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Date: January 20, 2013

DAVID ROBINSON M AX O LTERSDORF

Netflix: Pricing Decision 2011

On October 25th, 2011 Reed Hastings1, the CEO of Netflix, anxiously awaited the opening of the NASDAQ market. During the summer of 2011, he had watched the stock price of his company Netflix drop from an all-time high of nearly $300 in July with a market capitalization of $15.6 billion to $118.84 and a market capitalization of $6.2 billion. At its peak, the stock was a darling of investors seeking exposure to internet commerce and 90 percent of all traded shares were owned by mutual funds and institutional investors (compared to 58 percent of shares at P&G and 61 percent at IBM).

Hastings knew that Wall Street analysts had estimated that Netflix had lost 600,000 of its 24.6 million subscribers after the company had announced changes to its monthly pricing structure. However, the analysts had underestimated the drop-off. After the markets closed the day before, Hastings had announced2 that the previous quarter ended with 23.8 million paid subscribers3, a drop of 800,000. Stock markets were pretty good at anticipating bad news, so Hastings hoped that the stock price would hold up or rebound a little now investors could move beyond speculation to the facts. He winced as the first trades came in: The stock opened at $74.90—a shocking 37 percent drop from the night before and now down

75 percent from the July 2011 high. Instituting a simple price raise had cost the firm more than $11 billion in valuation4. Now he had to figure out how to move the company forward in terms of a pricing strategy.

1 This case represents a fictional portrayal of a public figure based on published sources. It is written for educational purposes and classroom discussion.

2 http://www.bloomberg.com/news/2011-10-24/netflix-3q-subscriber-losses-worse-than-forecast.html.

3 Netflix routinely used one or more months of free trial as a form of sales promotion to build membership. The figure of 23.8 million is the number of paid subscriptions, of which, 20.5 million were for US streaming subscriptions, 13.9 million were for DVD by mail subscriptions and 1.0 million were International streaming subscriptions. After backing out International subscriptions, it appears that 11.481 million US subscribers were paying for both DVDs by mail and for streaming at the end of the Third Quarter; 9.03 million had streaming-only subscriptions and 2.332 million were mail-only subscribers.

4 Stu Woo, “Investors Abandon Netflix Amid Subscriber Losses,” Wall Street Journal, October 26, 2011, p. B1.

Lecturer David Robinson prepared this case study with Max Oltersdorfas the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. This case represents a fictional portrayal of a public figure based on published sources. It is written for educational purposes and classroom discussion.

Copyright © 2014 by The Regents of the University of California. All rights reserved. No part of this publication may be reproduced, stored, or transmitted in any form or by any means without the express written permission of the Berkeley-Haas Case Series.

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NETFLIX 2

Company History

Netflix was an innovative pioneer in home entertainment, skillfully combining online account management with mail delivery of movie rentals on DVD. Indeed, the firm had been so successful that it had transformed an entire industry. Netflix used United States Postal Service first class mail to send out and return movies on disk that subscribers then watched at home on their own TVs.

Hastings was a serial entrepreneur who had sold his first company (a software firm whose product found bugs in other software) in 1996. He was inspired to found Netflix when he incurred a substantial late fee for returning a movie six weeks late to his neighborhood video store. He wondered why the industry had to run that way. After all, he had a gym membership and paid the same whether he went or not. Why shouldn’t the same apply to movie rentals?

With the fundamental principle of “no late fees,” Netflix was launched in 1998 as a mail-order video rental service. Before Netflix, consumers either bought DVDs for home use or rented them from video stores in protective plastic boxes, double the size of the disks; these bulky boxes made good display devices in-store, but were expensive to ship. The company’s first innovation was to eliminate the boxes. Unlike the predecessor technology, VHS tapes, DVD disks were light and easy to ship.

With some ups and downs, Netflix gradually built its subscriber base and in 2002, the company had 600,000 members and had a successful Initial Public Offering that raised $82 million from the sale of 5.5 million shares at $15 a share. Netflix used proceeds from the IPO to add distribution centers throughout the United States so that DVDs would spend less time in the mail on their way to customers.

Revenue grew from $153 million in 2002 to $2.2 billion in 2010; after early losses, annual net income had reached $161 million by 2010 (Exhibit 1).

Product Development

Netflix’s product development was a great example of continuous improvement. The DVD mailer had to balance protection against weight. Netflix initially used a substantial cardboard box, but that proved to be too heavy. The firm went through 10 subsequent modifications5 to come up with a single envelope that could be used both out and back.

Along the way the firm tried plastic and paper envelopes with foam liners, experimented with top and side loading, and finally settled on a paper two-way mailer design with a window that allows the liner bar code to be scanned without the envelope being opened. The most recent innovation was

to add a bar code to each disk to enable it to be identified by operators in the Netflix’s distribution centers without having to read the title. The picture above6 shows the current mailing system with the return envelope, bar-coded inner sleeve, and disk with center bar code.

5 See the gallery of the 11 different iterations at: http://money.cnn.com/2006/04/20/technology/business2_netflixgallery/index.htm.

6 Personal photo taken by case writer.

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NETFLIX 3

The Mail-Order DVD Model

Netflix’s traditional through-the-mail subscription worked as follows: once a customer had gone to the website, registered, and given their credit card information, they could search for specific movies by title, actor, director, and so on or browse genres such as Action, Comedy, or Foreign. Selecting a movie placed it into the customers Queue, which was managed online. Netflix sent the next available movie from the customers list.

Customers chose between plans that offered 1, 2 or 3 movies at a time, with most customers choosing the lowest level of service. In 2005 the prices were $9.99, $14.99, and $17.99 respectively. Netflix reported that typical customers rented between 2 and 11 movies per month.

The company had set up multiple fulfillment centers with the goal of being just one day by first class mail away from most customers. A customer ordering on Monday was highly likely to come home from work on Tuesday and see the DVD waiting in his or her mailbox. If the customer watched the movie that night and mailed it back to Netflix on Wednesday morning using the pre-paid mailer, by Thursday the customer would receive an email confirming receipt of the returned DVD at the fulfillment center. The same day, Netflix would select another DVD from the customer’s Queue and mail it out, arriving at the customer’s home by Friday. Even on Netflix’s lowest “one DVD at a time plan”, a well-organized customer could rent two movies a week. Netflix had negotiated the best possible bulk mail rates with the USPS. Even so, the round-trip postage for a single DVD rental cost Netflix $0.80. The envelope and inner sleeve cost an additional $0.10 per disk.

In the early years, Netflix bought some individual DVDs at retail7 but they were soon able to negotiate bulk purchases from the movie studios. Netflix was able to purchase multiple copies of a single title on a “spindle” without the unneeded box and printed description. On one hand, such bulk purchases (500 or more at a time) entitled Netflix to a price discount (and in some cases a negotiated revenue sharing model, paying the studios more when a movie was rented out more8). On the other hand, movie studios knew that the DVDs were destined for the rental market and would be seen by many customers, so they aimed to negotiate as high of a price as possible.

A limitation on the movie studios’ bargaining power was that Netflix could always buy the DVDs in bulk

from a distributor, just like a retail store would. Individual DVDs purchased at retail were priced $7.99 to

$17.99 based on multiple factors such as stars, recency, popularity and so on (Exhibit 2). Analysts estimate that Netflix paid about half of the retail price to acquire DVDs. They also estimate that, on average, a DVD had a lifespan of 24 round trips to customers before it became unplayable due to scratches or damage in transit.

Accusations of “Throttling”

Under Netflix’s subscription model, their most profitable customers were those who used the service least. Indeed, a well-organized customer who watched movies immediately upon receipt could be a loss- maker, especially if they selected expensive recent movies. Netflix managed this in part by its system of suggestions. When a customer logged on, they were invited to rate recently viewed movies and the website would suggest similar movies that the customer might enjoy renting. If these were older or more obscure, Netflix’s expenses were less.

7 Under US copyright law, it is legal for the owner of a DVD to rent it out.

8 http://www.fundinguniverse.com/company-histories/Netflix-Inc-company-History.html.

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NETFLIX 4

Netflix’s proprietary recommendation system matched each customer against others with similar likes on a multi-dimensional scaling system. It then proposed “if you like this, you will like that.” The system worked well, but renters noted some strange anomalies (suggested movies that the customer did not like). In 2006 Netflix started a competition for improving its recommendation algorithm challenging entrants to come up with a 10 percent improvement. The challenge was not won until 2009. Netflix’s system of suggesting movies is widely perceived as a customer benefit, leading subscribers to previously unknown gems.

In 2004, some heavy users filed suit against Netflix, claiming that although the company promised unlimited rentals, frequent renters were less likely to receive popular movies from their queue (they would see that there was a “long wait”)9. Netflix was forced to revise its terms of service and state: “In

determining priority for shipping and inventory allocation, we give priority to those members who receive the fewest DVDs through our service. Heavy renters are more likely to encounter shipping delays and are less likely to be immediately sent their top choices.”10

Competition for the Mail Order Business

Netflix competed with neighborhood video stores, some of which were independents (about 11 percent of stores in 1998) and others organized into large chains. However, Netflix was so successful that it transformed the whole industry. A typical neighborhood store held only 3,000 to 5,000 titles and often ran out of copies of newly released hit movies. In contrast, Netflix boasted more than 100,000 unique titles and their bulk buying from movie studios enabled them to have a generous supply of new movies.

Video rental stores typically used a transaction-based model: customers paid in cash for each movie rented and promised to return it typically within 48 hours. As Hastings had found, the stores were infamous for charging punitive “late fees” for any movie not returned by the deadline.

The major competitive chain was Blockbuster whose market share was as high as 40 percent in 1998 and at its peak had 7,000 stores. However, Blockbuster failed in attempts to make an online ordering system that would be directly competitive with Netflix and as, Netflix and Redbox (see below) drew more customers, Blockbuster filed for bankruptcy in September 2010.The chain was acquired from bankruptcy by the satellite entertainment provider Dish Network, and further closings left only 1,700 stores open. The chief competing national chain to Blockbuster had been Hollywood Video. They too suffered from declining sales and went bankrupt in May of 2010 and closed all remaining 1,900 stores.

Walmart attempted to clone Netflix’s through-the-mail model in 2003, with a strategy of undercutting on price by offering a more limited selection and less speedy turn-around of new movies. However, they allocated insufficient resources to the fight (for example, they had only six distribution centers against Netflix’s 58) and they terminated the service after just two years.

Redbox was an innovative delivery system for movies on disk. Initially funded by McDonald’s Corporation in 2002, by 2005 it was 51 percent owned by Coinstar. Redbox used automated kiosks (essentially customized vending machines) that allowed customers to rent a small selection of current titles for just $1 per day. There was no late fee per se but a customer’s credit card would be charged $1 for each additional day that a movie was not returned. Redbox specialized in hit movies and stocked each

kiosk with multiple copies of the currently most-popular movies. This strategy “creamed” a portion of the home entertainment market from the video stores. By 2011 Redbox had grown to a total of 33,000 kiosks in 27,800 separate locations and had achieved a 34.5 percent market share for on-disk rentals.

9 http://www.msnbc.msn.com/id/11262292/ns/business-us_business/t/frequent-netflix-renters-sent-back-line/.

10 Netflix website.

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NETFLIX 5

Netflix’s Business Model

Netflix’s sole income was from monthly subscriptions. Before the streaming initiative began in earnest, in 200711, Netflix ended the year with 7.5 million subscribers and reported revenue of $1.205 billion, about

$160 per customer per year.

Netflix’s Income Statement is shown in Exhibit 1. Cost of Revenues is made up of Subscription and Fulfillment expenses: Subscription includes content acquisition (buying the DVDs and later the fees paid for streaming), mailing expense out and back, and packaging; Fulfillment is the monthly expense of running the distribution centers, handling and storage of the DVD library; additionally customer service expense and credit card fees were bookkept to this line.

Before streaming, the firm’s gross margin was about 35 percent. Expenses at the corporate level, which continued month-to-month independent of rental volume, were: Technology and Development (research and development costs, plus the costs of developing machinery of the shipping centers, and later the costs of the streaming servers), Marketing (promotional expenses which included mass media TV advertising, online advertising and the cost of free trials of the service) and the General and Administrative costs of running the business. The cost of acquiring new customers (part of Marketing) was $40.88 for each new subscriber in 2007. In subsequent years, Netflix became more efficient in the use of promotion and by 2011, the cost of acquisition had fallen to $18.00 per subscriber.

Streaming Changes the Business Model

The attraction of streaming movies was that the expense of mailing and returning physical DVDs would be eliminated. Instead, Netflix’s expense was the cost of running servers and getting streaming content out to the internet. In contrast to the mail system, (where Netflix was responsible for the expense door-to- door) when streaming, Netflix neither paid the cost of the infrastructure of the internet nor the delivery costs. Customers, in fact, paid for these themselves as part of their ISP (internet service provider) subscription, typically $30 to $75 a month. Analysts estimated that the cost to stream a movie was just

$0.05 to Netflix, excluding the royalty paid to movie studios.

Netflix first offered existing through-the-mail customers an opportunity to stream a limited selection of movies beginning in January, 200712. Netflix initially anticipated a very slow adoption of streaming, but this proved to be incredibly incorrect. By September 2011, Netflix reported 23.8 million subscribers, of whom 21.4 million were using streaming for at least some of their movie experience. This became a serious threat to cable TV providers as it was a large portion of the 83.2 million US households that had cable TV subscriptions. In 2011, cable companies saw a drop-off in the number of families who continued to subscribe, although whether that was attributable to high unemployment and an uncertain economy or whether it was a direct result of penetration by Netflix and other streaming services could not be determined13.

Netflix’s “experiment” with streaming had become so successful that it had a material effect on internet traffic. By May of 2011, it was estimated that Netflix alone was responsible for an astonishing 25 percent of all North American internet traffic14. This led to complaints from internet network operators that Netflix was becoming a “bandwidth hog”15. An interesting detail of the shift from through-the-mail to streaming was that, in the first model, consumers paid for the mailing by paying their monthly fee to

11 Netflix’s fiscal year ends at the end of the calendar year.

12 David B. Wilkerson, “Netflix Bets on Movie Downloads,” Wall Street Journal, September 20, 2008, p. B5A.

13 http://www.usatoday.com/money/media/2011-08-10-cable-satellite_n.htm.

14 http://www.pcmag.com/article2/0,2817,2385512,00.asp.

15 Spencer E. Ante & Amy Schatz, “Web-Traffic Spat over Netflix Highlights New Tensions,” Wall Street Journal, December 1, 2010, p. B1.

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NETFLIX 6

Netflix. In the streaming model, the consumers paid not to Netflix but to their Internet Service Providers who in turn paid the network companies that administered traffic on the internet. Netflix only had to pay to get the movies to their “front door” and subsequent transmission costs were borne by the network companies and in turn, the home users of internet connections.

Movie studios that owned the rights to the streaming content did not ignore this shift. In the DVD model, the number of disks Netflix had purchased and the time to mail them out and back naturally limited the number of views of a movie. However, almost the opposite was true for streaming: when viewers became aware that a title had been released for streaming, they were likely to demand to view it at once and would undoubtedly promote the online availability by word of mouth. Once a movie was available for streaming, the number of views could go up dramatically. Additionally, streaming renters would be more likely to watch hit movies than cheaper movies from Netflix’s archive. One survey16 estimated that an average Netflix disk subscriber watched 1.4 movies per week whereas subscribers who viewed by streaming watched 2.1 movies per week (in addition to several TV shows available through Netflix).

With this in mind, the studios demanded very high fees for rights to stream content for a particular time period. For example, a year of the rights to stream episodes of Disney-ABC’s TV show “Lost” went for

$45 million. An additional complication was that many first-run rights had been given to cable TV companies, many of which offered video-on-demand in direct competition to Netflix. For example, if Netflix wanted to show Disney’s title “Toy Story 3,” the firm had to pay the cable company Starz for permission, not Disney. There were several cable channels that depended on offering first-run movies including: Showtime, HBO, Starz, Cinemax, and Encore. In 2011 Netflix lost the right to show movies that had been contracted to the Starz network (which controlled the rights to new movies from Disney and Sony). Netflix had been paying about $30 million a year but negotiations to renew the contract fell apart

in September, 2011, when it was reported that Starz had upped its price to $300 million a year17.

Unlike the disk rental business where Netflix could assume to have access to any movie that had been released on disk (essentially all current movies and the vast majority of classic titles), the distribution of streamed movies was fragmented. Some were available through Netflix, others through iTunes, and still others through Amazon’s Video on Demand streaming service. The competing services charged $2.99-

$4.99 per movie on a pay-per-view model (watching the movie once in a 24 hour period) although Amazon had been offering a limited selection of movies to stream for free as a promotion of its Amazon Prime™ service(which had about five million members)18 (Exhibit 2).

The economics of movie production depend on a few hits in an industry that produces many unprofitable titles. Of the 600 or so movies made each year by the dominant US “Hollywood” studios, only a couple of dozen achieve hit status. Studios earn money from three streams: first run theatrical release, foreign distribution, and home entertainment (which encompasses DVD sales, rentals and cable TV royalties).

A typical hit movie appears to cover its production costs from the first stream, first run domestic movie theater release. For example, the 2007 release Pirates of the Caribbean—at World’s End had a production budget of $300 million and earned a “domestic gross” of $309 million19. However, movie studios only receive 50 percent of the domestic gross (the rest goes to the theater owners and the distributors) so after a first run in US cinemas, even a hit movie has only earned about half the cost of making it. Additionally, the movie studios incur heavy promotional costs—up to $150 million for the first run release of a major

16 http://www.reelseo.com/netflix-customers/.

17 Stu Woo, “Netflix, Amazon to Add Movies,” Wall Street Journal, September 27, 2011, p. B10.

18 Amazon prime was a $79 per year membership that provided customers with unlimited 2-day shipping on items bought online; since early 2011 they had also offered Prime members free streaming of several hundred movies. However this was a sales promotion—the free movies were classic pictures and more recent movies were available fee-for-service at a price of $2.99 to $3.99; as with other streaming providers they had only a limited selection of first-run movies available and could not provide subscribers with all the movies they wished to see.

19 Boxofficemojo.com.

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NETFLIX 7

hit movie like Pirates. Foreign first run rights can bring in enough money to come close to breakeven. For example, Pirates had total foreign ticket sales of $654 million; however, movie theaters and distributors take a much bigger share of ticket revenue outside the US, so the studio would’ve received about $250 million of that. In the Pirates example, US and foreign cinema showings would’ve brought in about $400 million against the production plus promotional costs of $450 million. Even for one of the biggest hit movies of all time, the studio still has not achieved profitability.

The movie industry was rescued by the development of the home entertainment revenue stream. No movie studio is required to ever release a movie for home viewing and historically the studios were very reluctant to do so. They relied on the hope of a second cinema release (typically one to two years after the first-run) when they earned incremental revenue from lower ticket prices. Studios initially viewed the advent of VHS tape recordings as a threat to the first-run in-theater business, but instead, the entertainment category grew and demand for first-run tickets was not diminished. Studios could earn

large sums for first-run network TV showings of hit movies (usually during ratings sweep weeks) or from licensing to cable TV. For example, Disney sold the rights to show Pirates over a five-year period on a single cable channel (USA Network) in the US market only for $28 million20.

Although the studios had initially priced streaming through Netflix fairly low, they began to realize that Netflix’s unlimited streaming would undoubtedly diminish the amount of money they could earn from cable TV. As a result, the studios began to hold out for very high prices21. In the nine months ending September, 2011, Netflix spent $805 million on additions to the content streaming library, compared with

$115 million in the year prior. Even this enormous permissions fee only covered some movies—by no means were all movies available for streaming through Netflix online. Netflix’s business model changed from the variable cost of purchasing additional DVDs as their number of subscribers grew, to very substantial period fixed costs for the right to stream content. Analysts estimated that a broader selection of first-run movies available for streaming might costs Netflix $2 billion or more22 per year.

With the cost of content ballooning, it was time for Netflix to stop giving streaming away for free.

Summer of Discontent

Although Netflix has a history of price changes, subscribers were unprepared for an announcement from the company on July 12, 2011. Rather than proposing a price-raise for the enhanced service of disks-plus- streaming, Netflix announced that the two services were to be split into separate charges for DVDs and streaming. Subscribers who were on the one-disk-at-a-time program would see their monthly rate change from $9.99 down to $7.99—a price decrease. But to continue to view movies online, they would now have to add a separate streaming subscription, an additional $7.99 a month. Not surprisingly, consumers saw this as a sudden price increase from $9.99 to a total of $15.98 a month, a 60 percent unexpected rise.

This provoked a huge backlash from consumers. Subscribers had more than two years of experience of free streaming and were unprepared to pay for it—many consumers threatened to quit the service entirely. Netflix management insisted that the new pricing structure was still a “terrific value” but analysts worried that the sharp, substantial price rise would lead to defections.23 Throughout the summer, the storm of complaints on blogs and social media did not abate.

20 Thenumbers.com.

21 Ronald Grover and Cliff Edwards, “Can Netflix Abandon its Future?”, Bloomberg Business Week, September 26, 2011, p. 29.

22 Case writer estimate; See Sam Schechner, “Netflix Adds to Web Films,” Wall Street Journal, August 11, 2010, p. B4. Netflix agreed to pay Epix (a joint venture of Viacom, Lion’s Gate and MGM Studios) $200 million a year over five years for the rights to stream, but allowed a 90-day “carve out” in which Epix could show first-run movies on affiliated cable channels before their release on streaming video.

23 http://online.wsj.com/article/SB10001424052702304584404576442231619018422.html.

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NETFLIX 8

One unnoticed part of the new pricing structure was that the new scheme would involve two separate queues for movies. Indeed, in September, Hastings wrote to customers with an apology (Exhibit 3) that was largely seen as a backhanded24 “sorry you’re so upset,” but affirming the two-price plan and clarifying that there would now be two separate websites, two separate subscriptions and two separate

queues for customers to manage. The DVD service would be renamed “Qwikster” and the original Netflix site would be streaming only.

This led to another wave of broadly expressed consumer outrage. Analysts were beginning to predict a significant loss of membership and that Netflix would be likely to lose more than half a million members. This time Hastings repented and admitted that the two separate websites would cause a substantial inconvenience to customers—the Qwikster name was abandoned as was the plan to have two separate queues25. However, Hastings was adamant that the new pricing structure would remain unchanged.

The Decision

Hastings was reasonably confident that the worst damage had been done. The drop in the company’s stock price was probably an over-reaction by the stock market. As October 25th drew to a close, he checked the stock price one more time. The closing price of $77.37 was 35 percent down from the previous close.

For Netflix to continue as a company, it had to embrace the new online streaming technology. In retrospect, there had to be a better way to manage the price change. The firm had probably let too many customers stream too many movies at no additional charge for too long. Giving something away for free that was costing the company billions of dollars a year probably hadn’t been a smart move. But now the problem was how to turn the situation around. Despite the insistence on the two-part pricing structure,

$7.99 per month for disks through the mail and an additional $7.99 for unlimited streaming, a new pricing scheme that consumers would see as a fair value and that would lead to sustained profitability for the firm was desperately needed for the stock price to recover.

In developing a pricing structure, it would be simpler if the firm could be split into two: online streaming and a separate disk rental service. The rationale for this would be that the cost structures for the two were different. Online streaming required very high period fixed costs for content acquisition, whereas disk rental was a variable cost that depended on the number of subscribers, the number of disks they rented and hence the number of new disks that had to be bought.

The company knew that in the two-year experiment with free streaming, 21.4 million of their remaining

23.8 million US subscribers had used streaming for at least some of the movies they watched. The company estimated that with the new pricing structure, many users would drop their disk rental subscriptions and they estimated that about 10 million disk subscriptions26 would remain. After the transition, there would be three segments of customers: 1. Streaming only: Primarily families interested in watching hit movies or children’s movies; 2. Disk only: this would be families without a fast internet connection or perhaps a group of movie aficionados who wanted a wider range of movies than would ever be available on streaming27; 3. Disk and Streaming renters: Households that watched a lot of movies.

24 http://www.washingtonpost.com/national/on-leadership/netflix-schwarzenegger-weiner-the-science-behind-saying-youre-

sorry/2011/09/28/gIQAfYUv4K_story.html.

25 Stu Woo, “Under Fire, Netflix Rewinds DVD Plan,” Wall Street Journal, October 11, 2011, p. A1.

26 http://www.bloomberg.com/news/2011-10-24/netflix-3q-subscriber-losses-worse-than-forecast.html.

27 Almost all movies were made available on disk, whereas only some movies are available for streaming and of those that are available for streaming, many had the rights already sold to cable networks and would not be available to Netflix.

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NETFLIX 9

There were many uncertainties that the company had to factor in while building a pricing model: The drop-off in total membership as a protest to the end of free streaming might continue, might have run its course, or might even reverse once subscribers felt they had made their point. The percentage of subscribers choosing streaming-only might increase or might have reached its natural equilibrium point already. The percentage of subscribers using disks only or disks-and-streaming might be higher or lower than predicted.

Additional uncertainties concerned the movies available from the studios for streaming. As streaming became more widely adopted by consumers, the studios might resist making exclusive licenses so that more movies would become available. Alternatively, if consumers found that they had to shop between different providers (Apple’s iTunes, Amazon and Netflix) to find a particular title to stream, they might find Netflix’s “unlimited” service much less valuable. The fees for streaming might come down a bit, or might continue to rise if there was a bidding war between streaming services.

Going forward, analysts could see three possible pricing options for Netflix:

1. Stick it out: After the drama of the Summer of Discontent, maintain the two-price model at $7.99 a month each for disks by mail and streaming.

2. Make a single, lower bundle price: This plan would continue unlimited disks and unlimited

streaming but would offer a “fair value” price for the two services together. Instead of $7.99 +

$7.99 = $15.98 a month, a slightly lower bundle price for the two services together, in the range of $11.99 to $13.99 a month. If seen by consumers as a good value, this would increase the number of “both” subscriptions.

3. Abandon “unlimited” for streaming: Under this option, Netflix would move closer to a pay- per-view model charging a fee for each movie downloaded, the same as the pricing model of their online competitors. One variation of this would be to allow subscribers to watch, say, two movies a week within their subscription, but then pay-per-view for additional movies. To model this, they would have to make some assumptions about the distribution of number of movies streamed per week—although the average was 2.1 per week, some families rented more, others less.

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NETFLIX 10

Exhibit 1 Netflix Income Statement

Netflix Inc. (NFLX) Income Statement Fiscal year ends December 31st. In USD millions

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Revenue $ 76 $ 153 $ 272 $ 506 $ 682 $ 997 $ 1,205 $ 1,365 $ 1,670 $ 2,163

Cost of revenue $ 50 $ 78 $ 148 $ 276 $ 465 $ 627 $ 786 $ 910 $ 1,079 $ 1,357

Gross profit $ 26 $ 75 $ 124 $ 230 $ 218 $ 370 $ 419 $ 454 $ 591 $ 805

Operating expenses

Sales, General and Administrative

$

45

$

72

$

102

$

188

$

186

$

262

$

271

$

249

$

289

$

364

Other operating expenses $ 18 $ 15 $ 18 $ 23 $ 29 $ 44 $ 57 $ 84 $ 110 $ 157

Total operating expenses $ 63 $ 86 $ 119 $ 210 $ 215 $ 305 $ 328 $ 333 $ 399 $ 522

Operating income $ (37) $ (12) $ 4 $ 19 $ 3 $ 64 $ 91 $ 122 $ 192 $ 284

Interest Expense $ 2 $ 12 $ - $ - $ - $ - $ - $ 2 $ 6 $ 20

Other income (expense) $ 39 $ 24 $ (4) $ 3 $ 6 $ 16 $ 20 $ 12 $ 7 $ 4

Income before income taxes $ - $ - $ - $ 22 $ 8 $ 80 $ 112 $ 132 $ 192 $ 268

Provision for income taxes $ - $ - $ - $ - $ (34) $ 31 $ 45 $ 48 $ 76 $ 107

Other income $ (39) $ (22) $ 7 $ - $ - $ - $ - $ - $ - $ -

Net income $ (39) $ (22) $ 7 $ 22 $ 42 $ 49 $ 67 $ 83 $ 116 $ 161

3Q2011 Income Statement 3 months ending 9/30 9 months ending 9/30

In USD millions 2011 2010 2011 2010

Revenue $ 822 $ 553 $ 2,329 $ 1,567

Cost of revenue $ 537 $ 345 $ 1,465 $ 967

Gross profit $ 285 $ 208 $ 864 $ 600

Operating expenses

Sales, General and Administrative

$

119

$

97

$

372

$

278

Other operating expenses $ 69 $ 42 $ 178 $ 117

Total operating expenses $ 188 $ 139 $ 550 $ 395

Operating income $ 97 $ 69 $ 314 $ 205

Interest Expense $ 5 $ 5 $ 15 $ 15

Other income (expense) $ 2 $ 1 $ 4 $ 3

Income before income taxes $ 94 $ 65 $ 303 $ 193

Provision for income taxes $ 31 $ 27 $ 112 $ 79

Other income $ - $ - $ - $ -

Net income $ 63 $ 38 $ 191 $ 114

Source: Case writer analysis.

This document is authorized for use only by xuewu bao in MKT435 S'19 taught by MICHAEL DENNING, Arizona State University from Dec 2018 to Jun 2019.

Netflix Disc Netflix Streaming Hulu Plus Amazon

Amazon Instant Video iTunes

($7.99/month) ($7.99/month) ($7.99/month) ($79/year)

Retail price

for disc

Toy Story 3

x

x

$14.99

$14.99

$15.49

Pirates of the Caribbean: On Stranger Tides

x

$3.99 (rent)

$14.99

$16.99

Fast Five

x

$3.99 (rent)

$4.99 (rent)

$14.99

Bad Teacher

x

$3.99 (rent)

$4.99 (rent)

$17.99

Gosford Park

x

x

x

$2.99 (rent)

$3.99 (rent)

$7.14

The Dead

x

$2.99 (rent)

$9.99

Women on the Verge of a Nervous Breakdown

x

$12.99

Das Boot

x

$10.71

Casablanca

x

$2.99 (rent)

$2.99 (rent)

$7.99

Doctor Zhivago

x

x

$2.99 (rent)

$3.99 (rent)

$7.33

Silence of the Lambs

x

$2.99 (rent)

$9.99

$9.99

Rocky

x

$2.99 (rent)

$11.99

Fog of War

x

$9.99

$9.99

$12.21

Supersize me

x

x

$2.99 (rent)

$2.99 (rent)

$9.69

Bowling for Columbine

x

$2.99 (rent)

$2.99 (rent)

$11.49

Inside Job

x

$14.99

$14.99

$15.99

Southpark

x

x

x

$1.99/$14.99*

$299/$24

$20.49

NCIS

x

$1.99/$24.99

$299/$24

$29.99

Lost

x

x

x

x

$1.39-$2.99/episode

$299/$24

$32.23

Entourage

x

$1.99/$14

$19.21

For the exclusive use of x. bao, 2019.

NETFLIX 11

Exhibit 2 Price and Availability for Selected Movies and TV Shows from Various Providers

Hit

Movies

Older

Movies

Classic

Movies

Document-

aries

TV Shows

x = Available, blank = not offered * Per episode/complete season

Fiscal year ends in December. 2006-12 2007-12 2008-12 2009-12 2010-12 TTM

Net income 49 67 83 116 161 238

Net income available to common shareholders 49 67 83 116 161 238

Source: Case writer analysis.

This document is authorized for use only by xuewu bao in MKT435 S'19 taught by MICHAEL DENNING, Arizona State University from Dec 2018 to Jun 2019.

For the exclusive use of x. bao, 2019.

NETFLIX 12

Exhibit 3 Reed Hastings’ Letter to Subscribers, September 2011