Assignment #7

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Adapted by Richard Robinson, J hn III and Ram Subr man

1 As we saw in the Netftix (A) case, by the end of 2011, Reed Hastings and the N'IIII I ecutive team were trying desparately to stop the fallout caused by their plan 10 ntiHl' JlI II and separate Netftix into two companies-a DVD mailer called Qwikster and a S(I'l' 1111 It I entity still under the Netftix name. In no time, they had lost millions of cust 111 rs lint! It Netftix's share price fall from $298 to $52.81. The team faced extraordinarily tryin I 111111 Eighteen months later, in May 2013, BloombergBusinessWeek correspondent Ashl ' , V 11111 visited that same team and filed this report on their amazing, uprecedentedly su 'l'l' <I III turnaround that is reshaping the entertainment, online entertainment, and Internet lndu II' structure:"

On a normal weeknight, Netflix accounts for almost a third of all Internet traffic enterin ' North American homes. That's more than YouTube, Hulu, Amazon.com, HBO Go, i'Iun 's,

o and BitTorrent combined. Traffic to Netflix usually peaks at around 10 p.m. in each time zone, at which point a chart of Internet consumption looks like a python that swallowed a cow. By midnight Pacific time, streaming volume falls off dramatically.

As prime time wound down on Jan. 31,2013, though, there was an unusual amount of tension at Netflix. That was the night the company premiered House of Cards, its political thriller set in Washington. Before midnight about 40 engineers gathered in a conference room at Netflix's headquarters. They sat before a collection of wall-mounted monitors thai displayed the status of Netflix's computing systems. On the conference table, a few dozen laptops, tablets, smartphones, and other devices had the Netflix app loaded and ready to stream.

When the clocks hit 12 a.m., the entire season of House of Cards started appearing on the devices, as well as in the recommendation lists of millions of customers chosen by an algorithm. The opening scene, a dog getting run over by an SUV, came and went. At 12: 15 a.m., around the time Kevin Spacey's character says "I'm livid," everything was working fine. "That's when the champagne comes," says Yury Izrailevsky, the vice presicl nt in charge of cloud computing at Netflix, which has a history of self-inflicted catastrophes. Izrailevsky stayed until the wee hours of the morning-just in case-as thousands of customers binge-watched the show. The midnight ritual repeated itself on April 19, when Netflix premiered its werewolf horror series Hemlock Grove, and again on May 26, when ils revival of Arrested Development went live.

2 Netftix has more than 36 million subscribers. They watch about 4 billion hours of pm grams every quarter on more than 1,000 different devices. To meet this demand, th 'Olll pany uses specialized video servers scattered around the world. When a subscrib r .li 'I , on a movie to stream, Netftix determines within a split second which server containin ' 111(11

'This Netflix (B) case is based on the article by Ashlee Vance, "Netflix, Reed Hastings Survive Missteps 10 .10111 Silicon Valley's Elite," BloombergBusinessWeek, May 9, 2013. ©2013, BloombergBusinessweek. All Ri Ills Reserved. May not be reprinted or used without written permission from Bloomberglsusinesswcck. 2Ashlee Vance, "Netflix, Reed Hastings Survive Missteps 1'0Join Silicon Vall y's Illil '," Bloombergliusinessweek, May 9, 2013. ©20 13, Blooinl. ergi3usillcs.,·wl'I'k. /\ II 1{II1111Hl{ ',~.rvcd,

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NIIII \ I 1111\'OJ' III \ world's bigg 'sl us 'rs or 'loud xunpuring, whi '11 m 'nns running a dill II "1'1111'1'Oil som one else's equipment. The company rents serv r and storage systems II III 1 huur, and it rents all this computing power from Amazon Web Services, the cloud division of Amazon.com, which runs its own video-streaming service that competes with Netflix.

4 It's a mutually beneficial frenemy relationship. Over the years, Netftix has built an array of sophisticated tools to make its software perform well on Amazon's cloud. Amazon has mimicked the advances and offered them to other business customers. President Barack Obarna's data fueled reelection campaign, for example, was run almost entirely on Amazon with the help of code built by Netftix engineers.

5 While Netftix started out as a DVD-by-mail rental service, it's now striving to become something far more complex: an entertainment power on par with HBO, if not HBO's parent company, Time Warner. Netftix plans to lead the shift to delivering television-style programming over the Internet and has developed sophisticated technology to support that transition. The company has invested hundreds of millions of dollars in original series- House of Cards, Hemlock Grove, Arrested Development, Orange Is the New Black, a Ricky Gervais show called Derek, and Turbo: F.A.S.T, a kids' show co-produced with Dream- Works Animation-to become a major player in Hollywood. "We think of the technology as a vehicle for creating a better, more modem experience for the content we have," says Chief Executive Officer Reed Hastings. "What we're really competing for quite broadly is people's time."

6 About 18 months ago, Netftix and Hastings were spending much of their time trying to save face. Netftix had awkwardly unveiled plans to raise prices and separate into two companies-a DVD mailer called Qwikster and a streaming entity still under the Netftix name-and lost millions of customers in the process. The share price fell from $298 to $52.81.

7 After issuing a fturry of apologies, Netftix has mounted one of the all-time great come- backs. House of Cards arrived to mostly spectacular reviews, while investors were equally enthusiastic about the company's first-quarter results. Revenue rose 18 percent from the same period last year to $1.02 billion, while the company added 2 million subscribers in the U.S. alone, dispelling widespread fears that its growth had slowed. Shares of Netftix are back above $200. It's one of the best-performing stocks of the year.

S Hastings doesn't have an office. He moves around headquarters meeting with people and plopping down at spare tables to deal with e-mail. When he needs a quiet place, he heads to his watchtower, a room-size glass square built on the roof of Netftix's main building. To get there, you climb a staircase to the roof and walk along a narrow walkway past air condi- tioning units and other machinery. Usually someone turns on the AIC in advance. The room can get hot since it's basically a greenhouse with a round conference table and spectacular views of the Santa Cruz Mountains.

9 As the watchtower's AIC blasts on a late afternoon, Hastings, 52, sits in one of the suede chairs, exuding calm. He's goateed, skinny, and sounds extremely Californian when he talks about Netftix's prospects. "We are trying to set this up as a continuously learning organization," me says between mouthfuls of granola. "My role is creating that learning atmosphere."

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unveiling increasingly complex businesses, culminating with Nutqwakflikster-a nut, ill surance, and movie seller. "We know you hate us," the faux Hastings concludes.

11 Qwikster was a fiasco, but far less threatening than a debacle that preceded it. In All '1I1>t 2008, Netflix's technology infrastructure melted down. This was when the company WII, still known for DVDs-by-mail, and for three days it could not send discs because a cru .iul Oracle database kept malfunctioning. Reporters and customers took notice. Netflix tral'\'d the problem to an expensive, third-party storage system that went haywire after a software update. The incident still annoys Hastings. When the subject comes up in the watchtower, Chief Product Officer Neil Hunt, who's also gathered at the table, suggests they not men tion the storage-system vendor by name. Hastings responds, "Let IBM have it, baby." (All IBM spokesman declined to comment.)

12 Hastings and Hunt have worked together on and off for 25 years, meeting when till' were both in the research division of Schlumberger, the oil field-services cont:racLor. Av cording to Hastings, Hunt is responsible for Netflix's technology. "It's mostly list nilll' to Neil," he says. "He's on a first principles basis with this stuff. It's not like I saw SCHIll' golden tablets and then went forward." Still, engineers at Netflix recall Hastings pr sidi lip over a number of meetings following the 2008 shipping disaster. He warned that a siruilru technical issue on the streaming side of the business would be even more devastati ng. !\ lid Hastings began to see that as the streaming business grew, Netfiix would need ever 11101\' computing horsepower. It could hire an elite team of data-c nt I' engineers an I build itl> own computing centers-a Ia Google, Microsoft, and Amuzou.corn-e-or it could J110V • ev cryrhing to th cloud.

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13 Netftix began to experiment with cloud services from Amazon and Microsoft, where Hastings served as a board member. In 2009 he bet his company's future on Amazon. Up to that point, nothing the size of Netftix had placed so much of its crucial technology on Amazon's systems. Hastings sent an e-rnail to Amazon CEO Jeff Bezos, announcing his plans. "I asked him if he was comfortable with that idea," Hastings says. "If not, there was no point going forward." Bezos gave the go-ahead.

14 At any moment, Netfiix draws upon 10,000 to 20,000 servers running in Amazon data centers somewhere. The computers handle customer information, video recommendations, digital rights management, encoding of video files into different formats, and monitoring the performance of the systems. When a new device like an upgraded Xbox or a Samsung smartphone comes along, Netftix uses thousands of extra servers to reformat movie files and deal with the new users. By day, some servers handle the grunt work tied to stream- ing video; by night, they're repurposed to analyze data. The company has been pushing Amazon Web Services to its limits. "We're using Amazon more efficiently than the retail arm of Amazon is," says Adrian Cockcroft, Netflix's cloud architect. "We're pretty sure about that."

15 Few relationships in the technology industry are as complex as Netftix and Amazon's. Netftix's status as Amazon's biggest customer has earned it favorable pricing and direct lines of communication to Amazon's top engineers. When Netftix wants a new software feature, Amazon is quick to deliver it, and other customers eventually benefit from that work. "There's no question in my mind that our platform is stronger from a performance and functional standpoint because of the collaboration we have with Netfiix," says Andy Jassy, who heads Amazon's cloud business.

16 Netfiix has been forced to build from scratch much of the software it needs to survive. Since it relies om.Amazon for data centers, its 700 engineers focus on coming up with tools for, say, automating the ways in which thousands of cloud servers get started and config- ured. In Silicon Valley, Netftix has become best known for its so-called Simian Army, a [acetiously named set of applications that test the resilience of its systems. Chaos Monkey, 1'01' insuinc ,simLilates small outag ~ by ran lomly turning s rvio s off, whil haos KOIl) 111111'I down nil '1IIil" dllill "111'1",

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18 Hastings tends to exist in one of two emotional states: relaxed and attentive, or rclu II and dismissive. The things he cares about he'll discuss animatedly; with everything '11'1',II disengages. Architecture? He claims he never looked at the designs for Netflix h 'adqlllil tel's, preferring to just walk in and get to work when someone said the facility was I''ad ,"II was the symbolism of not having me focus on the building," he says. But if you want II)l'llIll about contemporary computer science techniques such as distributed hash tag databus 'S 1111I1 the merits of key value stores, then, yes, Hastings does have an opinion.

19 His geeky side became fully apparent in December 2005. He was convinced 1111111111 star rating system provided all the information Netflix needed to predict accurately wluu people want to watch. Others at the company argued that more indicators-whether p~'IIf1h' started playing something and then stopped, or searched for a particular actor, etc.- wen needed as well. Hastings spent two weeks over his Christmas vacation pounding awn 011 an Excel spreadsheet with millions of customer ratings to build an algorithm that could 1l\'1I1 the prediction system designed by his engineers.

20 He failed. Still, the attempt sparked the creation of the Netflix Prize, a $1 million bouut y to the person or group that could improve its ratings-based algorithm the most. It was 1111' rare meaningful publicity stunt: The winning team, a collection of independent engin '\'1 from around the world, built Netflix a better prediction engine. And a company thut WII famous for red DVD mailers and outmaneuvering Blockbuster started gaining attent ion 1\ a place for creativity.

21 Netftix can now hire just about any engineer it wants. That's a function of the computet science the company does and its reputation as the highest payer in Silicon Valley. Mallup. ers routinely survey salary trends in Silicon Valley and pay their employees 10 perc 'lit III 20 percent more than the going rate for a given skill. Fired employees also get ultra 1 '11\'1 ous severance packages; the idea is to remove guilt as an obstacle to management I Hl'lilll-l ways with subpar performers.

22 Netftix also tends to employ older people than its peers. "We hire fully formed adults," says Cockcroft. "We let them do five years at Google before taking them on." A wull, around the company's offices bears this out. Engineers work in proper cubicles with hil,lI walls that are very out of fashion in the Valley, which has embraced open floor plans. Till' only real flair: Bathroom doors are decorated to look like entertainment legend (HOIIII'1 and Marge Simpson, for example), and the meeting rooms are named after TV hows 1111(1 movies, with famous lines written on the glass wal-ls.

23 One regular engineering meeting takes" place in the Office Space room. (Quotation: '" wouldn't say I've been missing it, Bob.") To kick things off, everyone talks about wluu they've been watching. One guy says he saw The Hunger Games and started getting 1" '0111 mendations for Bachelorette and The Longshots.''I'm not sure how these have anything In do with Hun.ger Games," he says. "They're all cast as post-ape .nlyptic movies."

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25 Netftix is always testing things. It will select a group of customers, typically by the tens of thousands, and use them as guinea pigs. One group has been given the ability to create avatars for each member of their families, who in turn get individualized recommendations. Others who watch Netftix via the Sony PlayStation have been greeted by a voice that asks what people in the room want to watch.

26 The most rigorous testing concerns recommendations. Netftix has a vast catalog of mov- ies and shows, but much of its content is old and of limited appeal. To make its service feel valuable, Netftix tries to maximize the likability of the titles that get displayed on some- one's home page.

27 One of Netftix's mathematicians is known as lO-Foot User Interface Guy because the average person watching the service via TV sits 10 feet away. His job is to arrange the box art of videos in the most appealing way on a big screen. There's also Two-Foot Guy, who deals with laptops, and 18-Inch Guy for tablets.

28 The master copies of all the shows and movies available to Netftix take up 3.14 pet- abytes of storage space. (In comparison, Facebook uses about 1.5 petabytes to store about 10 billion photos.) Hollywood studios used to send individual films and shows to Netftix on a disc or thumb drive; now they use a Netftix system called Backlot to send encrypted files via the Internet. Netftix then compresses the files and creates more than 100 different ver- sions, each tuned for the varying bandwidth, device, and language needs of its customers. (An hour of video for the iPhone would be about 150 megabytes.) This compressed catalog comes to about 2.75 petabytes.

29 Each night, Netftix performs an analysis to see which shows were the most popular where. From 2 a.m. to 5 a.m. local time, it fills its servers with the appropriate programs. If Battlestar Galactica is popular in Houston on Tuesday, then servers in Texas will be loaded up with more episodes in time for Wednesday night. The most popular videos go on high- .speed ftash storage drives; everything else gets stored on cheaper, slower hard disks. "We use this predictive model to make sure the content is there before the user asks for it," says Ken Florance, vice president for content delivery at Netftix.

30 The biggest bets Netflix is making now are on its original shows. The company won't disclose how much it paid for two seasons of House of Cards, though the Hollywood blog Deadline.com says it was about $100 million. Rather than make it a weekly show, Netftix released all 13 episodes at once. That meant viewers could watch the whole season in one marathon sitting. It also meant the producers didn't have to alter the plot to give every episode a cliffhanger ending. "If you give people a more creative format, then they can tell their stories better," says Ted Sarandos, the company's Beverly Hills-based content chief. He adds that Netftix's goal is, in part, to become HBO before HBO can become Netftix. "They do great content that people love. What are the things we do well? It's the delivery technology, the user interface stuff, the integration into computing devices, and the earn- il'SH sl ream ing."

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32 Amazon is introducing its own series, too, and Hollywood is abuzz with hop '1IllIi Nctlllx and Amazon will spend wild sums of money on even more shows. Sarandos, Ihou 'h, say, Netfiix is very calculating in its buys. The company puts actors' names and th show Iyp(' through its algorithms to determine the likely size of an audience. "I can justi i'y the sp 'lid with our data and do so with a far greater degree of confidence than the televi .ion n 'I works," he says. Viewers have given House of Cards a rating of 4.5 stars out of fi ve, wh i '1\ Sarandos says suggests the company is on the right track. "It's definitely art and scicn '(' mixing," he says. Sarandos goes on to say that Netfiix will use its data to help pick whi '1\ actors should be in future shows and who should direct them.

33 Beau Willimon, the show runner for House of Cards, says the story and actors were all decided before Netfiix bought the series. "Every single casting and story choice was made from the creative side," he says. Even though Netfiix has a rich trove of data about 11ll' House of Cards audience, Willimon has tried to avoid hearing about any viewership statis tics. "That sort of data is a dangerous thing," he says. "If you put too much thought into thnt stuff, you run the risk of trying to pander to people."

34 Despite its stash of data, Netfiix refuses to release any viewership numbers. Unlike the networks, it doesn't have to prove the size of its audience to advertisers. "The networl s have to spend tens of millions of dollars to promote must-see events and create an audi ence," says Sarandos. "When we buy ads, it's just to let people in the industry know thai something different is happening." Kohan says Netfiix has gotten under the networks' skill, "They've pissed a lot of people off," she says. "There is rage because they won't reveal th .ir data. But I think they're being brilliant because everyone is talking about them."

35 Netfiix's critics argue that the company has sacrificed too much control over its te h nology in its effort to get ahead of rivals. "The problem with Netflix is that they are in x- tricably bound into Amazon for all eternity," says Paul Maritz, a computing infrastructur ' veteran and CEO of the cloud computing startup Pivotal. "If they want to go somewh rc else, it will be hard." Hastings and his staff characterize such criticism as sour grapes.

36 Another concern is that the studios will stop licensing content now that Netfiix is in rh ' originals business. Hollywood is right to remain wary ofletting any single entity get too pow- erful. As Netflix expands overseas, it intends to strike worldwide licensing deals instead of hammering them out country-by-country. From a studio perspective, that could give Netllix the ability to come up with lucrative terms that no regional competitor could match.

,37 Over the past five years ,'.l chart of Netflix's share price has shifted from a smooth, upward curve to more of a scribble. Hastings seems unperturbed. The experimentation is a goal in itself, whether it's big things like corporate missions or little things like the personal technol ogy he uses. For one month, he'll only use products made by Apple, and the next he's on to phones, tablets, and laptops running Windows. May is Google month, and Hastings has one of the company's touchscreen Chromebook Pixel laptops. "I just keep it rotating," he says.

38 The stock, which has been trading in the low 200s at a price-earnings ratio of 300, is just another side effect of learning, and Hastings doesn't consider the ride all that rocky. "Th 'Il' was the Blockbuster battle and there were our own mistakes on Qwikster," he says, li 'kin! off a greatly abbreviated list of his company's melodramas and n .ar-d ath expcri 'n 'l's, "Other than that, it's not that volatile."

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har of downstream North American Web traffic by time of day

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earned if they were working

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36 million

members worldwide

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GRAPHIC BY BLOOMBERG BUSINESSWEEK. DATA: SANDVINE NETWORKS, BUREAU OF LABOR STATISTICS