yale case 12-019 august 15, 2012 Netflix and Qwikster
Would Success in DVDs Lead to Success in Streaming?
Sharon M. Oster1 M. Keith Chen2 Jean W. Rosenthal3
In 2011, Netflix announced changes that observers characterized as among the greatest missteps in the history of corporate strategy. First, the company significantly raised prices. Then, Reed Hastings, the founder and CEO of Netflix, described plans to split the company between streaming and disc rental, spinning off the DVD-rental business to a new entity called Qwikster. The outrage from customers and investors was extreme. Within two weeks, Hastings reversed the plan to split the company (though maintaining the price increases). During the debacle, Netflix lost 2 million subscribers and the stock dropped more than 75 percent in value.
Before his controversial move to split the company, Reed Hastings had built a reputation as a savvy businessman. He founded Netflix in 1998 as a DVD rental business, which allowed subscribers to order discs online and then receive and return the DVDs through the mail. By the end of 2010, Netflix had grown to 20 million subscribers, gained revenues of over $2.1 billion, and delivered net income of $160 million. The company had crushed its bricks and mortar competitors in DVD rental. Other competitors that had tried to mimic Netflix’s net and mail service had failed to find subscribers and had similarly fallen by the wayside.
In addition to its success with DVDs, Netflix had established a growing online video-on-demand service. Hastings believed internet streaming would be the future of content delivery and increasingly described Netflix as "a streaming company, which also offers DVD-by-mail." Many investors seemed convinced – by early July 2011 the stock price had reached $304, giving Netflix a market capitalization of over $16 billion.
But then came Hastings’s disastrous decision and its reversal. In the year since, Netflix had not managed to convince investors that it knew the way forward. Observers noted that the company was attempting to compete in two fundamentally different businesses with the same list of subscribers. While the company was the leader in the physical rental of DVDs, the streaming video space was becoming more crowded, and Netflix’s success hardly seemed assured. Could Hastings find some way to leverage success in one type of business to overcome the obstacles in another?
Building Success One Red Envelope at a Time
Reed Hastings changed the landscape of the video rental industry. His company, Netflix, became the darling of investors after it established itself as the leading disc rental company and had been among the first to get into online streaming video. Hastings was profiled on 60 Minutes and appeared on the cover of Fortune as the 2010 businessperson of the year.4
Hastings’s initial vision for Netflix had been simple. Subscribers paid a fixed monthly fee to receive a set number of DVDs, returning them and getting new titles as often as they wanted. When the subscriber returned one DVD, Netflix mailed out the next available title in the customer’s personal queue. There were no late fees and no limit to the number of rentals per month. Netflix optimized every aspect of its DVD operations. It designed its envelopes and located its 41warehouses to minimize postage and transit times. The facilities scanned an incoming DVD and mailed out the next title in the queue within a few hours, providing two-day turnaround for much of the country.
In addition to refining its operations, Netflix worked on a number of fronts to insure it had inventory to satisfy its subscribers. New releases were the bane of most DVD rental establishments, since customers wanted popular movies the week they were released to DVD. Working with the film studios, Netflix had worked out cost sharing for new releases so that it could stock the popular offerings at lower costs.
But far more important to Netflix’s efforts to manage demand was its maintenance of subscriber queues and its recommendations engine. The queue meant that customers maintained a list of movies they wanted to see rather than habitually reaching for whatever was on the new releases rack. The recommendations engine augmented the queue. The engine used customer ratings to suggest new titles for every subscriber’s queue. The company even sponsored an open contest to find the best collaborative filtering algorithm to predict customer preferences of these old movies. Recommendations moved subscribers to the backlist, "chasing the long tail of distribution," reducing the demand for popular recent releases and encouraging the rental of independent films and nostalgic television series. The company built an impressive backlist to supply this demand. By the end of 2010 Netflix had an inventory of over 100,000 DVD titles. (For more on the development of Netflix’s operations, see Yale Case 07-014, Netflix: Will Its Operations Model Be a Short Subject or a Long-Run Feature? February 2007.)
The popularity of Netflix subscription service decimated the once-thriving video rental store sector. In 1989, there had been 89,000 video rental stores in the U.S. By 2009, the number had dwindled to 14,000. Netflix killed off not only independent video stores but also substantial chains. The most prominent chain, Blockbuster, filed for bankruptcy in September 2010. (Barely avoiding liquidation, Blockbuster was purchased by Dish Network, a pay TV provider, in a spring 2011 auction. 5)
Many others tried to copy Netflix’s online and mail model, but failed. Blockbuster, Amazon, and Wal- Mart had all attempted to develop online DVD rental services, but none had matched Netflix’s strategic and operational success. All of these companies exited the business.
The one company that managed to compete with Netflix on DVD rentals was Redbox. In 2002, a division of McDonalds piloted automatic vending machines that provided the latest movie releases and video games. Later christened Redbox, each machine held around 600 DVDs, renting for a dollar a day. Coinstar purchased Redbox, and by 2011 it had 30,000-plus kiosks in place, many of them franchises, renting to 21 million customers. (Citing increased charges from content providers, Redbox raised the rental fees to $1.20 a day in October 2011.)6
Hastings assured investors in a 2009 Wall Street Journal article that Redbox was not a direct threat to Netflix, "because we’re a movie vertical and they’re a vending machine horizontal." Moreover, he emphasized that Netflix would not explore new ways to ship discs to compete with Redbox, but was focused on innovation in content delivery through streaming, and would succeed in that new arena as it had in DVD rental.7
Netflix Starts Streaming
Technologists had forecasted for years that video on demand over the internet was "just around the corner." By 2010, many believed that the U.S. had turned that corner. Sixty-eight percent of all American households had some form of broadband internet at home, though this access skewed toward higher income and urban households.8 (See Exhibit 1 for the breakdown of broadband access by technology.)
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Hastings saw online streaming as providing Netflix subscribers with access to content without the wait and the expense of sending a physical object through the mail. Netflix had begun its "over-the-top" streaming service in 2007, sending its videos over customers’ existing internet connections. The company launched its service with roughly 1,000 films available to subscribers after a one-time download of a Netflix app onto a Windows computer with high-speed internet access.
Netflix integrated its streaming listings into its DVD rental service. If a DVD in a subscriber's queue was also available online, it would be highlighted with a WATCH NOW button. The streaming content was available under Netflix monthly subscription fees, with no advertising. Netflix had initially limited video streaming time based on DVD rental subscription plans – one hour of monthly streaming video for every dollar of monthly subscription fees. In 2008, Netflix began offering unlimited access, and LG electronics announced a new set-top box connector, the beginning of access to the television set.
Netflix said it spent more than $40 million in 2007 to create its online service, with a major portion of the expense going to securing rights to video content. Although some studios were not willing to offer their products, Netflix had been able to negotiate arrangements with NBC Universal, Sony Pictures, Metro- Goldwyn-Mayer Inc., 20th Century Fox, Paramount Pictures, Warner Bros., Lionsgate, New Line Cinema, and a number of television studios. In 2008 Hastings announced a major coup as Netflix negotiated a fixed-price partnership with Starz, which brought 25,000 movies and TV shows to Netflix’s streaming service, including Disney and Sony films.
By 2008, several other companies were beginning to stream movies online, including Starz Entertainment's Vongo and the studio-owned MovieBeam, MovieLink and CinemaNow services.9 Apple offered movies through iTunes while Disney joined with NBCUniversal, News Corporation, and others to create Hulu to provide television content on computers. Hulu was free to users, with advertising support.
Even with many other options available, Netflix streaming continued to grow. By October 2010, Hastings noted:
We are very proud to announce that by every measure we are now a streaming company, which also offers DVD-by-mail. In Q4, we’ll spend more on streaming content than DVD content, and we’ll deliver many more hours of entertainment via streaming than on DVD. More impressively, a majority of our subscribers will watch more content streamed from Netflix than delivered by us on DVD. DVD-by-mail shipments are still growing, but streaming for us is much larger and growing much faster.10
At the beginning of 2011, Netflix had 28,000 titles available in streaming, 4,315 of them available in HD. At the same time, its DVD catalog counted 102,000 titles. In terms of streaming movies provided, Netflix moved past iTunes in streaming movies over the internet. One industry survey showed that Netflix was the source of 20 percent of all data flowing over the internet during prime time. 11 (See Exhibit 2 for Nielsen Data for various aspects of usage of online video in the U.S.)
In addition to providing customers with immediate access to content and avoiding postage charges, the streaming business allowed Netflix to expand internationally (its disc rental business had been optimized to fit the requirements of the U.S. postal system). The company began offering streaming services in Canada in September 2010 and was planning to enter South America and the Caribbean in July 2011.12
Netflix Valuation Surges
Success in DVD rental and growing internet video on demand service, not to mention the collapse of major brick-and-mortar competitors, helped Netflix's earnings reach $160 million for 2010, its second year of a nearly 40 percent increase in earnings. Netflix stock rose steeply and steadily. The price grew
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from around $30 per share at the end of 2008, to $55 in 2009 to $175 at the end of 2010. It then surged to nearly $300 a share by mid-2011, giving the company a market capitalization of $16 billion in July 2011.
Despite the market rise, there were questions about the valuation. For example, one investor, Whitney Tilson, wrote in December 2010 that his fund had shorted Netflix stock since mid-year and continued to do so, even though that strategy had led to significant losses. He described his assessment that Netflix was caught in a fundamental market shift:
We think the valuation is extreme and that the rapid shift of its customers to streaming content (vs. mailing DVDs to customers) isn't the beginning of an exciting, highly-profitable new world for Netflix, but rather the beginning of the end of its incredible run. In particular, we think margins will be severely compressed and growth will slow over the next year.13
Naysayers like Tilson believed that Netflix might still have its brand name and customer base, but as customers shifted to online content delivery it would face many threats to its margin. Netflix would be up against "some of the largest, most powerful, aggressive and deep-pocketed companies in the world."14
In response, Reed Hastings' acknowledged that Netflix faced risks, but argued that the company was well positioned. Netflix faced capital expenditures as it expanded into international markets, but the potential for growth justified the investment. He acknowledged that the company would face increased costs for content, but it could hold its margin by reducing content choices if necessary. He remained optimistic about the industry and Netflix's position:
Streaming is growing rapidly; it is propelling Hulu, YouTube, Netflix, and others to huge growth rates. Streaming adoption will likely follow the classic S curve, and we’re still on the first part (acceleration) of the S curve.15 The Short Unhappy Life of Qwikster
But in mid-2011, everything changed.
The problems began on July 12 when Jessie Becker, Netflix’s VP of Marketing, announced that the company was restructuring its pricing. Streaming would no longer be a free, unlimited add-on to subscriptions for DVD rental, but each service would require separate monthly charges. Customers who wanted to continue both mail rental of DVDs and internet streaming would need to subscribe to both plans. For some subscribers, this meant an increase in their monthly charges of 60 percent. Before the price increase, a customer could get one DVD at a time, unlimited service for $9.99 a month, with internet streaming at no extra charge. After September 1, 2011, the same service would cost $15.98. Customers who selected DVD rental only or online streaming only would pay $7.99, but there was no discount for combined service.16
Customers expressed their outrage in online comments and blogs, with nearly 13,000 comments directed to Netflix’s blog. Many canceled their subscriptions. Within a few days the stock began to slide, losing a third of its value in eight weeks.
Then on September 18, Netflix made a second change. Hastings announced that the company was spinning out the DVD rental service, completely separating DVD rental from streaming. It would keep sending DVDs by mail under a new name, Qwikster.com. Andy Rendich, former head of DVD rental at Netflix, would lead Qwikster. The Netflix name would be applied only to the newly independent streaming service. Customers seeking access to both DVD rentals and online streaming would have to maintain two accounts, with separate bills, separate queues, and separate recommendation lists.17
In addition to the blog posting, Netflix provided a short welcome video on YouTube featuring Hastings and Rendich sitting on a patio of the Netflix offices in Los Gatos, California. In both the video and the
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Netflix blog, Hastings apologized for the tone (but not the content) of the July price announcement. The blog entry began:
I messed up. I owe everyone an explanation…It is clear from the feedback over the past two months that many members felt we lacked respect and humility in the way we announced the separation of DVD and streaming, and the price changes. That was certainly not our intent, and I offer my sincere apology. I’ll try to explain how this happened.18
Hastings blamed the earlier uproar as a failure of communication. He explained that the price and service changes were necessary to help transition the company into streaming. Hastings argued that once customers understood the strategy, they would understand why the changes were necessary.19
The response to these announcements was immediate. Pundits ridiculed the Qwikster idea and logo. More than two million customers canceled their service. The announcement video became an object of ridicule and was even parodied by Saturday Night Live.20 Vanity Fair’s description was typical:
Accompanying this surprising announcement was a lame video of Hastings along with Andy Rendich – the presumptive new C.E.O. of Qwikster. Hastings was rocking the casual look in a Gap T-shirt underneath some sort of flimsy, ill-fitting teal work shirt. His Oakley sunglasses rested in front of him on his IBM ThinkPad. At one point, he flubbed a line and repeated it – a homey touch that remained in the video. He observed correctly on the Netflix Blog, "You’ll probably say we should avoid going into moviemaking after watching it."21
Then, on October 10, 2011, less than a month after its birth, Qwikster was gone. Hastings reversed the September changes, killing off Qwikster in a short post on the Netflix blog:
DVDs will be staying at netflix.com. It is clear that for many of our members two websites would make things more difficult, so we are going to keep Netflix as one place to go for streaming and DVDs.
This means no change: one website, one account, one password… in other words, no Qwikster.
While the July price change was necessary, we are now done with price changes… We value our members, and we are committed to making Netflix the best place to get movies & TV shows.
Thank you.
– Reed 22
A few observers praised him for being willing to abandon a bad idea, while most were simply bewildered. As one investor noted:
It is astonishing that a company that had done everything right for so long suddenly lost its way. There wasn't a change in leadership or any other perceptible cause that I could find. In light of the absence of a reasonable explanation I decided to consider the unreasonable and inexplicable: temporary insanity, alien abduction, conspiracy.23
Hastings described the missteps as a question of timing rather than strategy. In the announcement of the birth of Qwikster, Hastings had written, "Companies rarely die from moving too fast, and they frequently die from moving too slowly." In discussing the reversal, Hastings later said, "there is a difference between moving quickly – which Netflix has done very well for years – and moving too fast, which is what we did in this case."24
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Even though the price increases for combined service stayed in place and the company had made up for its loss of over two million unique domestic subscribers by the end of 2011, the policy reversal did not restore investor confidence. (A domestic customer who elected both a DVD and a streaming subscription plan was considered a single unique subscriber.) From its July 13, 2011 close at $298.73, the stock lost three- quarters of its value, dropping to near $70 by the end of 2011 and sliding to $56.85 by the end of July 2012. (See Exhibit 3 for a chart of Netflix stock prices, and Exhibit 4 for selected Netflix financial data.) Staying Afloat in the Streaming World
After the Qwikster debacle, investors seemed to awaken to Netflix’s precarious position in an increasingly crowded world of streaming content providers. Growing broadband access and rising consumer taste for video-on-demand had induced the entry of numerous players. Content developers were looking for ways to provide their material directly to customers as well as providing licenses to multiple content aggregators, including cable networks and other streaming sources. Cable providers, television networks, and premium movie channels like HBO were all developing their own streaming and on-demand services, particularly to reach mobile devices such as smart phones and tablets. Meanwhile, technology companies and telephone companies were readying their own offerings. By 2012, providers of streaming videos included:
Technology companies: Apple (iTunes); Google (YouTube).
Retailers: Amazon.com (Amazon Video on Demand available through Amazon Prime); Walmart (Vudu).
Content providers: Disney, NBC-Universal and News Corp. (Hulu and Hulu Plus); HBO (HBO Go).
Cable and Satellite Television companies: Time Warner Cable (On-Demand) Comcast (Xfinity, Comcast Anyplay for tablets) Dish Network (Blockbuster@home)
Telephone companies: ATT (U-verse Mobile and U-verse online) Verizon (FIOS)
Not only did these companies provide direct competition to Netflix for subscribers, many of the companies also provided crucial services that Netflix needed to stream video content to its subscribers. Particularly in the areas of securing and distributing content, Netflix often found itself relying on these alternative providers to license its content and reach its customers.
Securing Content
In 2012, Netflix’s inventory of titles for streaming remained smaller than its inventory of through-the- mail DVD titles. Nonetheless, the company announced that its streaming reached a billion hours per month, roughly 38 hours per streaming subscriber. Interestingly, Netflix's streaming customers increasingly were watching television shows rather than feature films.
Streaming avoided the costs of mailing and handling DVD discs, but usage charges were much higher. Unlike a DVD, which Netflix was free to rent out over and over once it purchased the disc, streaming
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required specific licensing, and fee structures varied dramatically. Some content owners charged Netflix a fee each time a video was watched, while others opted for a one-time charge per title. According to one industry observer, licensing costs could be as low as a few cents per play for older content and as high as $4.00 per play for recent movies.25 (See Exhibit 5 for Netflix’s description of its contractual obligations for streaming content, both on and off the books, and some public reporting of contracts and terms. See Exhibit 6 for a comparison of the contribution to margin from Netflix's streaming and DVD services.)
For content providers, revenue from streaming sources was an important and growing source of earnings. Licensing fees from streaming providers, like syndication charges, went directly to the developer's bottom line, since costs for movies or TV shows had already been spent. Besides increasing licensing fees, content developers were restricting access to popular offerings. Many television show developers gave licenses to stream past seasons, but retained the current season for their own distribution channels.
In the early days of streaming, Netflix was able to negotiate attractive rates from content providers. But even these deals contained restrictions. Under the Netflix 2008 contract with Starz, Sony had required a cap on the number of streaming subscribers. When Netflix's subscriber numbers reached that cap in June 2011, Sony's movies disappeared from the "Watch Now" catalog.
Many of the early contracts, including the Starz arrangement, expired in 2012 or soon thereafter. Analysts expected the studios to raise prices to Netflix and other streaming providers. One analyst predicted Netflix's streaming content licensing costs under the new contracts could rise as much as tenfold, from $180 million in 2010 to a whopping $1.98 billion in 2012. As a first portent, in September 2011 negotiations for a new contract with Starz collapsed, with Starz pulling its movies and TV shows from Netflix the following February. The Los Angeles Times reported that Starz had rejected a Netflix offer of more than $300 million per year, holding out for a premium tier with an additional fee for subscribers to see Starz content. In June 2012, Disney failed to reach terms with streaming and rental providers, leaving Netflix to buy DVDs of Disney movies at retail and entirely curtail streaming any Disney movies.26
As content providers restricted access and raised prices, Netflix decided to get into content production itself, by bankrolling a number of original series through guaranteed licensing fees. The first, Lilyhammer, told the story of a former American Mafia member who lived in the Norwegian city of Lillehammer when he entered the witness protection program. In early 2012 the series played first in Norway and then was available on Netflix streaming (but not through Netflix's DVD rental). All eight episodes of the first season were released at once, avoiding the typical one-show-a-week airing described by Netflix as "linear programming." Netflix considered the show a success and planned a second season (although filming was delayed while the star, Steven Van Zandt, was on tour with Bruce Springsteen and the E Street Band).27
Netflix then contracted with independent studio Media Rights Capital to create 26 episodes (two years) of House of Cards, a remake of a BBC political thriller, starring Kevin Spacey. Netflix committed $100 million to license the series, expected to be available in late 2012. The company partnered with Fox to develop a fourth season of Arrested Development, an American TV show which had aired on the Fox channel from 2003-2006. Finally, Netflix announced a series called Hemlock Grove, from horror director Eli Roth, for 2013.28
In its investor letter, Netflix set a standard of success for these original ventures, based on comparable purchased rights: "If Lilyhammer or House of Cards is popular enough on Netflix so that the fees we’ve paid for each are in-line with that of other equally-popular content on Netflix during the same time period, we’ll consider them a success."29
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Netflix also explored other ways of differentiating its content. In July 2011, the company created a "Just for Kids" catalog of streaming films and television programs suitable for children. The feature was made available over the Wii game system.
Distributing Content
Many subscribers were streaming videos to their computers or mobile devices, but Hastings knew he had to make it as easy for users to watch on their televisions as popping a DVD into a player. He negotiated Netflix-ready technology on connection devices such as Apple TV and Roku, and game console players such as the PS3, Xbox360, and the Wii. New Blu-Ray DVD players could transmit the Netflix stream to the television and even sported a Netflix button on the remote control. Some new HDTVs came "Netflix ready."30
But getting streaming content to home devices required considerable investment. Quality and bandwidth for delivering the signal were major issues for all streaming services. Streaming services did not yet provide the high-definition quality that customers received from their cable or satellite services, given the level of compression necessary to move content over the internet and particularly over "the last mile," the internet provider's connection into the consumer's household. Netflix had to find ways to reduce the amount of re-buffering, accelerate start-up, and deliver higher quality streams, with minimal signal breakup or interruptions.
Signal quality was in part a function of the bandwidth available to customers, and in part a function of the distance and number of connection points that the signal had to travel to get to the customer. To minimize the distance traveled and improve video quality, Netflix first contracted with a content delivery network (CDN) called Akamai, which had installed server boxes at internet service provider (ISP) locations at the "end of the internet." The Akamai system of over 100,000 service boxes in 75 countries put it "a single network hop away from 90% of internet users." 31
While initially purchasing services from Akamai and others, in the summer of 2012 Netflix began to disperse its internal capabilities to deliver video. Netflix set up servers in London, England, and six U.S. locations: Ashburn Virginia, Atlanta, Chicago, Los Angeles, Miami, New York, and San Jose. In addition to these regional hubs, it offered to install free "appliances" to local ISPs, recommending a cluster of Netflix Open Connect boxes for any metro network serving populations of 100,000 or more broadband subscribers, recommending one box for every 5 Gigabits per second of Netflix traffic. The local ISP had to provide only the space for the box, power, and one system port for the cable from each Open Connect box. Each Netflix box held 100 terabytes of data, enough to store 70 to 90 percent of the titles that customers would seek to stream. Netflix's algorithms updated the local boxes daily, refreshing the content using slower speeds during off-peak times, usually changing around 5 percent of the content daily to reflect national usage patterns. More obscure requests would still have to move over the internet, but the majority of the subscriber demand could be met by the local box.
Moving Netflix's movies storage closer to the customer would make the quality more reliable. Moreover, by making streaming content available locally, Netflix and the ISP could stream video for a much lower cost. Local service was essentially free for ISPs, but there were hefty congestion charges for moving content over the internet, particularly at peak times. By 2012 Netflix streaming had grown to 30 percent of US peak-time usage, and it expected to cut the streaming costs of a full-length movie from a nickel down to two-and-a-half cents. 32
But even with this substantial investment in infrastructure, Netflix’s access could be threatened if internet providers began to limit bandwidth or show preferences for their own channels.
For example, Comcast, a major cable provider that had merged with NBCUniversal in early 2011, had engaged the ire of Reed Hastings and Netflix. Part of the government approval for the Comcast- NBCUniversal merger required Comcast as an internet provider to maintain "net neutrality," treating all
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internet traffic equally. Net neutrality would in theory give over-the-top providers such as Netflix equal access to Comcast customers' internet bandwidth. However, in spring 2012 Netflix complained that its streaming subscribers were being subjected to Comcast’s customers' monthly data caps of 250 Gigabytes, while Comcast's Xfinity.tv streaming service for its own customers was not counted against the usage cap. For its part, Comcast argued that Xfinity.tv was actually part of its cable offerings and therefore appropriately not counted against the cap.33
Exploring another direction for improving picture quality and avoiding internet signal breakup, Hastings was reportedly in talks with cable networks (other than Comcast) to consider offering Netflix as a Video- on-Demand cable channel, directly competing with premium channels like HBO and Showtime.34
The Promise and Perils of the Streaming World
A Consumer Reports September 2012 survey of its readers suggested the promise and perils of the new streaming world for Netflix. As Hastings might have predicted, the survey revealed that twice as many Netflix customers had opted for streaming service as for DVD rental. The preference among Netflix subscribers was mirrored by Consumer Reports readers generally; more than half of over 15,000 subscribers had used a streaming video service within the previous month, more than the number that reported seeing a movie in theaters, on disc, or on cable video on demand channels.
The good news for Hastings was that of those who had used a streaming service, 81 percent had used Netflix. The bad news was that customers ranked Netflix in sixth place of the streaming services in terms of satisfaction. The company got high marks for convenience and price, but was down-rated for its limited content selection.
The survey also revealed that Netflix’s disc rental service remained the top-rated company for getting content on physical discs.35
The difference in Netflix’s standing in the survey outlined the dilemma facing Hastings. On one hand, he had the top-rated company in the declining market for DVD rentals. On the other hand, Netflix was struggling to find its niche in the rapidly expanding market for online streaming. In 2011, Hastings had believed the answer to this problem was to split the two businesses and invest heavily in the expanding market. When this organizational solution to the problem was widely rejected by customers and investors, Hastings nonetheless kept investing in Netflix’s streaming side of the business. But would this be enough? The competition in the online streaming marketplace was fierce and many of Netflix’s competitors held important assets that could prevent the company’s ability to expand its streaming services.
This case has been developed for pedagogical purposes. The case is not intended to furnish primary data, serve as an endorsement of the organization in question, or illustrate either effective or ineffective management techniques or strategies. Copyright 2012 © Yale University. All rights reserved. Reprinted with permission of Yale University School of Management. To order copies of this material or to receive permission to reprint any or all of this document, please contact the Yale SOM Case Study Research Team, 135 Prospect Street, PO Box 208200, New Haven, CT 06520. Email at [email protected].
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Endnotes
1 Frederic D. Wolfe Professor of Management and Entrepreneurship & Director of the Program on Social Enterprise, Yale School of Management. 2 Associate Professor of Economics, Yale School of Management. 3 Project Editor, Case Study Research and Development, Yale School of Management. 4 http://www.youtube.com/watch?v=K3GzO2_NFfQ&feature=player_embedded; http://tech.fortune.cnn.com/2010/11/18/reed-hastings-leader-of-the-pack/ 5 http://dealbook.nytimes.com/2011/04/06/dish-network-wins-blockbuster-bankruptcy-auction/ 6 http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/10/redbox-raises-rates.html; http://www.coinstarinc.com/company/history 7 Nick Wingfield, Netflix Boss Plots Life After the DVD, Wall Street Journal, June 23, 2009, http://online.wsj.com/article/SB124570665631638633.html# 8 http://www.ntia.doc.gov/report/2011/exploring-digital-nation-computer-and-internet-use-home 9 Gina Keating, “Netflix Launches 1,000-Title Online Movie Feature,” January 16, 2007, http://www.washingtonpost.com/wp-dyn/content/article/2007/01/16/AR2007011600621.html 10 http://gigaom.com/video/netflix-ceo-we-are-now-a-streaming-company/ 11 Sandvine study, plus Netflix fan blog FeedFlicks, as of Sept. 11 2011. 12 http://multivu.prnewswire.com/mnr/netflix/46101/ ; http://www.ft.com/intl/cms/s/0/5e4f39ca-a733-11e0- b6d4-00144feabdc0.html#axzz21fhLsip1 13 Whitney Tilson: Why We're Short Netflix: http://seekingalpha.com/article/242320-whitney-tilson-why-we-re- short-netflix [After Netflix’s stock dropped to $85 in April 2012, Tilson began buying the stock again: http://www.cnbc.com/id/47159729/ ] 14 Ibid. 15 "Netflix CEO Reed Hastings Responds to Whitney Tilson: Cover Your Short Position. Now." http://seekingalpha.com/article/242653-netflix-ceo-reed-hastings-responds-to-whitney-tilson-cover-your-short- position-now 16 http://screenrant.com/netflix-streaming-price-hike-details-benk-123247/ 17 Announced by Hastings on his official blog - http://blog.netflix.com/2011/09/explanation-and-some- reflections.html , along with a video explanation available on YouTube: http://www.youtube.com/watch?v=c8Tn8n5CIPk 18 http://blog.netflix.com/2011/09/explanation-and-some-reflections.html 19 Announced by Hastings on his official blog - http://blog.netflix.com/2011/09/explanation-and-some- reflections.html , along with a video explanation available on YouTube: http://www.youtube.com/watch?v=c8Tn8n5CIPk 20 The Netflix announcements were parodied in an inevitable set of video spoofs. Two memorable ones include “Qwikly Forgotten”: http://www.youtube.com/watch?v=qqyZOJc_kn0&feature=related and a Saturday Night Live skit that is available online, but was not aired on the show. See the skit through online streaming, directly from NBC: http://www.nbc.com/saturday-night-live/video/netflix-apology/1359563 or Hulu: http://www.hulu.com/watch/284938/ . 21 http://www.vanityfair.com/business/2012/02/netflix-201202. 22 http://blog.netflix.com/2011/10/dvds-will-be-staying-at-netflixcom.html
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23 Scott MacDonald, 2012, http://seekingalpha.com/article/637971-netflix-s-perfect-blunder 24 http://mediadecoder.blogs.nytimes.com/2011/10/10/netflix-abandons-plan-to-rent-dvds-on-qwikster/ 25 http://www.streamingmedia.com/Articles/Editorial/Featured-Articles/Stream-This!-Netflixs-Streaming-Costs- 65503.aspx 26 http://money.cnn.com/2011/07/08/technology/netflix_starz_contract/index.htm ; http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/11/starz-planning-new-digital-strategy-as-netflix- deal-ends.html and http://business.time.com/2012/06/11/why-disney-is-fighting-with-redbox-and-netflix-over-a- movie-no-one-wanted-to-see/ 27 Netflix, Investor Letter, Q4. 28 http://www.hollywoodreporter.com/news/netflix-house-cards-david-fincher-media-rights-capitol-297444 29 Netflix, Investor Letter, Q4. 30 http://www.macworld.com/article/1155624/netflix_hdtv.html 31 http://www.akamai.com/html/technology/index.html and http://tech.fortune.cnn.com/2010/11/04/netflix-will- ruin-the-internet/ 32 https://signup.netflix.com/openconnect/faq 33 http://venturebeat.com/2012/04/16/netflix-reed-hastings-vs-comcast/ 34 http://www.reuters.com/article/2012/03/07/us-netflix-cable-idUSTRE8251U520120307 35 "Video When You Want It," Consumer Reports, September 2012, pages 34-39.
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Exhibit 1: Household Internet Adoption by Type of Technology, 2010
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Exhibit 2: Nielsen Data for US Online Usage
A. Overall Online Video Usage (U.S.) June 11 June 10 Unique Viewers (000) 142,550 136,225 Total Streams (000) 14,469,232 10,207,980 Streams per Viewer 101.5 74.9 Time per Viewer (hh:mm) 4:30 3:15
B. Top Online Video Destinations by Unique Viewers (U.S.) (000)
Read as: During June 2011, 8.9 billion videos were streamed on YouTube via PCs/laptops from home and work locations
Video Brand June 2011 June 2010 YouTube 108,408 101,131 VEVO 36,029 * Facebook 25,332 26,651 Yahoo! 23,004 26,685 MSN/WindowsLive/Bing 15,152 15,926 The CollegeHumor Network 14,535 * Hulu 13,505 12,325 AOL Media Network 13,057 * Netflix 7,976 * CNN Digital Network 7,666 *
C. Top 10 Online Video Destinations by Total Streams (U.S.) (000)
Read as: During June 2011, 8.9 billion videos were streamed on YouTube via PCs/laptops from home and work locations
Video Brand June 2011 June 2010 YouTube 8,861,918 5,799,702 Hulu 630,208 598,812 VEVO 427,130 * MSN/WindowsLive/Bing 198,303 190,431 Netflix 192,335 * Dailymotion 183,030 * Yahoo! 176,923 184,516 AOL Media Network 125,437 * Facebook 118,633 123,603 Turner-SI Digital Network 116,126 128,322 * Not in top 10 in that survey
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D. Top 10 Online Video Brands Destinations by Time per Viewer (hh:mm)
Read as: During June 2011, Netflix video viewers spent an average of 8 hours, 34 minutes watching video content on Netflix using PCs/laptops from home and work locations
Video Brand June 2011 June 2010 Netflix 8:34 7:09 Hulu 3:42 3:31 Ustream.tv 2:41 * YouTube 2:37 1:45 Justin.tv 2:30 2:32 Megavideo 2:28 * Cwtv.com 1:35 * ABC Family 1:35 * Lifetime Digital 1:16 * CBS Sports 1:14 * * Not in top 10 in that survey
E. Television Distribution Sources - Number of Households (in 000’s)
Q4 11 Q4 10
Broadcast Only 11,043 11,147 Wired Cable 60,473 63,393 Telco 8,452 7,339 Satellite 34,553 34,273
F. Cable/Satellite with Internet Status - Number of Households (in 000’s)
Q4 11 Q4 10
Broadcast Only and Broadband 5,122 4,491 Broadcast Only and No Internet/Narrowband 5,911 6,130 Cable Plus and Broadband 79,238 78,525 Cable Plus and No Internet/Narrowband 22,381 25,610
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G. Comparison of Netflix and Hulu Users
Survey of 12,000 online interviews in March 2011, focusing on usage and attitudes for over-the-top video, particularly Netflix and Hulu, published July 27, 2011. http://blog.nielsen.com/nielsenwire/online_mobile/what- netflix-and-hulu-users-are-watching-and-how/
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Exhibit 3: Chart of Netflix Stock Closing Prices
Data Source: google.com; annotations added
Netflix's initial advertising shot for Qwikster
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NETFLIX, INC.
CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data)
As of December 31, 2011 2010 Assets Current assets: Cash and cash equivalents ...... $ 508,053 $194,499 Short-term investments ...... 289,758 155,888 Current content library, net ...... 919,709 181,006 Prepaid content ...... 56,007 62,217 Other current assets ...... 57,330 43,621 Total current assets ...... 1,830,857 637,231 Non-current content library, net ...... 1,046,934 180,973 Property and equipment, net ...... 136,353 128,570 Other non-current assets ...... 55,052 35,293 Total assets ...... $3,069,196 $982,067 Liabilities and Stockholders’ Equity Current liabilities: Content accounts payable ...... $ 924,706 $168,695 Other accounts payable ...... 87,860 54,129 Accrued expenses ...... 63,693 38,572 Deferred revenue ...... 148,796 127,183 Total current liabilities ...... 1,225,055 388,579 Long-term debt ...... 200,000 200,000 Long-term debt due to related party ...... 200,000 — Non-current content liabilities ...... 739,628 48,179 Other non-current liabilities ...... 61,703 55,145 Total liabilities ...... 2,426,386 691,903 Commitments and contingencies (Note 5) Stockholders’ equity: Preferred stock, $0.001 par value; 10,000,000 shares authorized at December 31, 2011 and 2010; no shares issued and outstanding at December 31, 2011 and 2010 ...... — — Common stock, $0.001 par value; 160,000,000 shares authorized at December 31, 2011 and 2010; 55,398,615 and 52,781,949 issued and outstanding at December 31, 2011 and 2010, respectively ...... 55 53 Additional paid-in capital ...... 219,119 51,622 Accumulated other comprehensive income ...... 706 750 Retained earnings ...... 422,930 237,739 Total stockholders’ equity ...... 642,810 290,164 Total liabilities and stockholders’ equity ...... $3,069,196 $982,067
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data)
Year ended December 31, 2011 2010 2009 Revenues ...... $3,204,577 $2,162,625 $1,670,269 Cost of revenues: Subscription ...... 1,789,596 1,154,109 909,461 Fulfillment expenses ...... 250,305 203,246 169,810 Total cost of revenues ...... 2,039,901 1,357,355 1,079,271 Gross profit ...... 1,164,676 805,270 590,998 Operating expenses: Marketing ...... 402,638 293,839 237,744 Technology and development ...... 259,033 163,329 114,542 General and administrative ...... 117,937 64,461 46,773 Legal settlement ...... 9,000 — — Total operating expenses ...... 788,608 521,629 399,059 Operating income ...... 376,068 283,641 191,939 Other income (expense): Interest expense ...... (20,025) (19,629) (6,475) Interest and other income ...... 3,479 3,684 6,728 Income before income taxes ...... 359,522 267,696 192,192 Provision for income taxes ...... 133,396 106,843 76,332 Net income ...... $ 226,126 $ 160,853 $ 115,860 Net income per share: Basic ...... $ 4.28 $ 3.06 $ 2.05 Diluted ...... $ 4.16 $ 2.96 $ 1.98 Weighted-average common shares outstanding: Basic ...... 52,847 52,529 56,560 Diluted ...... 54,369 54,304 58,416
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (in thousands, except share data)
Accumulated Additional Other Total Paid-in Treasury Comprehensive Retained Stockholders’ Common Stock Capital Stock Income Earnings Equity Shares Amount Balances as of December 31, 2008 ...... 58,862,478 $ 62 $ 338,577 $(100,020) $ 84 $ 108,452 $ 347,155 Net income ...... — — — — — 115,860 115,860 Unrealized gains on available-for-sale ...... securities, net of taxes ...... — — — — 189 — 189 Comprehensive income, net of taxes ...... — — — — — — 116,049 Issuance of common stock upon exercise of options ...... 1,724,110 1 29,508 — — — 29,509 Issuance of common stock under employee stock purchase plan ...... 224,799 — 5,765 — — — 5,765 Repurchases of common stock and retirement of outstanding treasury stock ...... (7,371,314) (10) (398,850) 100,020 — (25,495) (324,335) Stock-based compensation expense ...... — — 12,618 — — — 12,618 Excess stock option income tax benefits ...... — — 12,382 — — — 12,382
50 Balances as of December 31, 2009 ...... 53,440,073 $ 53 $ — $ — $273 $ 198,817 $ 199,143 Net income ...... — — — — — 160,853 160,853 Unrealized gains on available-for-sale securities, net of taxes ...... — — — — 477 — 477 Comprehensive income, net of taxes ...... — — — — — — 161,330 Issuance of common stock upon exercise of options ...... 1,902,073 2 47,080 — — — 47,082 Issuance of common stock under employee stock purchase plan ...... 46,112 — 2,694 — — — 2,694 Repurchases of common stock ...... (2,606,309) (2) (88,326) — — (121,931) (210,259) Stock-based compensation expense ...... — — 27,996 — — — 27,996 Excess stock option income tax benefits ...... — — 62,178 — — — 62,178 Balances as of December 31, 2010 ...... 52,781,949 $ 53 $ 51,622 $ — $750 $ 237,739 $ 290,164 Net income ...... — — — — — 226,126 226,126 Unrealized losses on available-for-sale securities, net of taxes ...... — — — — (68) — (68) Cumulative translation adjustment ...... 24 24 Comprehensive income, net of taxes ...... — — — — — — 226,082 Issuance of common stock upon exercise of options ...... 659,370 — 19,614 — — — 19,614 Issuance of common stock, net of costs ...... 2,857,143 3 199,483 — — — 199,486 Repurchases of common stock ...... (899,847) (1) (158,730) — — (40,935) (199,666) Stock-based compensation expense ...... — — 61,582 — — — 61,582 Excess stock option income tax benefits ...... — — 45,548 — — — 45,548 Balances as of December 31, 2011 ...... 55,398,615 $ 55 $ 219,119 $ — $706 $ 422,930 $ 642,810
See accompanying notes to consolidated financial statements. NETFLIX, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
Year Ended December 31, 2011 2010 2009 Cash flows from operating activities: Net income ...... $ 226,126 $ 160,853 $ 115,860 Adjustments to reconcile net income to net cash provided by operating activities: Additions to streaming content library ...... (2,320,732) (406,210) (64,217) Change in streaming content liabilities ...... 1,460,400 167,836 (4,014) Amortization of streaming content library ...... 699,128 158,100 48,192 Amortization of DVD content library ...... 96,744 142,496 171,298 Depreciation and amortization of property, equipment and intangibles ...... 43,747 38,099 38,044 Stock-based compensation expense ...... 61,582 27,996 12,618 Excess tax benefits from stock-based compensation ...... (45,784) (62,214) (12,683) Other non-cash items ...... (4,050) (9,128) (7,161) Deferred taxes ...... (18,597) (962) 6,328 Gain on sale of business ...... — — (1,783) Changes in operating assets and liabilities: ...... Prepaid content ...... 6,211 (35,476) (5,643) Other current assets ...... (4,775) (18,027) (5,358) Other accounts payable ...... 24,314 18,098 1,537 Accrued expenses ...... 68,902 67,209 13,169 Deferred revenue ...... 21,613 27,086 16,970 Other non- current assets and liabilities ...... 2,883 645 1,906 Net cash provided by operating activities ...... 317,712 276,401 325,063 Cash flows from investing activities: Acquisition of DVD content library ...... (85,154) (123,901) (193,044) Purchases of short-term investments ...... (223,750) (107,362) (228,000) Proceeds from sale of short-term investments ...... 50,993 120,857 166,706 Proceeds from maturities of short-term investments ...... 38,105 15,818 35,673 Purchases of property and equipment ...... (49,682) (33,837) (45,932) Proceeds from sale of business ...... — — 7,483 Other assets ...... 3,674 12,344 11,035 Net cash used in investing activities ...... (265,814) (116,081) (246,079) Cash flows from financing activities: Principal payments of lease financing obligations ...... (2,083) (1,776) (1,158) Proceeds from issuance of common stock upon exercise of options ..... 19,614 49,776 35,274 Proceeds from public offering of common stock, net of issuance costs . . . 199,947 — — Excess tax benefits from stock-based compensation ...... 45,784 62,214 12,683 Borrowings on line of credit, net of issuance costs ...... — — 18,978 Payments on line of credit ...... — — (20,000) Proceeds from issuance of debt, net of issuance costs ...... 198,060 — 193,917 Repurchases of common stock ...... (199,666) (210,259) (324,335) Net cash provided by (used in) financing activities ...... 261,656 (100,045) (84,641) Net increase (decrease) in cash and cash equivalents ...... 313,554 60,275 (5,657) Cash and cash equivalents, beginning of year ...... 194,499 134,224 139,881 Cash and cash equivalents, end of year ...... $ 508,053 $ 194,499 $ 134,224 Supplemental disclosure: Income taxes paid ...... $ 79,069 $ 56,218 $ 58,770 Interest paid ...... 19,395 20,101 3,878 See accompanying notes to consolidated financial statements.
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Exhibit 5: Netflix Statement on Obligations for Streaming Content
A. Contract Obligations for Streaming (Including amounts not on balance sheets) (See Exhibit 5c for explanatory note.)
December 31, of year: 2011 2010 2009
3,907 1,120 0 Timing of Dec 31, 2011 payments Less than one year $798 Due after one year and through 3 years 2,384 Due after 3 years and through 5 years 650 Due after 5 years 75 Total streaming content obligations $3,907
B. Selected Netflix Contracts for Streaming Rights for Movies and Television Shows, from News Reports
Term Dollar Value Date Content Creator Type (years) (millions)
2008 Starz Netflix replay 4 years $30 million/year
July 2010 Relativity Media and Rogue (rights to Netflix replay Not public $32 million /year stream films before they are available on premium channels)
August 2010 Epix (Movies from Paramount, Lionsgate, Netflix replay Not public Not public MGM) June 2011 Open Road Films Netflix replay Not public Not public (exclusive rights to streaming Killer Elite and The Host)
September 2011 Discover Netflix replay 2 years, w/ Not public (hits from channels like TLC and Animal option for a Planet, including "Say Yes to the Dress," third "River Monsters")
September 2011 Dreamworks Animation Netflix new unspecified $30 million/ (three new films, new TV specials, titles content picture from library [over time]) (replacing HBO) October 2011 Warner Bros/CBS Netflix replay 4 years lifetime contract (Gossip Girl, Vampire Diaries, One Tree value estimated at Hill, Star Trek, CSI Miami) $1 billion
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October 2011 Disney-ABC-TV Netflix & Not public Not public (Greek, Lost, Gray's anatomy, Phineas & Amazon Prime Ferb, Spider Man and X-Men Evolution replay
November 2011 Miramax Netflix replay Not public Not public UK and Ireland November 2011 Lilyhammer (8 episodes) Netflix first-run Not public Not public license November 2011 26 episodes (two full seasons) of "House Netflix first-run Not public $100 million of Cards," Media Rights Capital) license
July 2011 NBC Universal (Movies, "The Office," "30 Netflix replay Multiyear Rock," "Law and Order SVU")
February 2012 Starz contract ENDS, even with offer reported at $300 million ------February 2012 Weinstein Co. ("The Artist", other exclusive Multiyear Not public foreign-language films) Netflix streaming
March 2012 TED Talks Netflix replay Not public Not public
April 2012 "Arrested Development," Series 4 Netflix first-run Not public Not public license April 2012 Lionsgate, new series "Orange is the New Netflix first-run Not public Not public Black" license May 2012 13 episodes based on werewolf novel Netflix first-run Early 2013 Not public "Hemlock Grove" license
May 2012 Twentieth Century Fox (content for Latin Netflix replay Not public Not public American and Brazil)
August 2012 ESPN Films Netflix replay Not public Not public
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C. Statement from Netflix 2011 10-K on content liabilities
Content liabilities consisted of the following: ______2011 2010 ______
(In thousands) Streaming DVD, other Total Streaming DVD, other Total
Content accounts payable $905,792 $18,914 $924,706 $136,841 $31,854 $168,695 Non-current content liabilities 739,628 — 739,628 48,179 — 48, 179 ______Total content liabilities $1,645,420 $18,914 $1,664,334 $185,020 $31,854 $216,874
Streaming Content
The Company had $3.91 billion and $1.12 billion of obligations at December 31, 2011 and December 31, 2010, respectively, including agreements to acquire and license streaming content that represent long-term liabilities or that are not reflected on the Consolidated Balance Sheets because they do not meet content library asset recognition criteria. The license agreements do not meet content library asset recognition criteria because either the fee is not known or reasonably determinable for a specific title or it is known but the title is not yet available for streaming to subscribers. For those agreements with variable terms, the Company does not estimate what the total obligation may be beyond any minimum quantities and/or pricing as of the reporting date. For those agreements that include renewal provisions that are solely at the option of the content provider, the Company includes the commitments associated with the renewal period to the extent such commitments are fixed or a minimum amount is specified.
The expected timing of payments as of December 31, 2011 for these commitments is as follows:
(in thousands)
Less than one year ...... $ 797,649
Due after one year and through 3 years ...... 2,384,373
Due after 3 years and through 5 years ...... 650,480
Due after 5 years ...... 74,696
Total streaming content obligations ...... $ 3,907,198
The Company has entered into certain license agreements that include an unspecified or a maximum number of titles that the Company may or may not receive in the future and /or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether the Company will receive access to these titles or what the ultimate price per title will be. Accordingly, such amounts are not reflected in the commitments described above. However such amounts are expected to be significant and the expected timing of payments could range from less than one year to more than five years.
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In addition to the streaming content obligations above, the Company has licenses with certain performing rights organizations (“PRO”), and is currently involved in negotiations with other PROs, that hold certain rights to music used in connection with streaming content. For the latter, the Company accrues for estimated royalties that are due to PROs and adjusts these accruals based on any changes in estimates. While the Company anticipates finalizing these negotiations, the outcome of these negotiations is uncertain. Additionally, pending litigation between certain PROs and other third parties could impact the Company’s negotiations. If the Company is unable to reach mutually acceptable terms with the PROs, the Company could become involved in similar litigation. The results of any negotiation or litigation may be materially different from management’s estimates.
Source: Netflix 10K-June 2012, pages 62‐63.
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Exhibit 6: Contribution Margin from Streaming and DVD Services
Netflix Investor Letter Q4_2011.pdf
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