Case 2: Netflix

W16761

NETFLIX INC.: THE SECOND ACT — MOVING INTO STREAMING1

Sayan Chatterjee, Wayne Barry, and Alexander Hopkins wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality.

This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) [email protected]; www.iveycases.com.

Copyright © 2016, Richard Ivey School of Business Foundation Version: 2016-11-18

Netflix Inc. (Netflix), a subscription-based movie and television (TV) show rental service, offered content to its subscribers either via DVDs delivered by mail or through Internet-based streaming. Netflix’s 2011 third-quarter financial reports confirmed some widely anticipated negative news. Netflix, which depended on perpetually increasing its subscription base, had lost 800,000 customers.2 While this loss represented only 3.4 per cent of its 24 million patrons, the company had never suffered a decrease in its customer base (see Exhibit 1). Alarmingly, this contraction resulted in a near 9 per cent hit to the company’s earnings-per- share, which dropped to US$1.163 per share from $1.27 per share in the previous quarter.4

This situation was compounded by the fact that it was not caused by market trends or the slumping world economy, but by Netflix itself. In July, just three months prior, Netflix had increased customers’ subscription fees by 60 per cent. Netflix was at a crossroad; the path it chose could affect its future. Should it return to combining the two services or continue with two separate services and live with the consequences?

While the price increase seemed extreme, Netflix faced rising costs, particularly in acquiring content. Netflix’s second change, made several weeks earlier, in September, was to split its DVD mail-order service (renamed Qwikster) and streaming video service (remaining as Netflix). Reed Hastings, Netflix’s chief executive officer, stated, “Streaming and DVD by mail are becoming two quite different businesses, with very different cost structures, [and] different benefits that needed to be marketed differently, and we needed to let each grow and operate independently.”5 Netflix needed to differentiate the two services, ensuring that each had the latitude to rightfully respond to customers’ changing desires.

1 This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of Netflix Inc. or any of its employees. 2 New York Times, “Netflix Inc.,” The New York Times, October 25, 2011, accessed November 8, 2011, http://topics.nytimes.com/top/news/business/companies/netflix-inc/index.html. 3 All currency amounts are in US$ unless otherwise specified. 4 New York Times, op. cit. 5 Rene Ritchie, “Reed Hastings Apologizes, Announces Netflix as Streaming Only, Rebrands DVD Business as Qwikster,” Tipb.com, September 19, 2011, accessed November 16, 2011, www.tipb.com/2011/09/19/reed-hastings-apologizes- announces-netflix-streaming-rebrands-dvd-business-qwickster/.

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Page 2 9B16M080 Irrespective of the company’s rationale, the aforementioned changes were met with public disdain and a mutiny of sorts. Forced to pay exorbitantly more and to work twice as hard to manage their online profiles, many Netflix customers, some once very loyal, cancelled their subscriptions. Netflix’s stock price plummeted by nearly 77 per cent in four months,6 indicating widespread displeasure. Nearly every mass media outlet chastised Netflix’s decisions, calling them outrageous. Full blame was placed on Hastings himself, whom many not only defamed but also bludgeoned verbally. Once the darling of the business world for guiding Netflix’s ascension to market domination, Hastings’s qualifications were now called into question. Both he, and the company he had incepted, had incurred losses to their once-celebrated reputation. The demise of DVDs would soon give way to streaming technology. Netflix’s commitment to this new reality was obvious: by 2011, it commanded a market share of 61 per cent in movies that were either streamed over the Internet or offered on-demand through a cable or satellite TV service. Comcast was next with 8 per cent, followed by other services, such as Direct TV and Apple TV, at 4 per cent or lower. Netflix faced stiff competition from other entities that had both the desire and capability to capture a share of the streaming market. Additionally, the acquisition of content was becoming ever more difficult as the production companies were employing licensing policies that were becoming more stringent and costly. This situation starkly contrasted Netflix’s cost of acquiring DVDs, particularly movies that were not the most recent releases (see Exhibit 2), as was Netflix’s practice. These different economies had an impact on Netflix’s cash flow, which was only around $356 million (cash on hand) in the final quarter of 2011, compared with more than $76 billion for Apple. Effectively adapting to these and other stark contemporary realities was tantamount to Netflix’s continued success. Unfortunately, the changes Netflix thought were necessary caused nothing but turmoil. NETFLIX: EMERGENCE TO MARKET DOMINATION Netflix delivered movie and TV shows via Internet streaming and U.S. mail (for DVDs) for a monthly subscription. Starting at $7.99 per month, subscribers could instantly watch an unlimited number of TV episodes and movies by streaming the shows over the Internet to their computer or TV. Customers could connect with their Netflix account through their Nintendo Wii, Sony PlayStation 3, Xbox 360, iPad, iPhone, and many other devices, to instantly watch programs and movies. Netflix also offered unlimited DVD rentals and no fees of any kind. Netflix was the first company of its kind. Capitalizing on the white space, Netflix had dominated the industry, with 23.6 million subscribers as of April 2011. Netflix was founded in Los Gatos, California, in August 1997, by entrepreneurs Reed Hastings and Mark Randolph. Hastings, a former high school math teacher and software developer, started the company with $2.5 million after selling his software company. Randolph had founded the computer mail-order company, MicroWarehouse, and his resulting expertise was valuable to Netflix. Randolph was also the vice-president of marketing for Borland International. The fast adoption of DVD players was fortuitous for Netflix. The lightweight DVDs made it possible to use the U.S. Postal Service to deliver a DVD with a single first-class stamp. Netflix tested more than 200 mailing packages before discovering that it could effectively ship the product in a single package.

6 Greg Sandoval, “Netflix’s Lost Year: The Inside Story of the Price-Hike Train Wreck,” CNET, July 11, 2012, accessed August 23, 2015, www.cnet.com/news/netflixs-lost-year-the-inside-story-of-the-price-hike-train-wreck/.

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Page 3 9B16M080 Growth Progression In December 1998, Netflix formed a partnership with Amazon.com Inc. The Netflix website directed customers interested in buying DVDs to Amazon.com, which in turn promoted Netflix on its high-traffic site. Despite Netflix’s popularity, in FY1999, the company reported losses of $29.8 million on revenues of only $5 million. In February 2000, Netflix developed CineMatch, a personalized recommendation system that compared customers’ rental patterns, looked for similarities, then used this information to recommend titles to people with similar profiles. (The algorithms driving CineMatch were continually updated. Recently, Netflix had offered $1 million for the person who developed the best new algorithm for CineMatch, which led to a 10 per cent increase in CineMatch’s recommendation ability.) In its first few years, Netflix incurred substantial losses, but its stated future goal was to move beyond DVD rentals to streaming video. By February 2002, Netflix had reached its target of 500,000 subscriptions and initiated an initial public offering in May 2002, at which it sold 5.5 million shares of common stock. In 2003, Netflix posted its first profit of $6.5 million on revenues of $272 million. The company also enjoyed a rapid increase in its subscriber base, from one million in the fourth quarter of 2002, to approximately 5.6 million in 2006, and nearly 14 million in March 2010. Netflix had the advantages of an early start in its business, a strong distribution system, customer loyalty, and patents for its software programs.7 Profit Model Netflix’s profit model relied on a “virtuous cycle” — that is, the more subscribers it had, the more content it could buy; and the more content it had, the more subscribers found the service attractive. Subscriber word of mouth led to new subscribers. The following information was from the Netflix investor relations site:

Our primary competitive advantage is our large and growing subscriber base, which gives us tremendous operating efficiencies and, which we believe, drives the following virtuous cycles:  More subscribers means more money to license content, which drives more subscriber growth.  More subscribers means more word of mouth from subscribers to those who are not yet

subscribers, which drives more subscriber growth.  [M]ore subscribers means we could increase R&D spend to improve our user experience, [which]

drives more subscriber growth.8 As long as Netflix continued to grow its subscription base, and negotiated the best possible flat-fee deals for content (versus revenue sharing), the company would remain profitable. Customer churn and subscription-based (per user) licensing fees represented the main threats to the profit engine. Customer Intimacy Through the shrewd utilization of technology, Netflix had cultivated tremendous intimacy with its customers. The company had invested heavily in its operational backbone: its website technology. Invisible 7 The background on Netflix is based on “Netflix,” Ivey product # 9B09M093. 8 R. Hastings and D. Wells, Letter to Shareholders, Netflix, accessed November 16, 2011, http://ir.netflix.com/common/ download/download.cfm?companyid=NFLX&fileid=511277&filekey=85b155bc-69e8-4cb8-a2a3-22465e076d77&filename= Investor%20Letter%20Q3%202011.pdf.

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Page 4 9B16M080 to customers, a state-of-the-art system captured mass quantities of empirical data, amalgamated the given data points, applied germane analytics, and predicted customers’ desires. This complex system enabled Netflix to tailor its website for each subscriber to a “one-of-a-kind” experience that provided recommendations, requested ratings, offered customer reviews, and created unique, customer-specific genre names. The more information subscribers provided to Netflix, the more personalized their long-term experience — and Netflix reaped tremendous benefit through customers who were motivated to remain engaged. Moreover, Netflix’s information on customer preferences and purchasing trends enabled it to better its service, and to leverage suppliers and advertisers. Finally, Netflix deliberately targeted movie aficionados who saw value in the information provided by Netflix and by other like-minded subscribers in the Netflix-facilitated chat rooms. The virtuous cycle resulted in subscriber loyalty, and Netflix cemented this loyalty by making content available (often at lower costs than blockbuster movies). New Customers Many analysts wondered whether Netflix could leverage its data-mining capabilities to create the same level of engagement with its streaming customers, many of whom had a latent demand for watching popular TV serials in one go (i.e., TV “binging”), a formula successfully adopted by TV channels such as Nickelodeon. Netflix’s primary goal had never been to offer the latest content, and it focused instead on offbeat movies favoured by movie aficionados. Many felt Netflix was trying to adopt the same formula as “rerun TV.” A CHANGING WORLD BRINGS ABOUT NEW REALITIES Technological Progression: Antiquating the DVD All technologies were inevitably eventually antiquated by newer inventions. Just as the eight-track tape gave way to the cassette tape, the cassette tape to the compact disc, and the compact disc to the MP3 player, DVDs were losing out to streaming video. Advancements in data packaging and transfer led to the migration from the old DVD technology to new streaming services. Streaming services had previously been prone to interruptions and glitches, rendering them unreliable. Extremely large files, once too big to transfer virtually, needed to be saved on physical media and shipped by mail. Now, those files could be easily transferred to a small portable computing device such as a cellphone. Streaming data was more reliable than DVDs (it did not scratch or break), could be played anywhere (via mobile devices), and was far more responsive (received in real time). For all these reasons, writer Jan Ozer noted that

Streaming media usage had grown exponentially over the past few years, both for entertainment purposes and as a vehicle for organizations to market, sell, and support their products and services, as well as for internal communications and training. For many such organizations, streaming video had transitioned from a “nice to have” curiosity to a mission critical technology.9

Hastings had known full well that streaming technology would eventually take flight and ultimately bring about the demise of the DVD. In his company’s annual reports, he had bluntly stated that streaming was invariably the future of the industry. Hastings knew that, as technology advanced, those qualities that once set his company apart from its competition would become nothing more than new requirements for entry. 9 Jan Ozer, “What Is Streaming? A High-Level View of Streaming Media Technology, History, and the Online Video Market Landscape,” Streamingmedia.com, February 26, 2011, accessed November 16, 2011, www.streamingmedia.com/Articles/ Editorial/What-Is-.../What-is-Streaming-74052.aspx.

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Page 5 9B16M080 New Requirements for Entry While not entirely different from what they once were, the technological progression and resulting shift from a DVD- to a streaming-dominated market had changed the resources required to enter the entertainment distribution market. Certain capabilities were required of any competitors on this new battlefield. Content Whether viewing a movie in the theatre, opting for a premium channel on a cable service, or subscribing to Netflix, customers sought content. To maintain allure, content provision services needed to keep their catalogues fresh. Continuously stocking their libraries with new movies and shows was paramount now, because of this content’s ubiquitous accessibility. Competitors needed to find success in three principle elements: maintaining fresh content, offering a large variety of content, and ensuring their content was easy to find. With one or two notable examples,10 all Netflix content was also available elsewhere. Content Delivery to Television Most American households viewed their media content on a TV set.11 Cable TV and/or direct satellite systems tapped into almost every domicile. Remarkably, the average U.S. household watched eight hours and 18 minutes of TV per day.12 For consumers to find value in a media provider’s service, content needed to be delivered to their TV sets with relative ease. Content Delivery to Mobile Devices While content delivery to consumers’ TVs was essential, so too was the content’s universal availability. The prevalence of smartphones, micro-computers, tablets, and other devices for data receiving and processing, coupled with the near ubiquitous coverage of cellular and Wi-Fi services, had made it possible for people to demand content just about anywhere. Viewers, once tethered to their DVD and Blu-ray players, could now watch what they wanted with ease from wherever they might find themselves. As streaming technologies improved, content delivery was becoming more a requirement than a competitive advantage. Content distributors such as Netflix worked on improving two customer attributes: stuttering, which meant the streaming might be interrupted as the data was buffered to avoid resolution issues, and the resolution itself. High-definition streaming required much more bandwidth (which was one reason Amazon did not offer it). In 2011, Netflix was working on a downloadable application that subscribers could use to monitor their connection speed and thereby optimize resolution (less than high definition) and minimize streaming interruptions. However, this application would not be ideal if the

10 Kyle Thibaut, “Netflix Gets into the Original Content Game, Buys an Upcoming Show for a Rumored $100M,” TechCrunch, March 15, 2011, accessed November 16, 2011, http://techcrunch.com/2011/03/15/netflix-gets-into-the-original-content- game-buys-upcoming-show-for-100m/. 11 A study from Horizon Media indicates that in first quarter of 2010, Americans spent an average of 158 hours and 25 minutes watching TV, and only three hours and 10 minutes watching video online. Source: Paul Bond, “As the Company Plans to Spend $1.2 Billion in 2012, Some Express Relief That They Are Buying Content No One Else Wants Such as ‘Pushing Daisies,’” Hollywood Reporter, January 14, 2011, accessed November 16, 2011, www.hollywoodreporter.com/ news/hollywood-execs-privately-netflix-71957. 12 Alana Semuels, “Americans Now Watch More TV than Ever,” Los Angeles Times, November 24, 2008, accessed November 14, 2011, http://latimesblogs.latimes.com/technology/2008/11/americans-now-w.html.

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Page 6 9B16M080 requirement was high-definition video. In the long run, a provider that could guarantee high-definition streaming would have an advantage. The differentiator would be bandwidth — any service that could deliver more content using less bandwidth would be favoured — especially from a remote device on a data plan. Production companies had been quick to realize that the omnipresent nature of their material, and customers’ ability to watch it anytime and anywhere, had exponentially increased the value of that content. As discussed below, this reality had proven the antecedent to drastic hikes in content licensing fees. User Interface and User Engagement Much of Netflix’s success had been based on the intimacy it had cultivated with its subscribers.13 Through technology, Netflix had developed a sense of customer engagement by combining thousands of data points to create a “one-of-a-kind” experience for each subscriber and/or household. Recommendations were based on customer feedback, both individually and in the aggregate, which provided a connection between the company and the customer, who was motivated to stay engaged. The more information provided to Netflix, the better the experience. To preserve the customer intimacy it had previously enjoyed, Netflix needed to continually improve its search, queues, recommendations, ratings, and other social media features so its subscribers became reliant on Netflix for data they required. However, these predictive analytics worked best when user preferences had some variability. Whether this approach worked with “rerun TV” was unclear, because most users were watching the same shows. The transition to streaming services threatened this differentiator, because customers were less invested when choosing a streaming movie: they experienced no wait or penalty if they had chosen a show they later found they did not like (versus waiting a few days to receive a DVD replacement). So Netflix needed to decide how much to invest in the predictive analytics going forward. Domestic Versus International Because of logistics, Netflix had distributed DVDs only to U.S. households, ignoring the total worldwide content distribution market. While international penetration presented significant issues in the distribution of DVDs, streaming data around the world was no different from streaming content domestically. Thus, the proliferation of streaming technologies had opened up large segments of the market that were once inaccessible. Netflix was thus looking to expand its streaming services into new geographical regions (as of 2011, Netflix provided streaming service in the United States, Canada, and Latin America). Streaming required a broadband connection, an area in which Chinese subscribers led, though not as a percentage of the total population (see Exhibit 3). Netflix’s first move, planned for the first quarter of 2012, would be toward the United Kingdom and Ireland. STREAMING GIVES RISE TO NEW CHALLENGES Content Acquisition and Distribution There was no doubt that streaming would help Netflix save on its distribution costs. It was estimated that Netflix had to pay the postal service $0.80 (this was a preferential arrangement) for mailing the DVD to the

13 See “Netflix,” Ivey product # 9B09M093.

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Page 7 9B16M080 subscriber (and return). Netflix also had to build distribution centres across the country in order to meet its stated goals of having the DVDs in the mailboxes within one day of placing the order. It would cost only $0.05 to stream a movie and perhaps a little more in high definition. However, renting DVDs was covered by the “first sale doctrine.” This meant that once Netflix paid full price for a DVD from the studio, Netflix had the rights to rent it out as many times as it wanted. Also, Netflix could acquire the latest DVDs as soon as they became available for retail purchase (usually two to three months after the theatrical release). In many instances, Netflix would actually be able to acquire the DVD as early as 28 days after the theatrical release because of its buying clout with the studios. This meant that Netflix DVD subscribers had access to the latest movies.14 This was no longer the case under streaming. Typically, the latest movies were available through streaming in a one-year window, simultaneously with the DVD release (see Exhibit 4). Most of this availability was pay-per-view except for airlines passengers in first-class and now international coach. Netflix had a stated policy of owning the rights of unlimited streaming (which was simply a continuation of the DVD subscription model) and not pay-per-view. So the latest movies were simply not available to Netflix streaming subscribers during this one-year window. After one year, the latest movies became available through premium channels (like Starz, HBO, or Epix) that negotiated the rights to broadcast these movies for up to 18 months. However, not all movies were available in a particular premium channel. In 2008, Netflix negotiated a three-year deal with Starz to have unlimited rights to broadcast all the movies in Starz’s portfolio. This deal was struck for $30 million at a time when Netflix had only seven million subscribers, and was not considered to be a threat by Starz’s other customers, such as the cable and satellite companies. For Starz, this was nothing but some extra revenue. This all changed by 2011, when Netflix (with its 24 million subscribers) began to be viewed as a legitimate option for “cord cutters” who were giving up their cable or satellite subscriptions. In the third quarter of 2011, Starz turned down a $300 million offer from Netflix to renew the three-year arrangement. Further, production companies (studios) had recently revalued their material and accordingly increased their licensing fees (see Exhibit 4). While the lifecycle remained the same as in years past, production companies now wanted to reap significantly more for their creations than they had previously. Their elevated expectations had all but eliminated the trade space that once existed between the producers of the material and the distributors. This conundrum left Netflix very few options so far as acquisition of new movies was concerned, unless it was willing to embrace pay-per-view (see Exhibit 4). Content Acquisition Costs With the new tiered and updated pricing, content providers posed a real threat to the profitability and continued viability of Netflix. Production companies recognized that the streaming services had increased the value of their material and were demanding premium compensation for licencing agreements. Distributors were being squeezed by the rise in prices of their raw materials, and finding common ground with their suppliers was often more difficult. One analyst believed Netflix would spend $700 million in 2011 and $1.2 billion in 2012 to license Hollywood content for its streaming video service. The content acquisition costs that Netflix had most recently been forced to shoulder included the following:  Total licensing costs: $180 million in 2010  Epix: $900 million over five years ($200 million annually)

14 “Act II: Netflix and the Shift from Mailing Atoms to Streaming Bits,” Getting the Most Out of Information Systems, accessed January 6, 2016, http://2012books.lardbucket.org/books/getting-the-most-out-of-information-systems-v1.3/s08-03-act-ii- netflix-and-the-shift-f.html.

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Page 8 9B16M080  Time Warner, CBS, CW: Close to $1 billion over eight to 10 years15  DreamWorks: $30 million per picture16  NBC Universal: estimated at $275 million per year (up from $22 million)  Disney/ABC: $183 million per year  Fox: financial terms not disclosed  Relativity: $100 million per year As noted, Netflix negotiated its content acquisition deals as a flat fee that allowed it to have unlimited distribution rights of the content to as many viewers it wanted. Competition Considering the capture of streaming-video consumer dollars, Netflix had rivals in several different areas (see Exhibit 5). However, not all of these competitors were targeting the same customer segments. The advent of streaming technology had entirely changed and significantly reduced the barriers to entry into the content distribution market. Competition in the streaming arena was thus much more severe than competition had been within the DVD sector. Even old rivals such as Blockbuster, acquired by DISH Network, were able to re-enter the market and vie for market share. Further, production companies, in their efforts to increase profits and control the material they produced, were forward-integrating into the distribution market; for example, Walt Disney had been successful in this endeavour, as had others. Threat of New Entry Netflix faced moderate risk that a new entrant might change the competitive paradigm within the streaming segment of the content distribution market. The emergence of a fledgling or not-yet-conceived company was always a possibility, as was the downstream integration from content providers into this space. Content producers made heavy upfront investments; as such, they wanted to wring every cent out of each show they produced. If they could cost-effectively stream content they already owned, any intermediaries would be eliminated. For example, Universal Studios or 21st Century Fox, could, given their resources, establish their own streaming distribution channels, which would effectively eliminate this content from Netflix’s library (i.e., Netflix customers would be unable to access the latest blockbuster from Universal Studios because the production company retained sole rights to its distribution). Ease of Switching Netflix faced the grim reality that customers of streaming services enjoyed a privileged position. Competition meant that subscribers could easily leave one service for another, giving buyers considerable power. Netflix was, in essence, another “premium channel,” like HBO, competing for consumers. The low cost of Netflix streaming ($7.99 per month) made it attractive and affordable, but also easy to leave. The threat was not that subscribers would leave Netflix for a competing service, but rather, that they might leave due to a lack of compelling content for the price charged. The same attributes that made Netflix

15 Lauren A. E. Schuker and Stu Woo, “Netflix Digs Deep for ‘Gossip Girl,’” Wall Street Journal, October 14, 2011, accessed August 23, 2015, www.wsj.com/articles/SB10001424052970204002304576628983215283342. 16 Brooks Barnes and Brian Stelter, “Netflix Secures Streaming Deal with DreamWorks,” New York Times, September 25, 2011, accessed August 23, 2015, www.nytimes.com/2011/09/26/business/media/netflix-secures-streaming-deal-with- dreamworks.html.

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Page 9 9B16M080 easy to join also made it easy to cancel. Low switching costs and the “free” available alternatives were a clear threat to Netflix. Potential Customer Segments Expanding on the service to the United States, Canada, and Latin America already established by 2011, Netflix planned to expand into the United Kingdom and Ireland in the first quarter of 2012.17 WHAT NOW? Netflix needed to address two pivotal questions: (1) How could it retain the customer base that it already had and, more importantly, gain expansion in its total subscriptions? (2) How could it minimize the costs associated with content acquisition? Neither were easy questions to address. Netflix knew the future was in the non-physical diffusion of media, but how should it make the transition? This new “streaming” battlefield had a multitude of competitors, which increased the rivalry for exclusive content. Perhaps most shocking of all, the producers of movies and TV shows were revaluing their products. Starz had turned down a $300 million offer from Netflix. These contemporary realities were dramatically increasing Netflix’s costs of doing business. Netflix had tried to pass these expenditures on to consumers but had been met with revolt. So what next? Should it reverse its recent decisions on subscription prices and the division of the company into two parts? Would Netflix be best served by entering into a strategic partnership with another player? If so, who, and at what cost? Should Netflix pursue integration, either forward or backward, to dislodge the problems facing it regarding the licensing of content and its delivery to where people desired it? If so, where was the start point and what was the strategy? An alternative approach would be to refocus on the DVD market. If Netflix chose this route, should it still consider forward or backward integration? Should it expand internationally? If so, how would the company navigate the associated logistical matters? Finally, should it reconsider its flat pricing strategy and embrace a pay-per- view model?

17 Hastings and Wells, op. cit., p. 7.

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Page 10 9B16M080

EXHIBIT 1: CUSTOMER REACTIONS TO NETFLIX’S PRICE CHANGES, Q1 2010 TO Q3 2011

Source: “Netflix Stock Quote & Chart,” Netflix, accessed November 30, 2011, http://ir.netflix.com/stockquote.cfm; “Netflix Quarterly Earnings,” Netflix Inc.: Proving the Skeptics Wrong, accessed November 30, 2011, http://ir.netflix.com/results.cfm.

EXHIBIT 2: DVD RETAIL ECONOMICS

Source: Chris Anderson, “Why Better DVD Recommendations Are Worth a Million Bucks,” The Long Tail, October 3, 2006, accessed November 27, 2011, www.longtail.com/the_long_tail/2006/10/why_better_dvd_.html.

 $‐

 $50

 $100

 $150

 $200

 $250

 $300

12

14

16

18

20

22

24

26

Q110 Q210 Q310 Q410 Q111 Q211 Q311

Subscriptions (in millions)

Stock Price

‐30%

‐20%

‐10%

0%

10%

20%

30%

40%

50%

60%

$0

$2

$4

$6

$8

$10

$12

$14

$16

$18

$20

2 4 6 8 10 12 14 16 18 20 22

Age (months)

Acquisition cost

Ave. Sale price

Gross  margin

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Page 11 9B16M080 EXHIBIT 3: TOTAL BROADBAND SUBSCRIBERS, SELECTED COUNTRIES, Q4 2010 AND Q1 2011

Source: WebSite Optimization, “US Broadband Penetration Drops to 27th Place Worldwide: July 2011 Bandwidth Report,” accessed November 27, 2011, www.websiteoptimization.com/bw/1107/.

EXHIBIT 4: ECONOMIC LIFECYCLE OF A MOVIE

1. Theatrical Release 2. DVD sales (3+ months later)

 Retail (e.g., Green Lantern — released 10/14/2011)  Netflix (Green Lantern — released 11/11/2011) – 28 days later

i. Direct deals with studios to drive DVD sales 1. Sony, Universal, 20th Century Fox, Warner Bros.

3. Pay Per View (e.g., cable TV, hotels, airplanes, iTunes (Apple)) (simultaneous with DVD release)  Once theatrical release has run its course — usually two months  24-hour viewing period — holdover from hotel days

4. Premium Channels (Starz, HBO, Epix) (up to a year after theatrical release)  “Pay TV Window”  15- to 18-month exclusive window  At this point, a movie is also likely available on Netflix streaming  Movies no longer available for rental on iTunes (in pay-per-view category)  80 per cent of major Hollywood content  Typically hold rights for seven years

5. TV — TNT, USA, NBC, CBS, ABC  Ad-supported TV networks  Movies no longer available on Netflix streaming

6. 2nd run on Premium (Step 4) 7. “Library” (10 years after theatrical release)

 Generally available for streaming  Majority of Netflix streaming content comes from movies at this stage

Source: Hilary Lewis, “Why There’s No iTunes for Movies,” Business Insider, April 19, 2009, www.businessinsider.com/hollywoods-outdated-movie-rental-system-2009-4, accessed April 15, 2015.

0

20

40

60

80

100

120

140

160

Q410

Q111

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Page 12 9B16M080

EXHIBIT 5: COMPETITORS IN STREAMING MOVIES AND TV PROGRAMS Amazon Prime

Amazon Prime customers, who paid an annual fee in return for unlimited two-day priority shipping of all their purchases through Amazon’s network, enjoyed the benefit of a complimentary streaming service. Prime’s instant videos provided unlimited, commercial-free, instant streaming of thousands of movies and TV shows at no additional cost with a paid annual Amazon Prime or paid Amazon Student membership. Prime instant videos could be watched instantly on a Mac, PC and nearly 300 models of Internet-connected TVs, Blu-ray players and set-top-boxes that were compatible with Amazon Instant Video (Note: through the Kindle Fire, Amazon provided hardware, software and content — all optimized to make purchases from Amazon).

Hulu and Hulu Plus

Hulu offered its subscribers television content, both old and new. For a monthly rate, members could call up and watch any show they wished to, “wherever, whenever, however.” All of Hulu’s content was offered in high definition and posted immediately after the original showing on network/cable television. While Netflix did not offer recently released television material, Hulu might very well expand into the feature film market and become a direct competitor.

Premium Television

Premium television included such channels as HBO, Starz, ShowTime and Epix. Although employing a wholly different model, Netflix considered itself a member of this segment. Each of these outlets stood in direct competition with the others, fighting to provide the contents people desire in a seamless fashion. The content was mainly movies but also some original shows and sporting events.

BitTorrent Services

BitTorrent was the global standard for delivering high-quality files over the Internet, especially for large video, audio or software files. Counterintuitively, the speed of BitTorrent downloads improved commensurate with a file’s popularity because BitTorrent employed a protocol that allowed people downloading the file to upload (distribute) parts of it at the same time.

Through the aforementioned services, pirated content was readily available via the Internet through peer-to-peer networks or torrents. Virtually all content was available for download, including most movies before they were released on DVD.* Netflix believed that people were willing to pay for legal content if it was inexpensive and convenient.

TV Anywhere

TV Anywhere was an authenticated content delivery service offered in different forms by multichannel video programming distributors (MVPDs) and cable TV networks. The service essentially allowed a consumer to view material on any device that carried the requisite receiving and processing hardware and software. This capability was already built into computers, i-devices, tablets and other electronic systems. MVPD applications (e.g., DISH Online and Comcast) threatened Netflix because the once DVD-centric company did not have an application to compete on these platforms. Although TV Anywhere was not yet ready for market entry, Netflix believed that it would eventually become its primary competitor. Note: *Of the top 17 movies on thepiratebay.org at the time of this writing, 12 had not yet been officially released on DVD. Sources: Jason Kilar, “Introducing Hulu Plus: More Wherever. More Whenever. Than Ever,” Blog.Hulu.com, June 29, 2010, accessed November 16, 2011, http://blog.hulu.com/2010/06/29/introducing-hulu-plus-more-wherever-more-whenever-than- ever/; “Beginner’s Guide,” Bittorrent.com, accessed November 16, 2011, www.bittorrent.com/help/guides/ beginners-guide; R. Hastings and D. Wells, Letter to Shareholders, Netflix, accessed November 16, 2011, http://ir.netflix.com/common/download/download.cfm?companyid=NFLX&fileid=511277&filekey=85b155bc-69e8-4cb8-a2a3- 22465e076d77&filename=Investor%20Letter%20Q3%202011.pdf.

For the exclusive use of M. Darrat, 2017.

This document is authorized for use only by Mahmoud Darrat in 2017.