yale case 07-014 february 20, 2007 Netflix Will Its Operations Model Be a Short Subject or a Long-Run Feature? Jean W. Rosenthal1 Reed Hastings often told the story of his inspiration for Netflix: a $40 late fee from Blockbuster. He said, “It was all my fault. I didn’t want to tell my wife about it. And I said to myself, ‘I’m going to compromise the integrity of my marriage over a late fee?’”2 Still chagrinned over the late fee, Hastings, a dot-com multimillionaire, formed Netflix, a company that would rent DVDs through the mail for a monthly subscription price, with no postage charges or late fees. Hastings’s model for Netflix seemed simple enough. Netflix subscribers would create a wish list of DVDs on the company’s website, and Netflix would send a new title from the list when the previous rental was returned. Behind the simple model however, Netflix’s success had been built on attending to every detail of its operations and adapting to the company’s various constituencies. For subscribers, Netflix designed a recommendations engine that customers liked and that allowed Netflix to shift subscriber interest from new releases. By attending to United States Postal Service (USPS) processes, Netflix had located its 41 warehouses, created processing procedures, and even designed its envelope in such a way as to minimize both operating costs and turnaround times. By working with the film studios, Netflix had reached agreements through which it reduced its risk in holding large numbers of DVDs from new releases. The attention to detail paid off. Nine years after its April 1998 launch in the San Francisco Bay Area, Netflix generated net income of $49 million on revenues of $996.7 million. The firm boasted 6.3 million subscribers and carried an inventory of 70,000 titles on 42 million discs. Netflix’s website, in 2006, was rated the best website for retail satisfaction for the third year in a row.3 (See Exhibit 1 for Netflix financial data and stock prices.) In spite of the company’s operational success, Netflix faced two big challenges in 2007. First, in 2006 Blockbuster had made a major move into online rental. In Blockbuster’s new service, subscribers could bring mailers directly to a Blockbuster store and immediately rent a DVD, getting the instant gratification denied to Netflix subscribers. By January 2007, Blockbuster had grown its online business to two million customers. Second, a number of firms were beginning to offer video on demand (VoD). Netflix announced its own internet service in January 2007. The service complemented the existing subscriber service, generating no new fees. Netflix had budgeted $40 million to develop the system, but some analysts questioned whether that was sufficient to cover server data centers and licensing fees. Others argued that VoD would kill off the DVD rental business in general and that, for all its operational savvy, Netflix’s time had passed. Challenges to Operations: Netflix in January 2007 Netflix offered subscribers a choice of monthly subscription plans, with the most popular priced at $17.99/month for three movies out (at home or in transit) at one time, allowing as many movies as a subscriber wanted over the month. Netflix charged no late fees. (Indeed, the company’s business model depended on people holding onto DVDs.) Late fees were a strong initial point of differentiation from Blockbuster, whose in-store late fees (“extended viewing fees” in Blockbuster parlance) had been a primary source of Blockbuster customer complaints — and revenues — until Blockbuster began its new online service. To be able to make money on its customer service, Netflix had optimized their processes. Reed Hastings and his cofounders had come from dot-com companies and applied their knowledge of software and the internet to create Netflix’s operational strategy. They tailored their business to make the most of their relationships: adapting to studios as content suppliers to build inventory, adapting to customer interests to shift demand, and adapting to USPS procedures for quick and efficient delivery. But with challenges from Blockbuster and VoD to its core business, Netflix had to worry whether the procedures were sufficient, or whether Netflix would have to find further economies in order to survive. 70 Thousand Titles, 42 Million Discs The Netflix inventory did not include adult films or video games, but it had almost everything else. As Reed Hastings said in a December 2006 interview, “If it’s ever been put on DVD, chances are it’s in the warehouse.”4 (See Exhibit 2 for selected Netflix operational statistics.) When Netflix began in 1998, the average DVD player cost nearly $600, and DVD players were in fewer than 7 percent of homes with televisions, while videocassette recorders (VCRs) were in 86 percent of homes.5 In spite of the much larger market at the time for VHS videocassette tapes, Netflix rented only DVDs, because of the disc’s small size, inherent strength, and much lower mailing cost than a videocassette. (A DVD in a mailing envelope required only one first-class stamp.) As Hastings noted in an interview, “DVDs are very compact, so you don't have to have a big warehouse. You know, you can fit about 10,000 DVDs in the back of an SUV.”6 In its early years, Netflix did not buy advertising, but instead included free rental coupons in new DVD packaging. Hastings’ focus on DVDs foreshadowed market development. By 2006, more than 81 percent of homes had DVD players, while VCRs had fallen to 77 percent.7 As its list of available titles and its customer base grew, Netflix required more discs in inventory. By December 2006, Netflix offered more than 70,000 titles and had an inventory of 42 million discs. The discs were located in multiple centers, designed to provide most customers with a new title within one or two days of a return. Faster turnaround also made it possible for Netflix to control its inventory while satisfying its growing customer base. Incorporating the 100,000 new purchases that arrived every day into the Netflix’s inventory created its own operational challenges. In a 2005 interview, Tom Dillon, the company’s Chief Operating Officer and Chief Information Officer until his retirement in January 2006, described how Netflix had reduced labor costs related to receiving by 50 percent — and he was aiming for 75 percent. “When the company first started up, the receiving clerk would pick up a box from the pallet, find the paperwork, and match the box with the purchase order. Now the receiver just slaps a label and bar code on the box, and the system automatically matches the code with the purchase order.”8 2 NETFLIX Netflix distributed its inventory across 41 mailing centers, although a large portion, 26 million discs out of the 42 million total, were housed in its original center near San Jose, California.9 A 2002 article stated that Netflix’s satellite centers deliberately maintained “zero inventory.” It described the process in regional centers in 2002 as follows: Discs not mailed out (about 300 DVDs per day) are temporarily stored on a wire shelving unit. All the unshipped DVDs fit inside one cardboard container. At the end of every week, any unused inventory is shipped back to the main distribution center in San Jose for storage.”10 Netflix introduced software in January 2003 that dramatically reduced shelf time. As discs were returned by customers, many were matched to a customer request list and shipped back out the same day. Discs that were not matched for customer send-out that day were not sorted and shelved. Instead, they were tossed into bins to be rescanned the following day. If a disc remained in a regional center for more than a few days, it was returned to the California warehouse. With this software, Netflix reduced labor costs by about 15 percent, and the vast majority of discs never touched the shelf before they went out again. 11 Although Netflix had to grow its DVD library to deliver titles to subscribers with minimum delays, outside estimations of Netflix’s year-to-year inventory value were problematic, since Netflix changed its accounting methodology for valuing its DVD library several times. In its financial statements, Netflix showed its DVD library as a productive, non-current asset. In valuing inventory, Netflix considered the useful life (including utilization and loss and damage) of new release DVDs as one year, and back-catalog DVDs as three years.12 For DVDs that it had purchased directly and expected to sell, Netflix estimated a salvage value of $3.00. For DVDs obtained through revenue sharing agreements, after a fixed period, usually a year, the disc was either returned to the studio, destroyed, or purchased by Netflix.13 41 Distribution Centers, 1.6 Million DVDs a Day – One Disc at a Time From its inception, Netflix designed its service around post office procedures. By late 2006, Netflix was shipping more than 1.6 million DVDs a day, making it one of the post office’s top ten customers for first-class mail. The company made fast turnaround part of its brand identity, and saw delivery under three days as essential to retaining customers. It had located its mail centers so that, by 2006, close to 90 percent of the U.S. population — and 90 percent of Netflix’s customers — was within one-day delivery of its distribution centers, via first class mail. In January 2007, Netflix announced that it planned to reach 95 percent of customers with one-day service by the end of 2007, by adding nine additional mail centers and expanding its fleet of trucks to link those mail centers to an additional 50 regional post offices.14 Netflix had initially focused on the San Francisco Bay Area, and still enjoyed its greatest market penetration there, with 15 percent of households subscribing.