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4.1 Introduction

Learning Objectives

  1. Understand the basics of the Netflix business model.
  2. Recognize the downside the firm may have experienced from an early IPO.
  3. Appreciate why other firms found Netflix’s market attractive, and why many analysts incorrectly suspected Netflix was doomed.

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 that if he could change one strategic decision, it would have been to delay the firm’s initial public stock offering (IPO)Also known as “going public.” The first time a firm sells stock to the public.: “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.”M. Boyle, “Questions for…Reed Hastings,” Fortune, May 23, 2007. Once Netflix was a public company, financial disclosure rules forced the firm to reveal that it was on a money-minting growth tear. Once the secret was out, rivals showed up.

Hollywood’s best couldn’t 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 U.S. families were already card-carrying Blockbuster customers, and the firm’s efforts promised to link DVD-by-mail with the nation’s largest network of video stores. Following close behind was Wal-Mart—not just a big Fortune 500 company but the largest firm in the United States ranked by sales. In Netflix, Hastings had built a great firm, but let’s face it, his was a dot-com, an Internet pure playA firm that focuses on a specific product, service, or business model. An Internet pure play is a firm that only operates through the Internet channel (i.e., with no physical stores or catalogs). 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 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 where 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 analysts had even taken to referring to Netflix’s survival prospects as “The Last Picture Show.”M. Conlin, “Netflix: Flex to the Max,” BusinessWeek, September 24, 2007.

Fast-forward a year later and Wal-Mart had cut and run, dumping their experiment in DVD-by-mail. 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 fifty largest public software firms in the United States, had clearly established himself as one of America’s most capable and innovative technology leaders. In fact, at roughly the same time that Blockbuster CEO John Antioco resigned, Reed Hastings accepted an appointment to the board of directors of none other than the world’s largest software firm, Microsoft. Like the final scene in so many movies where the hero’s face is splashed across the news, Time named Hastings one of the “100 most influential global citizens,” while Fortune magazine named him “Businessperson of the Year.”M. Copeland, “Businessperson of the Year,” Fortune, December 6, 2010.

Why Study Netflix?

Studying Netflix gives us a chance to examine how technology helps firms craft and reinforce a competitive advantage. We’ll pick apart the components of the firm’s DVD-by-mail strategy and learn how technology played a starring role in placing the firm atop its industry. In the second part of this case, we recognize 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. Act II looks at the very significant challenges the firm faces as its primary business shifts from competing in shipping the atoms of DVDs to one focused on sending bits over the Internet. We’ll see that a highly successful firm can still be challenged by technical shifts, giving us an oportunity to examine issues that include digital goods, licensing, platform competition, and supplier power.

How Netflix Works

Reed Hastings, a former Peace Corps volunteer with a master’s in computer science, got the idea for Netflix when he was late in returning the movie Apollo 13 to his local video store. The forty-dollar late fee was enough to have bought the video 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. Under this model, customers don’t pay a cent in mailing expenses, and there are no late fees. Videos arrive in red Mylar envelopes that are addressed and postage-paid for reuse in disc returns. 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 isn’t available, Netflix simply moves to the next title in the queue. Consumers use the Web site to rate videos they’ve seen, specify their viewing preferences, get video recommendations, check out title details, and even share their viewing habits and reviews.

This model helped Netflix grow into a giant, but technology continues to radically change the firm. Hastings knew that if his firm was successful it would one day transition from reliance on mailed DVDs and introduce streaming video. Says Hastings, “We named the company Netflix for a reason; we didn’t name it DVDs-by-mail.”M. Boyle, “Questions for…Reed Hastings,” Fortune, May 23, 2007. In 2007, the firm added a “Watch Now” button next to those videos that could be automatically streamed over the Internet. By 2011, the firm was so focused on streaming that the first page at Netflix.com didn’t even mention DVDs or discs (although disc plans remain quite popular).

Key Takeaways

  • Analysts and managers have struggled to realize that dot-com start-up Netflix could actually create sustainable competitive advantage, beating back challenges from Wal-Mart and Blockbuster, among others.
  • Data disclosure required by public companies may have attracted these larger rivals to the firm’s market.
  • Netflix operates via a DVD subscription and video streaming model. Although sometimes referred to as “rental,” the model is really a substitute good for conventional use-based media rental.

Questions and Exercises

  1. How does the Netflix business model work?
  2. Which firms are or have been Netflix’s most significant competitors? How do their financial results or performance of their efforts compare to Netflix’s efforts?
  3. What recent appointment did Reed Hastings accept in addition to his job as Netflix CEO? Why is this appointment potentially important for Netflix?
  4. Why did Wal-Mart and Blockbuster managers, as well as Wall Street analysts, underestimate Netflix? What issues might you advise analysts and managers to consider so that they avoid making these sorts of mistakes in the future?