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Netflix, Inc.: Risks of a New Business Model

Introduction

On the morning of Monday, October 10, 2011, Reed Hastings, CEO and co-founder of Netflix, sat anxiously in front of his computer. He contemplated how to rectify some of the reputation and brand damage done to the video streaming and disc-by-mail subscription service company.

After mishandling communications regarding a price increase and a change in plan offerings, Hastings had seen his company’s stock price plummet more than 60 percent over the previous three months. Something had to be done.

The Communication Breakdown

The events leading up to the communication problem are as follows:

New Plans, New Prices

On July 12, 2011, Jesse Becker announced on Netflix’s company blog that the standard $9.991

fee for both streaming and disc-by-mail services would be splitting into two separate offerings: a streaming-only plan for $7.99 per month and a disc-by-mail plan, also for $7.99 per month. Customers who wished to retain both services would pay a combined $15.98, representing a price increase of nearly 60 percent over the current rate. Justification for the change arose out of financial necessity, as Becker stated, “Treating DVDs as a $2 add on to our unlimited streaming plan neither makes great financial sense nor satisfies people who just want DVDs.” These price changes were scheduled to take effect immediately for new members, and on September 1, 2011 for existing members.

T his case was prepared by Research Assistants D ouglas Allen and John V icente under the direction of James S.

O ’Rourke, T eaching Professor of M anagement, as the basis for class discussion rather than to illustrate either

effective or ineffective handling of an administrative situation. Information was gathered from corporate as well as

public sources.

Copyright © 2012. Eugene D . Fanning Center for B usiness Communication. All rights reserved. N o part of this

publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form by any

means – electronic, mechanical, photocopying, recording, or otherwise – without permission.

Additionally, Becker described the change as providing customers with additional choice when selecting a plan that best suits their needs, stating “Now we offer a choice . . . . We hope one, or both, of these plans makes sense for our members and their entertainment needs.”

Members React

On hearing news of the price increase, customers immediately took to social media outlets to vent their frustration over the move. Reactions from customers varied from annoyed indifference to outrage. A Facebook member vented his frustration on the blog site, saying “Becker’s presentation of the upcharge – as an added choice for my own benefit – insults my intelligence and reveals the breadth of your arrogance.” Another added, “Are you trying to lose market share?”

Netflix released its second quarter earnings report on July 25, 2011. In projecting the company’s financial performance for the third quarter, the report stated growth in new members was expected to fall dramatically specific to the increase in price. Netflix’s share price dropped 4 percent in the week following the announcement, from a high of $291.27 on the day of Becker’s blog post to $279.00. By late August, Netflix shares were down to nearly $205 per share.2

“An Explanation, and Some Reflection”

“I messed up. I owe everyone an explanation,” reported Hastings from the Netflix company blog3

more than two months after the original price announcement. It was the morning of September 18, 2011, “I slid into arrogance based upon past success” Hastings continued.

Hastings quickly shifted focus of his message onto future strategy, as Netflix would be splitting into two separate companies: Netflix would provide streaming video content, while all disc-by-mail operations would be handled by a new company, Qwikster. Andy Rendich, the head of Netflix’s disc-by-mail operations, would serve as the new chief executive of Qwikster. Hastings attributed the differing natures of the two businesses as the cause for the split, stating the two services were “two quite different businesses, with very different cost structures, different benefits that need to be marketed differently.” While Qwikster would also begin offering video games by mail, customers would be required to maintain two different accounts across the two websites. Hastings declared that the previously announced price increase would remain in effect.

Hastings concurrently posted a video to YouTube of himself and Rendich apologizing for4

the July announcement and also explaining the split of the two firms. The blog and subsequent video did little to quell the growing customer disapproval. The popular sketch comedy program Saturday Night Live parodied the executives’ video, poking fun at the overtly casual nature of both Hastings and Rendich and the confusing name associated with Netflix’s new strategic divestiture. 5

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Investors React

Netflix’s share price plummeted in the week following the Qwikster announcement, shaving off 20 percent of value in a matter of days (see Figure 1: Netflix Daily Adjusted Close Price). Share price would continue to fall to close to $100 per share.

Figure 1 - Netflix Daily Adjusted Close Price

Source: Y ahoo! Finance

Consumers reacted in a similarly negative fashion. Social media analytical firm Netbase reported a substantial drop in net sentiment (in other words, positive comments less negative comments) across popular social media platforms. In particular, the ratio of positive comments6

to negative comments about Netflix prior to the July 12 price increase was 3.57-to-1 across social media platforms. After the announcement, the ratio dropped to 1.85-to-1.

Reed Hastings

Born in Boston, Massachusetts, Hastings served two years in the Peace Corps before earning a masters degree in computer science from Stanford University. Upon graduating, he took a7

position with Adaptive Technology developing software. In discussing his time at Adaptive Technology, Hastings has said “I learned the value of focus. I learned it is better to do one product well than two products in a mediocre way.”

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Hastings left Adaptive in 1991 to begin Pure Software, a software troubleshooting company. After guiding Pure through its initial public offering in 1995 and a merger in 1997, Hastings took his fortune and left Pure two years later.

Netflix History

Netflix was formed in 1998 by Reed Hastings and Marc Randolph. Hastings developed the idea of disc-by-mail service after incurring a $40 late fee for a VHS movie rental of Apollo 13. In 1998, Netflix began offering disc-by-mail rental services for $4 per rental plus a postage fee. In 1999, Netflix’s revenue model changed from a per-rental charge to a flat monthly subscription model which included all shipping fees and no late charges.

Hastings took Netflix public in 2002, raising $85 million. Netflix posted their first profit in 2003, experiencing a meteoric rise in total subscriptions and revenues since (see Figure 2: Netflix Annual Revenues, Figure 3: Total Subscribers).

Figure 2 - Netflix Annual Revenues

Source: N etflix A nnual R eports (2002 through 2010)

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Figure 3 - Netflix Total Subscribers

Source: N etflix A nnual R eports (2002 through 2010)

In 2008, Netflix began offering most subscribers unlimited video streaming for a limited library of content. Netflix continued to add subscribers and total revenues through 2010, at which time their largest competitive rivals, Blockbuster and Movie Gallery, were forced into bankruptcy. Subsequently, Netflix was forced to renegotiate many of its streaming licensing agreements with content providers who wanted to be paid more money.8

Home Movie Rental History

The birth of the home movie rental industry began in the mid 1970’s, when the first video cassette recorder (VCR) began selling at retail stores. Sony Corporation introduced the Betamax format VCR in 1975; a VCR and 19-inch television set then retailed for $2,495. During October, 1977, RCA began to sell a VCR based on JVC’s “vertical helical scan” (VHS) format; RCA’s VCR retailed for $1,000. The following month Magnetic Video negotiated terms with Twentieth Century-Fox Productions to acquire licensing rights to directly sell fifty movie and television show titles directly to customers. Magnetic Video offered these releases in both the Betamax and VHS formats.

In December of 1977, George Atkinson opened a 600-square foot video rental store called Video Cassette Rentals in Los Angeles. In exchange for an annual $50 membership fee, customers had the ability to rent movies for $10 per day. After expanding to 42 stores in less than 20 months, Atkinson formally changed his firm’s name to The Video Station. Shortly after, Columbia Pictures decided to make twenty films from their catalog available for the home video market and retailer Fotomat began selling videocassette rentals at their 3,700 retail outlets. The Walt Disney Company also helped popularize the industry by entering the market with an authorized rental agreement proposal to retailers. Paramount Home Entertainment next offered the first major theatrical title priced for sale directly to consumers.

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During 1985, the home video business started to gain mainstream traction. Video Station had grown to 500 stores when a major rival opened its first store. Blockbuster Video was founded by David Cook in October of that year. Movie Gallery opened almost simultaneously in Dothan, Alabama. Within ten years of the first Betamax, the VCR had penetrated 30 percent of all U.S. households. In 1986, combined video rentals eclipsed receipts of theatrical box offices for the first time. Blockbuster Video’s majority interest was purchased by Wayne Huizenga in 1987, when Blockbuster had only nineteen retail stores. From 1987 through 1989, Blockbuster passed the 1,000-store mark. VHS became the dominant format over the next few years and Betamax was eventually discontinued by Sony Corporation.

In March of 1997, the DVD format was first introduced to the United States. The first titles included The Mask and Twister. The DVD player became one of the most adopted consumer electronic devices in history. With the invention and popularization of the World Wide Web, the video industry would soon begin to shift from retail stores to disc-by-mail, kiosk rentals, and streaming services.

Opportunities for Streaming Video

Streaming video is a technology which permits viewing video over the Internet, using industry standard TCP/IP protocols. Streaming media differs from other file downloads. A typical file cannot be opened and viewed until a full, compete copy is transmitted through the Internet in small data packets and reassembled on the client’s computer. After all data packets have non- sequentially arrived at a client computer, the file is reconstructed in proper order. The complete reassembly of the file is required before any portion of the file is usable by a user. Streaming media differs in that this format allows for partial downloads to be made and then made available to be consumed immediately. Streaming video formats made it feasible to watch a video file on demand without significantly long download times.

Since 2008, when Netflix began offering video streaming to the majority of its customers, the use of streaming video had steadily risen to the point that it consumed a large portion of all available bandwidth. By May 2011, streaming video accounted for 22 percent of all North American Internet traffic.9

Video Protection and Privacy Act

The Video Protection and Privacy Act (VPPA) was signed into law in 1998 by President Ronald Reagan. During Supreme Court Justice Nominee Robert Bork’s 1987 confirmation, his video rental history was leaked to the press. While his rental history appeared to be a non-factor in his nomination failure, it raised concerns over citizens’ rights to privacy. The law prohibits any “wrongful disclosure of video tape rental or sale records [or similar audio visual materials, to cover items such as video games and the future DVD format].” As a result of the VPPA,10

organizations such as Blockbuster were prohibited from sharing information about their customers’ purchasing and renting histories.

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The New Faces of Competition

In 1998 when Netflix was formed, their main competition was from brick-and-mortar video rental stores, primarily Hollywood Video, Movie Gallery, and Blockbuster Video. McDonald’s Corporation also identified the success of DVD rentals and created a venture called RedBox. RedBox was a kiosk style video rental business that successfully located kiosks at major foot traffic areas such as McDonald’s, Walmart, and retail grocery stores.

As the brick-and-mortar video rental stores began disappearing across the country, new competitors emerged:

• Cable providers, such as Comcast • Content providers, such as HBO and Cinemax • Cellular service providers, such as Verizon • Social media providers, such as FaceBook • Other streaming video providers, such as YouTube and Hulu

Many content providers began demanding a share of the profits Netflix was harvesting from their content libraries. Netflix was forced to enter into negotiations over some of their most popular content, including Starz! original programming. CNN reported in July 2011 that Netflix content costs would rise from $180 million in 2010, to $1.98 billion in 2012. Reed Hastings11

specifically singled out HBO’s “HBO Go” service as their largest potential rival.

Core Competencies

Ten years into its existence, Netflix began to diversify its core offering by introducing streaming video services to subscribers. Netflix’s subscriber count jumped from 9.4 million users in 2008 to more than 20 million users by 2010. During this time, revenues also increased from $1.36 billion to $2.16 billion. Netflix’s streaming subscriptions were generating 28 percent more revenue than disc-by-mail in Q3 2011. However, disc-by-mail accounted for 79 percent of its profitability. Quarterly profit-per-customer was $2.40 for streaming customers and an enormous $17.32 per disc-by-mail subscription.12

The disc-by-mail model was a highly profitable segment, yet Netflix was willing to divest itself of this division with its introduction of Qwikster. Reed Hastings said it best when he claimed, “We expect DVD subscribers to decline every quarter . . . forever.” In fact, of all new13

accounts Netflix created, only 7 percent wanted a disc-by-mail subscription.

With its most profitable segment in jeopardy, Netflix began looking to new sources of revenues. The United States has more than 80 million homes with broadband. With14

approximately 20 million streaming U.S. subscriptions, Netflix had already penetrated 25 percent of its possible U.S. market. Netflix has strongly denied that they were interested in limiting simultaneous streams; customers believed a single subscription covered the entire household.

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Social Integration

Facebook’s Mark Zuckerberg had been lobbying Reed Hastings in 2011 to move toward a Facebook-Netflix integration. After the New York Times reported an impending integration of the two companies’ technologies, Reed Hastings joined Facebook’s Board of Directors on June 23, 2011. In the next two weeks, Netflix had successfully helped lobby to place a clarifying bill to the VPPA in front of the House of Representatives. Supported by Facebook, Google, Sony, Walt Disney, and other media companies, Netflix and Facebook would hopefully soon be able to integrate in the U.S. At their Q2 earnings announcement later that month, Netflix announced that the rumors were true and that they would be participating in an integration project with Facebook. Reed Hastings believed that social sharing of movie preferences was valuable, stating, “Watching content ‘because my friend did it’ really trumped watching because of an algorithm.” 15

In September of 2011, Netflix released a Facebook integrated functionality to its interface, which allowed users to share movie preferences and the ability to “Like” a movie or television show. Unfortunately, Netflix only was able to release this feature to subscribers in Canada and Latin America. The VPPA prevented these features from being released in the U.S. During Facebook’s 2011 f8 Conference that month, Hulu announced they had released a similar integration with Facebook in the U.S. Without the burden of renting physical DVDs, Hulu was apparently exempt from the VPPA. Hulu is a streaming video service that allows users to watch ad-subsidized reruns of television shows.

Netflix recently announced that their declining DVD-by-mail business would be spun off and formed into a new firm: Qwikster. Netflix required that any subscribers who wanted both disc-by-mail and streaming service would have to maintain two separate and independent accounts. These accounts would not be linked and Netflix would not have access to any information from their Qwikster customers. This strategy set up Netflix to operate in a similar fashion to Hulu, allowing them to proceed with their Facebook integration plans.

Decision Point

• What steps, if any, should Netflix take to remedy customer outrage towards the price hike and creation of Qwikster? How would other stakeholder groups react?

• Hastings cited arrogance as a cause for the communication mishap. How can organizations with similar levels of leadership hubris prevent such problems from occurring?

• Reed Hastings waited more than two months to respond to strong negative social media sentiment following Jessie Becker's June announcement. Why do you believe Netflix waited so long to respond to strong negative customer reactions?

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B ecker, Jessie. “N etflix Introduces N ew Plans and Announces Price Changes,” N etflix, July 12, 2011 1

<http://blog.netflix.com/2011/07/netflix-introduces-new-plans-and.html>

Sandoval, G reg. “W hat happens to N etflix’s battered stock next week?” C/NET , Aug. 22, 2011 2

<http://news.cnet.com/8301-31001_3-20095483-261/what-happens-to-netflixs-battered-stock-next-week/

?tag=mncol;txt>

H astings, Reed. N etFlix, “An Explanation and Some Reflections,” Netflix, Sept. 18, 2011 3

<http://blog.netflix.com/2011/09/explanation-and-some-reflections.html>

Y ouT ube, “An explanation and some reflections,” Sept. 18, 2011 4

<http://www.youtube.com/watch?v=c8T n8n5CIPk>

N B C.CO M , Shows V ideo Schedule, Saturday N ight Live 5

<http://www.nbc.com/saturday-night-live/video/netflix-apology/1359563>

N etbase, as cited in D e Leo, M alcolm. “N et Sentiment N etflix,” T he Innovation M use-ings, O ct. 12, 2011 6

<http://innovationmuse.blogspot.com/2011/10/when-social-media-strikes-this-time-its.html>

H astings, Reed. W ikipedia < 7

http://en.wikipedia.org/wiki/Reed_H astings>

Pepitone, Julianne. “N etflix’s vanished Sony films are an ominous sign,” CN N M oney 8

<http://money.cnn.com/2011/07/08/technology/netflix_starz_contract/index.htm>

H ope, D an. “N etflix Streaming Is 22 % of N orth American Internet T raffic, T echN ewsD aily 9

<http://www.technewsdaily.com/2605-netflix-streaming-is-22-of-north-american-internet-traffic.html>

USC Chapter 121, Stored W ire and Electronic Communications and T ransactional Records Access, 10

Jan. 7, 2011

<http://uscode.house.gov/download/pls/18C121.tx>

Pepitone, Julianne. “N etflix’s vanished Sony films are an ominous sign,” CN N M oney 11

<http://money.cnn.com/2011/07/08/technology/netflix_starz_contract/index.htm>

N etflix, Q uarterly Information, Financial Information 12

<http://ir.netflix.com>

• Since the June price hike announcement, Reed Hastings has seen his company’s stock price drop 62 percent in less than three months and seen almost one million subscribers depart. What should Mr. Hastings do to regain customer favor?

• Reed Hastings said in an interview that companies like AOL and Borders Bookstores ultimately failed due to their failures to react quickly enough to changing technology. Did Netflix rush too quickly to focus on streaming video?

References

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Empson, Rip, “Reed H astings: W e Expect D V D Subscribers T o D ecline Every Quarter ... Forever,” T C 13

(T echCrunch), Jan. 25, 2012 <http://techcrunch.com/2012/01/25/reed-hastings-we-expect-dvd-subscribers-to-

decline-every-quarter-forever/>

T otal N umber of fixed (wired) broadband subscriptions, by country, millions, June 2011, O ECD Broadband 14

Statistics, O rganization for Economic Cooperation and D evelopment

<http://www.oecd.org/document/54/0,3746,en_2649_34225_38690102_1_1_1_1,00.html>

H ardawar, D evindra, “N etflix announces Facebook integration for Canada, Latin America - U .S. 15

W ill have to wait, “ V B/M edia, September 22, 2011

<http://venturebeat.com/2011/09/22/netflix-facebook-integration/>

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