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.) 2 netflix and qwikster 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.