DVD. After that, studios are done promoting a film, focusing instead on its most
current titles. But Netflix is able to find an audience for a film without the studios spending a
dime on additional marketing. Since so many of the titles viewed on Netflix are in the long tail,
revenue sharing is all gravy for the studios additional income theyd otherwise likely never get.
Its a win-win for both ends of the supply chain. These supplier partnerships grant Netflix a sort
of soft bargaining power thats distinctly opposite the strong-arm price bullying that giants like
Wal-Mart are often accused of.
The VCR, the Real Killer App?
Netflixs coziness with movie studios is particularly noteworthy, given that the film industry has often viewed new
technologies with a suspicion bordering on paranoia. In one of the most notorious incidents, Jack Valenti, the
former head of the Motion Picture Association of American (MPAA) once lobbied the U.S. Congress to limit the
sale of home video recorders, claiming the VCR is to the American film producer and the American public as the
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Boston strangler is to the woman home alone . Not only was the statement over the top, Jack couldnt have
been more wrong. Revenue from the sale of VCR tapes would eventually surpass the take from theater boxoffices, and today, home video brings in about two times box office earnings.
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Anderson, 2004
Leonhardt, 2006
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Bates, 2007
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Cinematch: Technology Creates a Data Asset that Delivers Profits

Netflix proves theres both demand and money to be made from the vast back catalog of film and
TV show content. But for the model to work best, the firm needed to address the biggest
inefficiency in the movie industry audience finding, that is, matching content with customers.
To do this, Netflix leverages some of the industrys most sophisticated technology, a proprietary
recommendation system that the firm calls Cinematch.
Each time a customer visits Netflix after sending back a DVD, the service essentially asks so,
how did you like the movie? With a single click, each film can be rated on a scale of one to
five stars. If youre new to Netflix, the service can prompt you with a list of movies (or you can
search out and rate titles on your own). Love Rushmore but hate The Life Aquatic? Netflix
wants to know.
The magic of Cinematch happens not by offering a gross average user rating user tastes are too
varied and that datas too coarse to be of significant value. Instead, Cinematch develops a map
of user ratings and steers you toward titles preferred by people with tastes that are most like
yours. Techies and marketers call this trick collaborative filtering. The term refers to a
classification of software that monitors trends among customers and uses this data to personalize
an individual customers experience. Input from collaborative filtering software can be used to
customize the display of a web page for each user so that an individual is greeted only with those
items the software predicts theyll most likely be interested in. The kind of data mining done by
collaborative filtering isnt just used by Netflix, other sites use similar systems to recommend
music, books, even news stories. While other firms also employ collaborative filtering, Netflix
has been at this game for years, and is constantly tweaking its efforts. The results are considered
the industry gold standard.

Netflix Community Features

Collaborative filtering software is powerful stuff, but is it a source of competitive advantage?

Ultimately its just math. Difficult math, to be sure, but nothing prevents other firms from
working hard in the lab, running and refining tests, and coming up with software thats as good,
or perhaps one day even better than Netflixs offering. But what the software has done, coupled
with the time Netflix leveraged as the first mover in its field, is build an enormous data
advantage that is valuable, results-yielding, and impossible for rivals to match. Even if Netflix
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Graphic from NetFlix Analyst Day presentation May, 2008

gave Cinematch to its competitors, theyd be without the over-two-billion ratings that the firm
has amassed (according to the firm, users add about a million new ratings to the system each
day). More ratings make the system seem smarter, and with more info to go on, Cinematch can
make more accurate recommendations than rivals.
Evidence suggests that users trust and value Cinematch. Recommended titles make up over 60
percent of the content users place in their queues an astonishing penetration rate. Compare that
to how often youve received a great recommendation from the sullen teen behind the video store
counter. While data and algorithms improve the service and further strengthen the firms brand,
this data is also a switching cost. Drop Netflix for Blockbuster and the average user abandons
the 200-plus films theyve rated. Even if one is willing to invest the time in recreating their
ratings on Blockbusters site, the rival will still make less accurate recommendations because
there are fewer users and less data to narrow in on similarities across customers.
One way to see how strong these switching costs are is to examine Netflix churn rate. Churn is a
marketing term referring to the rate at which customers leave a product or service. A low churn
is usually key to profitability because it costs more to acquire a customer than to keep one. And
the longer a customer stays with the firm, the more profitable they become and the less likely
they are to leave. If customers werent completely satisfied with the Netflix experience, many
would be willing to churn out and experiment with rivals offering cheaper service. However, the
year after Blockbuster and Wal-Mart launched with copycat efforts, the rate at which customers
left Netflix actually fell below four percent, an all-time low. And the firms churn rates have
continued to fall over time. By mid 2008, rates for customers in Netflix most active regions of
the country were below three percent, meaning fewer than three in one hundred Netflix
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customers canceled their subscriptions each year . To get an idea of how enviable the Netflix
churn rates are, consider that in 2007 the mobile phone industry had a churn rate of 38.6%, while
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roughly one in four U.S. banking customers defected that year .
All of this impacts marketing costs, too. Happy customers refer friends (read free marketing
from a source consumers trust more than a TV commercial). 94 percent of Netflix subscribers
say they have recommended the service to someone else, and 71 percent of new subscribers say
an existing subscriber has encouraged them to sign up. Its no wonder subscriber acquisition
costs have been steadily falling, further contributing to the firms overall profitability.
The Netflix Prize
Netflix isnt content to stand still with its recommendation engine. Recognizing that there may be useful
expertise outside its Los Gatos, California headquarters, the firm launched a crowdsourcing effort known as The
Netflix Prize (for more on crowdsourcing, see Chapter 4, Web 2.0, Social Media and Peer Production).

Netflix Analyst Day, May 2008

GeoConnexion, 2008

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The NetFlix Prize Leaderboard

The goal was simple: Offer $1 million to the first group or individual who can improve Cinematchs ratings
accuracy by 10%. In order to give developers something to work with, the firm turned over a large ratings
database (with customer-identifying information masked, of course). The effort has attracted over 20,000 teams
from 170 countries. Not bad when you consider that $1 million would otherwise fund just four senior Silicon Valley
engineers for about a year. And the effort earned Netflix a huge amount of PR, as newspapers, magazines, and
bloggers chat up the effort. While Netflix gains access to any of the code submitted as part of the prize, it isnt
exclusive access. The Prize underscores the value of the data asset. Even if others incorporate the same
technology as Netflix, the firm still has user data (and attendant customer switching costs) that prevent rivals with
equal technology from posing any real threat. Results incorporating many innovations offered by contest
participants were scheduled for Fall 2008 incorporation into Cinematch.
Patron Saint of the Independent Film Crowd
Many critically acclaimed films that failed to be box-office hits have gained a second life on Netflix, netting
significant revenue for the studios, with no additional studio marketing. Babel, The Queen, and The Last King of
Scotland are among the films that failed to crack the top 20 in the box office, but ranked among the most
requested titles on Netflix during the year after their release. Netflix actually delivered more revenue to Fox from
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the Last King of Scotland than it did from the final X-Men film .
In the true spirit of the long tail, Netflix has begun acquiring small market titles for exclusive distribution. One of its
first efforts involved the Oscar-nominated PBS documentary, Daughters from Danang. PBS hadnt planned to
distribute the disc after the Academy Awards, it was simply too costly to justify producing a run of DVDs that
almost no retailer would carry. But in a deal with PBS, Netflix assumed all production costs in exchange for
exclusive distribution rights. For months after, the film repeatedly ranked in the Top 15 most requested titles in
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the Documentary category. Cost to PBS? $0 .
Netflix has since begun trawling film festivals for gems to add to its long tail. Eighty-five percent of films screened
at Sundance don't get distribution deals, so Netflix may be the only chance for budding directors to get their work
in front of a wider audience. Netflix even uses data mined from its Cinematch ratings and viewer request patterns
to determine what to pay for distribution rights. The offer price for Favela Rising, a documentary about Brazilian
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musicians, was determined after examining customer requests for documentaries and movies set in Brazil .

A Look at Operations
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Netflix Analyst Day, May 2008

Anderson, 2004.
13
Mullaney, 2006.
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Tech also lies at the heart of the warehouse operations that deliver customer satisfaction and
enhance brand value. As mentioned earlier, brand is built through customer experience, and a
critical component of customer experience is for subscribers to get their DVDs as quickly as
possible. In order to do this, Netflix has blanketed the country with a network of over 50 ultrahigh-tech distribution centers that collectively handle in excess of 1.8 million DVDs a day.
These distribution centers are purposely located within driving distance of 119 U.S. Postal
Service processing & distribution facilities.
By 4 a.m. each weekday, Netflix trucks collect the days DVD shipments from these U.S.P.S.
hubs and returns the discs to the nearest Netflix center. DVDs are fed into custom-built sorters
that handle disc volume on the way in and the way out. Most DVDs never hit the re-stocking
shelves - scanners pick out incoming titles that are destined for other users, placing these titles
into a sorted outbound pile with a new, appropriately addressed red envelope. Netflix not only
helps out the postal service by picking up and dropping off the DVDs at its hubs, it pre-sorts all
outgoing mail for faster delivery. This extra effort has a payoff Netflix gets the lowest possible
postal rates for first-class mail delivery.
First-class mail takes only one day to be delivered within a 50-mile radius, so the warehouse
network allows Netflix to service over 97 percent of its customer base within a two-day window
one day to get in, early the next morning to process the next item in their queue, with arrival of
that new title at the customers address by that afternoon. That means a customer with the firms
most popular three disk at a time plan could watch a movie a day and never be without a fresh
title.

A Proprietary Neflix Sorting Machine & USPS Hubs Serviced by the Netflix Distribution Center network

Warehouse processes dont exist in a vacuum; theyre linked to Cinematch to offer the firm
additional operational advantages. The software recommends movies that are likely to be in
stock so users aren't frustrated by a wait. If a customers local fulfillment center looks like it
wont have enough DVDs of a particular title to meet demand, Cinematch will recommend
another title that it should have in stock.

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Images from Netflix Analyst Day, May 2008

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Everyone on staff is expected to have an eye on improving the firms processes. Every
warehouse worker gets a free DVD player and Netflix subscription so that they understand the
service from the customers perspective, and can provide suggestions for improvement. Quality
management features are built into systems supporting nearly every process at the firm, allowing
Netflix to monitor and record the circumstances surrounding any failures. When an error occurs,
a tiger team of quality improvement personnel swoops in to figure out how to prevent any
problems from recurring. Each phone call is a cost, not a revenue enhancement, and each error
increases the chance that a dissatisfied customer will bolt for a rival.
By paying attention to process improvements, and designing technology to smooth operations,
Netflix has slashed the number of customer representatives even as subscriptions ballooned. In
the early days, when the firm had 115,000 customers, Netflix had 100 phone support reps. By
the time the customer base had grown thirty-fold, errors had been reduced to so that only 43 reps
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were needed . Even more impressive, because of the firms effective use of technology to drive
the firms operations, fulfillment costs as a percentage of revenue have actually dropped, even
though postal rates have increased and Netflix has cut prices.
KILLER ASSET RECAP: UNDERSTANDING SCALE
Netflix executives are quite frank that the technology and procedures that make up their model
can be copied, but they also realize the challenges that any copycat rival faces. Says the firms
VP of Operations Andy Rendich, Anyone can replicate the Netflix operations if they wish. Its
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not going to be easy. Its going to take a lot of time and a lot of money . While we referred to
Netflix as David to the Goliaths of Wal-Mart and Blockbuster, within the DVD-by-mail segment
Netflix is now the biggest player by far, and this size gives the firm significant scale advantages.
The yearly cost to run a Netflix-comparable nationwide delivery infrastructure is about $300
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million . Think about how this relates to economies of scale. In the previous chapter we said
that firms enjoy scale economies when they are able to leverage the cost of an investment across
increasing units of production. Even if rivals have identical infrastructures, the more profitable
firm will be the one with more customers (see figure below). And the firm with better scale
economies is in a position to lower prices, spend more on customer acquisition, new features, or
other efforts. Smaller rivals have an uphill fight, while established firms that try to challenge
Netflix with a copycat effort are in a position where theyre straddling markets, unable to gain
full efficiencies from their efforts.

Running a nationwide sales network costs an estimated $300 million a year. But Netflix has over 3.5 times
more subscribers than Blockbuster. Which firm has economies of scale?

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McGregor, 2005.
Netflix Analyst Day, 2008
17
Reda and Schulz, 2008
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For Blockbuster, the arrival of Netflix plays out like a horror film where theyre the victim. For
several years now, the in-store rental business has been a money loser. Things got worse when,
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in 2005, Netflix pressure forced Blockbuster to drop late fees, costing it about $400 million .
The Blockbuster store network once had the advantage of scale, but then its many locations were
seen as an inefficient and bloated liability. Between 2006 and 2007, the firm shuttered over 570
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stores . By 2008, Blockbuster had been in the red for ten of the prior eleven years. During a
three-year period that included the launch of its Total Access DVD-by-mail effort, Blockbuster
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lost over $4 billion . The firm tried to outspend Netflix on advertising, even running Super
Bowl ads for Total Access in 2007, but a money loser cant outspend its more profitable rival for
long, and it has since significantly cut back on promotion. Blockbuster also couldnt sustain
subscription rates below Netflixs, so it has given up its price advantage. In early 2008,
Blockbuster even pursued a merger with another struggling giant, Circuit City, a strategy that has
left industry experts scatching their heads. A Viacom executive said about the firm,
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"Blockbuster will certainly not survive and it will not be missed" . This has gotta hurt, given
that at one point, Viacom was once Blockbusters parent (the firm was spun off in 2004). No
love from Papa.
For Netflix, what delivered the triple scale advantage of the largest selection, the largest network
of distribution centers, and the largest customer base, plus the firms industry-leading strength in
brand and data assets? Moving first. Timing and technology dont always yield sustainable
competitive advantage, but in this case, Netflix leveraged both to craft what seems to be an
extraordinarily valuable pool of assets that continue to grow and strengthen over time. To be
certain, competing against a wounded giant like Blockbuster will remain difficult. The latter
firm has few options and may spend itself into oblivion, harming Netflix in its collapsing gasp.
And as well see in the next section, while technology shifts helped Netflix attack Blockbusters
once-dominant position, even newer technology shifts may threaten Netflix. As they like to say
in the mutual fund industry past results arent a guarantee of future returns.
FROM ATOMS TO BITS: OPPORTUNITY OR THREAT?
Nicholas Negroponte, the former head of MITs Media Lab, wrote an essay in 1995 on the shift
from atoms to bits. Negroponte pointed out that most media products are created as bits digital
files of ones and zeros that begin their life on a computer. Music, movies, books, and
newspapers are all created using digital technology. When we buy a CD, DVD, or even a dead
tree book or newspaper, were buying physical atoms that are simply a container for the bits that
were created in software a sound mixer, a video editor, or a word processor. The shift from
atoms to bits is realigning nearly every media industry. Newspapers struggle as readership
migrates online and once-lucrative classified ads and job listings shift to the bits-based
businesses of Craigslist and Monster.com. Apple dominates music sales, selling not a single
atom of physical CDs, while most of the atoms-selling record store chains of a decade ago are
bankrupt. Amazon has even begun delivering digital books, developing the Kindle digital reader.
Who needs to kill a tree, spill ink, fill a warehouse, and roll a gas-guzzling truck to get you a
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Mullaney, 2006
Farrell, 2007
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MacDonald, 2008
21
Epstein, 2006
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book? Kindle can slurp your purchases through the air and display them on a device lighter than
most college textbooks.
Video is already going digital, but Netflix, as its conceived today is focused on handling the
atoms of DVDs. The question is, will the atoms to bits shift crush Netflix and render it as
irrelevant as Hastings did Blockbuster? Or can Reed pull off yet another victory and recast his
firm for the day that DVDs disappear?
Concerns over the death of the DVD and the relentless arrival of new competitors are probably
the main cause for Netflixs stock volatility these past few years. Through 2008, the firms
growth, revenue, and profit graphs all go up and to the right, but the stock has experienced wild
swings as pundits have mostly guessed wrong about the firms imminent demise (one well22
known Silicon Valley venture capitalist even referred to the firm as an ice cube in the sun , a
statement Netflix countered with three years of record-breaking growth and profits). The troughs
on the Netflix stock graph have proven great investment opportunities for the savvy. NFLX was
up more than 70 percent in early 2008, a time when the sub-prime crisis hammered the major
exchanges. But even the most bullish investor knows theres no stopping the inevitable shift
from atoms to bits, and the firms share price swings continue. When the DVD dies, the hightech shipping and handling infrastructure that Netflix has relentlessly built will be rendered
worthless.
Reed Hastings clearly knows this, and he has a plan. We named the company Netflix for a
23
reason; we didn't name it DVDs-by-mail . But he also prepared the public for a first-cut service
that was something less than wed expect from the long-tail poster child. When speaking about
the launch of the firms Internet video streaming offering in January 2007, Hastings said it will
be underwhelming. The two biggest limitations of this initial service? As well see below, not
enough content, and figuring out how to squirt the bits to a television.
Access to Content
First the content. A year after the launch of Netflix streaming option (enabled via a Watch
Now button next to movies that can be viewed online), only 10,000 videos were offered, just 10
percent of the firms long tail. And not the best 10 percent. Why so few movies? Its not just
studio reluctance or fear of piracy. There are often complicated legal issues involved in securing
the digital distribution rights for all of the content that makes up a movie. Music, archival
footage, and performer rights may all hold up a title from being available under Watch Now.
The 2007 Writers Guild strike occurred largely due to negotiations over digital distribution,
showing just how troublesome these issues can be.
Add to that the exclusivity contracts negotiated by key channels, in particular, the pay television
networks. Film studios release their work in a system called windowing. Content is available
to a given distribution channel (in theaters, through hospitality channels like hotels and airlines,
on DVD, via pay-per-view, via pay cable, then broadcast commercial TV) for a specified time
window, usually under a different revenue model (ticket sales, disc sales, license fees for
22
23

Copeland, 2008
Boyle, 2007

broadcast). Pay television channels, in particular, have negotiated exclusive access to content as
they strive to differentiate themselves from one another. This means that even when a title
becomes available for streaming by Netflix, it may disappear when a pay TV window opens up.
If HBO, Showtime, or Starz has an exclusive for a film, its pulled from the Netflix streaming
service until the exclusive pay TV time window closes.
Add to all this the influence of the king of DVD sales, Wal-Mart. The firm accounts for about 40
percent of DVD sales a scale that delivers a lot of the bargaining power it has used to
encourage studios to hold content from competing windows or to limit offering titles at
24
competitive pricing during the peak new release DVD period . Taken together its clear that
shifting the long tail from atoms to bits will be significantly more difficult than buying DVDs
and stacking them in a remote warehouse.

Film Release Windows

But How Does It Get to the TV?

The other major problem lies in getting content to the place where most consumers want to
watch it the living room TV. Netflix Watch Now button first worked only on Windows PCs.
Although the service was introduced in January 2007, the months before were fueled with
speculation that the firm would partner with Tivo. Just one month later, Tivo announced its
partner Amazon.com. At that point Netflix found itself up against a host of rivals that all had a
path to the television: Apple had its own hardware solution in Apple TV (not to mention the iPod
and iPhone), the cable companies delivered OnDemand through their set-top boxes, and now
Amazon had Tivo.
The Netflix solution was to think beyond one hardware partner and recruit many. The firm has
developed a software platform and made this available to consumer electronic firms seeking to
build Netflix access into their devices. LG Electronics announced the first device at the 2008
Consumer Electronics Show. By mid-year there were four manufacturers committed to building
devices with Netflix streaming capability. These included Roku, a startup that offered a tiny box
for just $99.
While the first generation Roku device has received positive reviews, Netflix hopes access to its
service will eventually be built into all sorts of devices, including DVD players, televisions, and
24

Grover, 2006

game consoles. Netflix has already struck a deal to stream titles over XBox. But it may be the
switch to Blu-ray DVDs that offers the most promise. Blu-ray players are on the fast track to
commoditization. A host of vendors will offer boxes that do essentially the same thing. If
consumer electronics firms incorporate Netflix access into their players as a way to attract more
customers with an additional, differentiating feature, Hastings firm could end up with more
living-room access than either Amazon or Apple. There are 73 million households in US that
have a DVD player and an Internet connection. Should a large portion of these homes end up
with a Netflix-ready Blu-ray player, Hastings will have built himself an enviable base through
which to grow streaming video.
Whos going to win the race for delivering bits to the television is still very much an uncertain
bet. The models all vary significantly. Apples early efforts were limited, with the firm offering
only video purchases for Apple TV, but eventually moving to online rentals that can also play
on iPods. Movie studios are now all in Apples camp, although the firm did temporarily lose
NBCs television content in a dispute over pricing. Amazon and Microsoft also have online
rentals and purchase services, and can get their content to the television via Tivo and XBox,
respectively. Hulu, a joint venture backed by NBC, Fox, and other networks, is free, earning
money from ads that run like TV commercials. While Hulu has also received glowing reviews,
the venture has lagged in offering a method to get streaming content to the television. The
Netflix pioneered all you can eat subscription streaming. Anyone who has at least the $8.99
subscription plan can view an unlimited amount of video streams. Waiting in the wings are a
host of additional competitors, including Blockbusters MovieLink, a service it purchased in Fall
2007.
Another tricky part of this competition is that the Netflix return on investment for streaming isnt
yet clear. The company spent $40 million on streaming in 2007, has another $70 million
earmarked for 2008, but when the effort will be profitable is unknown. The extra spending
doesnt come at the best time. The switch to Blu-ray DVD means that Netflix will be forced into
the costly proposition of carrying two sets of video inventory standard and high-def. It may be
that direct profits arent the driver. Rather, the service may be a feature that attracts new
customers to the firm, and helps prevent subscriber flight to rival video-on-demand efforts. The
stealth arrival of a Netflix set-top box, in the form of upgraded Blu-ray DVD players, might open
even more customer acquisition opportunities to the firm. Bought a Blu-ray player? For just $9
bucks a month you can get a ticket to the all-you-can-eat Netflix buffet. And more customers
ready to watch content streamed by Netflix may prime the pump for studios to become more
aggressive in licensing more of their content. Many TV networks and movie studios are leery of
losing bargaining power to a dominant firm, having witnessed how Apple now dictates pricing
terms to music labels. The goodwill Netflix has earned over the years may pay off if it can
become the studios partner of first choice.
While one day the firm will lose the investment in its warehouse infrastructure, nearly all assets
has a limited lifespan. Thats why corporations depreciate assets, writing their value down over
time. The reality is that the shift from atoms to bits wont flick on like a light switch, it will be a
hybrid transition that takes place over several years. If the firm can grab long-tail content, grow
its customer base, and lock them in with the switching costs created by Cinematch (all big ifs),
it just might emerge as a key player in a bits-only world. And theres an upside to the model

when it shifts to streaming. Postage represents one-third of the firms expenses. At some point,
if postage goes away, Netflix may be in a position to offer even greater profits with its studio
suppliers. Is the hybrid strategy a dangerous straddling gambit or a clever ploy to remain
dominant? Netflix really doesnt have a choice, but to try. Hastings already has a long history as
one of the savviest strategic thinkers in tech. As the networks say, stay tuned!

About the Author:

John Gallaugher is a member of the Dept. of Information Systems in Boston College's Carroll
School of Management. Prof. Gallaugher teaches courses and conducts research at the
intersection of technology and strategy. He leads the School's TechTrek programs, co-leads the
Asian field study program, and has consulted to and taught executive seminars for several
organizations including Accenture, Alcoa, Brattle Group, ING Group, Patni Computer Systems,
Staples, State Street, and the U.S. Information Agency. Writings, podcasts, course material, and
research by Prof. Gallaugher can be found online at www.gallaugher.com.
This reading is available to faculty for non-commercial use. Enjoy! If you do use it, please send
an e-mail to [email protected]. More chapters and cases will follow in Professor
Gallaughers forthcoming book Information Systems: A Managers Guide to Harnessing
Technology, to published (in both free online and low-cost print version) by Flat World
Knowledge (FlatWorldKnowledge.com). Thanks!

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