Netflix, Inc.

It’s not Netflix that’s making the changes. It’s the Internet.

- Reed Hastings, Netflix CEO

At the 2017 Golden Globe awards, Netflix CEO Reed Hastings applauded from his front row seat
as he watched screenwriter Peter Morgan approach the podium. Netflix content executives Ted
Sarandos and Cindy Holland were seated beside Hastings. Peter Morgan’s Netflix-produced original
series “The Crown” had just won the award for best television drama. The biographical series about
Queen Elizabeth II prevailed over formidable competitors including HBO’s “Westworld” and “Game of
Thrones.” With a budget of 100 million British pounds, “The Crown” was also one of the most expensive
dramas ever made. This fact was not lost on Hastings. Standing behind the microphone, Morgan
looked out into the audience for the Netflix executives. “Ted, Reed, Cindy–Thank you,” he began the
acceptance speech.

After returning to his hotel that evening, Hastings reflected on the career that had taken him, a
former vacuum cleaner salesman, onto the red carpet. His thoughts quickly wandered back to Netflix’s
business matters. The annual report would be released in two weeks. With Netflix’s stock trading at
record highs, investors were looking for numbers to justify Netflix’s $55 billion market capitalization.
Winning Golden Globes is noteworthy, but Netflix lived as much on Wall Street as it did in Hollywood
and Silicon Valley. Netflix had a negative free cash flow of $1.7 billion in 2016. How could Netflix ensure
that it was spending money on the right content? Netflix was now operating its streaming service in
190 countries worldwide and needed to cater its licensed and original content to a much more diverse
audience than ever before. Also on Hastings’ mind was Netflix’s sometimes contentious relationship
with internet service providers (ISPs). Netflix relied on ISPs to deliver its high-bandwidth content to
subscribers. How could Netflix ensure that the ISPs would provide the high-speed connections required
to deliver streaming content to its subscribers? Finally, Netflix was facing tougher competitors. Amazon,
HBO, and Hulu were investing heavily in streaming content too. As Netflix approached its twentieth
year, how could Netflix keep subscribers loyal and acquire new ones?

A Brief History of Netflix

I got the idea for Netflix after my company was acquired. I had a big late fee for “Apollo 13.” It was six
weeks late and I owed the video store $40. I had misplaced the cassette. It was all my fault. I didn’t want
to tell my wife about it. And I said to myself, “I’m going to compromise the integrity of my marriage over a
late fee?” – Reed Hastings, Netflix CEO

Reed Hastings late fee story may include a bit of corporate legend and marketing exaggeration. In
an interview, Netflix’s other founder and former CEO, Marc Randolph stated that Hastings’ late fee
story “never happened.” Instead, Netflix’s DVD rental-by-mail business was a carefully planned enter-
prise made possible by advances in video-on-demand and home internet technologies.

VIDEO-ON-DEMAND
Through the 1980s most television shows were commissioned and carried by major networks such
as ABC, CBS, and NBC. The networks had started in radio and followed the same business model with
the arrival of television. Using licenses granted by the Federal Communications Commission (FCC),
networks broadcast to viewers free of charge and earned money by selling advertising spots.
 With the advent of cable television, themed channels like Nickelodeon, CNN, ESPN, and HBO
emerged. Cable companies and channels made money by charging viewers monthly subscription fees
and selling advertising. The broadcasters’ advertising revenues declined, but they were able to
compensate by charging cable companies for carrying their content.

With the introduction of the video cassette recorder (VCR) in the 1980’s, viewers gained the ability
to watch video content on their own schedule. They could either purchase prerecorded cassettes or
make their own tapes from television broadcasts. Instead of being locked into the broadcasters’ sched-
ules, viewers could now consume content at their convenience and skip commercials.

Prerecorded cassettes initially retailed for around $50, spurring mom-and-pop retailers to form
local video rental clubs. The retailers purchased the tapes and rented them to customers to recover
purchase costs and earn a profit. By 1988, video rental revenue was $5.15 billion, surpassing movie
box office receipts. In the mid-1990s, the DVD (digital versatile disc) was co-developed by several
electronics companies. DVD discs delivered better video quality than VHS tapes and did not require
rewinding after viewing.

HOME INTERNET
On December 1, 1996, internet service provider America Online abandoned its pay-by-the-hour
billing system. Instead, its seven million customers were offered unlimited internet access for a flat
$19.95 monthly fee. Other internet service providers quickly followed suit. The “all you can eat”
pricing freed customers from hourly usage fees, but quickly clogged telephone lines with dial-up
modem traffic.

In 1997, 37 percent of US households owned a computer, and 18 percent of U.S. adults used the
Internet at home. The 56-kilobit dial-up modem was introduced in January 1997, potentially
doubling users’ connection speeds. Most connections, however, were limited to 40 kilobits per
second by telephone line quality. At the turn of the millennium, Internet service providers began
offer- ing substantially faster broadband service through digital subscriber lines (DSL) and cable
modems. Broadband technology enabled streaming of high-quality video. By 2005, broadband
adoption had surpassed dial-up Internet service (Exhibit 1).

REED HASTINGS AND MARC RANDOLPH

After high school, Reed Hastings spent a year selling Rainbow vacuum cleaners door-to-door
before enrolling in Bowdoin College where he majored in mathematics. He followed college with a
Peace Corps assignment teaching math in Swaziland before returning to school again, this time earn-
ing a master’s degree in computer science from Stanford.

In 1991, Hastings founded Pure Atria Software to commercialize a software debugging program he
had written. The company grew quickly under Hastings’ leadership and acquired Integrity QA, where
Marc Randolph was the Vice President of Marketing. After the acquisition, Hastings and Randolph
began working and commuting together.

Marc Randolph began his career fulfilling mail orders for songbooks at the Cherry Lane Music
Company. The job allowed him to experiment with different catalog designs and order forms to deter-
mine which generated the most sales. He moved on to designing software for managing Cherry Lane’s
music magazine subscriptions. In 1984, he helped start MacUser magazine which eventually led to his
career in software marketing.

In late 1996, Pure Atria’s board decided to sell the company to Rational Software for $585 million.
Randolph, knowing that his job would likely be cut after the merger was completed, began planning
a new venture. Based on his prior experience in direct mail sales, Randolph realized that the recently
released DVD format would dramatically change the movie distribution. Unlike VHS tapes, the new
DVD discs were thin and easy to mail. In 1997 with funding from Hastings, Randolph began
developing a business based on mailing DVDs.
 BUILDING SUBSCRIBERS
Netflix’s website went live on April 14, 1998. Netflix built an underground following before launch
by seeking out technology writers in Internet Usenet groups (an early form of blogging). Netflix
offered them the chance to be the first to write about Netflix after it launched in return for beta
testing their rental system. This provided Netflix with the opportunity to work out operational issues
and granted it immediate access to tech-savvy customers on launch day.

To attract new subscribers with the requisite DVD player, Netflix convinced electronics
manufacturers to package a Netflix coupon with new DVD players. The coupon was mutually
beneficial. DVDs were still not commonly available, but with the coupon, manufacturers could provide
their customers access to a library of hundreds of rental DVDs.

PERSONALIZED WEBSITE
Netflix’s website was designed to duplicate the best parts of the video store experience. Netflix’s
personalized recommendation engine replaced store clerk suggestions. It also pushed customers to
older, in-stock movies instead of suggesting new releases. This enabled Netflix to fulfill demand with
cheaper inventory and gave Netflix a reputation for having rare niche and foreign films.

One day we hope to get so good at suggestions that we’re able to show you exactly the right film or TV
show for your mood when you turn on Netflix. – Reed Hastings, Netflix CEO

Christina Kish, Netflix’s head of marketing, was inspired to create the Netflix Queue based on her
frugal reading habits. Kish often visited bookstores to find new books, making a list of the titles she
liked for later use at the library. Similarly, Netflix’s Queue allowed users to designate films that
interested them and mark them for later viewing.

BUSINESS MODEL EVOLUTION

Netflix’s early business model mirrored that of brick-and-mortar video stores. Netflix customers
could browse through DVDs on Netflix’s website and have them mailed directly to their homes. DVDs
rented for $4 each, plus an additional $2 shipping fee. If the renter wanted to keep the DVD they
could purchase it at a discount. Initially, Netflix was also one of the few places where customers could
buy DVDs, making sales a primary source of revenue. However, this income stream was under threat
as retailers like Amazon and Walmart began stocking DVDs. Randolph and Hastings met with
Amazon’s Jeff Bezos and agreed to a cross promotion deal with Amazon. Netflix would direct DVD
buyers to Amazon in exchange for ad placement on Amazon’s website.

In 1999, Netflix began testing different ways to increase rentals and drive customer loyalty. Netflix’s
Home Rental Library concept sent customers six DVDs at a time for a $20 per month subscription.
After returning all the discs, customers could select six more DVDs to rent. Netflix’s Serialized Delivery
concept continued using Netflix’s per disc rental pricing but allowed customers to create a short list of
future movie rentals. As soon as the customer returned a DVD, Netflix would send another movie from
their list. Customers in the market test groups liked both concepts, so Randolph decided to combine
them into a concept called the Marquee Plan. Customers were offered four movies for a
$15.99 per month subscription. Hastings labeled the program “near DVD-on-Demand” and positioned
it as an alternative to Blockbuster’s due dates and late fees. Within six months the program tripled
rentals to more than 100,000 per week. Netflix announced a change to the Marquee Program in
February 2000 to allow unlimited rentals with up to four DVDs out at a time.

Imagine watching whatever DVD movies you want, keeping them for as long as you want, and watching
as many as you want, all for a flat fee of $19.95 per month...Similar to AOL’s transformation of the Internet
with its unlimited access plan for a flat fee, Netflix is changing the rules of the movie rental market. –
Reed Hastings, Netflix CEO
 NETFLIX TAKES ON BLOCKBUSTER
David Cook founded Blockbuster in the mid-1980s. Cook owned a Texas-based software company
catering to customers in the oil and gas industry. When the 1980s glut in the oil market began
taking a toll on his software business, Cook decided to shift his focus to the video rental market.
Using

his experience with databases, he created an automated video rental tracking system. He opened the first
Blockbuster store in 1985 and used the tracking system to optimize video availability. By 1992, Blockbuster
was opening a new store every 24 hours and acquiring rival video store chains domestically and
internationally.

To improve the availability of new releases, Blockbuster established revenue sharing agreements with
studios. Instead of buying videos outright, Blockbuster negotiated steep discounts for videos and gave
studios 40 percent of rental revenue. The DVD was introduced in March 1997, and although it was a
consumer success, with nearly 400,000 DVD players sold in the first six months, Blockbuster viewed the
format as a threat to its VHS-based business and refused to stock it in stores until late 1998.

By 2000, Blockbuster had grown to 7,700 stores and generated $535 million in earnings on $4.96
billion in revenue. In contrast, Netflix had 300,000 subscribers and was expecting losses of $57
million.34, 35 Running low on cash, Netflix’s Hastings proposed an equity alliance to Blockbuster:

’ be their online
We offered to sell a forty-nine-percent stake and take the name [Link]. Wed
service – Reed Hastings, Netflix CEO

Blockbuster declined the offer. Blockbuster’s management believed that spontaneity drove the video
business; it doubted that Netflix’s mail-based business would succeed. Furthermore, Blockbuster was
already working on a product that would potentially make VHS and DVD rentals obsolete. In partner-
ship with Enron Broadband, Blockbuster was creating a video-on-demand movie streaming system.
During a trial launch of the system, customers were able to purchase a $100 device that allowed them
to watch rented movies without a trip to a Blockbuster store. However, within months, Blockbuster’s
attempt to create a video-on-demand service with Enron fell apart. In 2001, Blockbuster took a $450
million charge to replace obsolete VHS inventory with DVDs.

Netflix’s continued growth astounded Blockbuster and analysts alike. A report from Kagan Research
indicated a maximum of 3.6 million potential users for online rental services, paling in comparison to
Blockbuster’s 65 million members. One Gartner analyst described Netflix as, “a good niche business.”
By 2002, however, Netflix was profitable and had launched an initial public offering (Exhibit 2).

NETFLIX, MCDONALD’S, AND REDBOX

While Blockbuster continued to ignore Netflix, the online-movie rental business experimented
with physical retail locations. Netflix’s Marc Randolph and Mitch Lowe wanted to give Netflix users
the same instant gratification that Blockbuster customers received when visiting stores by using self-
service kiosk machines. Lowe had in fact attempted this idea unsuccessfully years earlier with VHS
tape rentals after becoming frustrated with his own video store’s employees and overhead expenses.
Due to the high cost of the machines, however, Randolph and Lowe decided to test the idea with a
Netflix counter operated by a single employee inside a Las Vegas grocery store. This ‘Netflix Express’
concept tested well. McDonald’s contacted Netflix and was interested in using the rental kiosk idea
to draw more customers into their restaurants. Despite its promise, Netflix’s Reed Hastings shelved
the idea. The video business appeared to be heading towards online distribution and the self-service
kiosks looked like a step backward. Not ready to give up on the idea, Lowe quit his job at Netflix and
went to work for McDonald’s Ventures, where he helped create McDonald’s Redbox DVD rental kiosk
business. Randolph left Netflix in 2003 and was replaced by Hastings as CEO. By 2004, McDonald’s
had installed Redbox kiosks in all 50 states.
BLOCKBUSTER GOES POSTAL
Blockbuster finally acknowledged Netflix’s threat to their business in 2004:

...in August 2004 we jumped into the online business in a big way. A few months later we made a dramatic
change by eliminating late fees, which had been a major customer irritant. Those moves put Blockbuster
back into growth mode...We were planning to spend $200 million to launch Blockbuster Online and
another $200 million to eliminate late fees. – John Antioco, Blockbuster CEO

Blockbuster Online launched in August 2004 at $19.99 per month undercutting Netflix’s $22
per month rate for new customers. Blockbuster Online subscribers could select DVDs to rent on
Blockbuster’s website instead of visiting stores. The subscription included unlimited DVD rentals by
mail, and customers were allowed to have up to three DVDs out at a time. Two free in-store movie
rentals per month were included with the subscription as well. Netflix responded by cutting its
three-out subscription price to $17.99. Not to be outdone, Blockbuster then dropped their price to
$14.99. Blockbuster advertised the new service heavily with television commercials and in-store
coupons. Within four months Blockbuster achieved 750,000 subscribers, a number that had taken
Netflix four years to reach. In April 2005, Hastings commented on an investor conference call that
Blockbuster had thrown everything at them except the kitchen sink. Blockbuster’s management obliged
and shipped Hastings a kitchen sink from a hardware store the next day.

In November 2006, Blockbuster announced a hybrid mail and in-store rental model dubbed
Blockbuster Total Access. Total Access allowed Blockbuster Online subscribers to exchange their
DVDs at store locations as well as by mail. The program also offered subscribers a shorter shipping
cycle. If they returned their online rental to a Blockbuster store, it would automatically release the
next movie in their queue for shipment.

Customers shouldn’t have to choose between renting online versus in-store, and they should never have to
be without a movie. Now thanks to Blockbuster Total Access, they don’t have to. – John Antioco,
Blockbuster CEO

Blockbuster’s success with Total Access crippled Netflix’s subscriber growth. Wall Street analyst
Michael Pachter declared, “I don’t know how Netflix can win this thing. The only way they can get
back to growth is if Blockbuster goes away.”

LEADERSHIP CHANGES AT BLOCKBUSTER

A compensation dispute between Blockbuster’s CEO, John Antioco and billionaire activist share-
holder Carl Icahn resulted in Antioco’s departure from Blockbuster in July 2007. Jim Keyes, a former
chief executive from 7-Eleven replaced Antioco. Keyes was renowned for his data-driven decision
making. He extended this practice even to 7-Eleven’s doughnut orders, which were adjusted daily
based on historic sales data and weather forecasts. When Keyes left 7-Eleven, he had overseen 36
consecutive quarters of revenue growth. His retail success was badly needed at Blockbuster. The chain
had closed 9 percent of its stores in 2006 and was planning to close an additional 242 in 2007.

The opportunity for Blockbuster is to provide true total access whether in the form of physical stores or
mail delivery or digital distribution. – Jim Keyes, Blockbuster CEO
 During a July 2007 corporate retreat, Keyes presented a store-focused strategy. Stores would be
transformed into entertainment destinations with prepared foods, retail electronics, and kiosks where
customers could load rented movies and games onto flash drives. In April 2008, Keyes made an
unsolicited offer to buy Circuit City for $1 billion in an attempt to transform Blockbuster into an
electronics retailer. Circuit City’s board rejected the offer, doubting Blockbuster’s ability to finance
such the deal.

The company announced a big price increase for online customers, cut way back on marketing, and
decided to intensify the focus on the store-based business… I sold my stock and bought a bunch of
Netflix shares… – John Antioco, former Blockbuster CEO

STREAMING
In January 2007, Netflix launched an on-demand streaming service. A new Netflix website feature
allowed subscribers to watch one thousand titles instantly on their computers. Blockbuster acquired
similar capabilities that August by purchasing Movielink, a streaming service backed by Universal,
Paramount, Sony Pictures, MGM, and Warner Brothers. The move resulted in an 8 percent gain of
Blockbuster’s stock price.

In May 2008, Roku, a company incubated at Netflix’s headquarters, launched a set-top box that
allowed Netflix subscribers to watch streaming content on their televisions. Later that year, Microsoft
and Netflix announced that the streaming software would be included in an upgrade to the Xbox
360. Over the next three years Netflix made deals to incorporate their software on over two hundred
internet-connected devices.

Let everybody fight it out, kill each other, and spend lots of money on set-top boxes tethered to big screen
TVs. – Jim Keyes, Blockbuster CEO

Acquiring streaming content was a challenge for Netflix. The film industry had long-term contracts
in place with the cable subscription channels. In 2008, Netflix struck a deal with Starz to license con-
tent Starz had previously acquired. Content providers, however, soon recognized that Netflix offered
them not only a good way to generate revenue from old content, but also the ability to generate inter-
est for current shows. For example, by providing past seasons of “Breaking Bad” on Netflix, AMC was
able to increase ratings of the current season. Moreover, “Breaking Bad” drew many more viewers on
Netflix than when shown originally on AMC. One reason is that Netflix allowed binge watching (of
all 62 episodes), without any advertising interruptions.

The television business is based on managed dissatisfaction. you’re watching a great television show you’re
really wrapped up in? you might get 50 minutes of watching a week and then 18,000 minutes of wait-
’ rather make it all about the joy. – Ted Sarandos, Netflix Chief
ing until the next episode comes along. Id
Content Officer
BLOCKBUSTER KIOSKS
Blockbuster and other traditional video stores were feeling the effects of Redbox’s rapid expansion
across the U.S. The machines were drawing customers away from brick-and-mortar establishments
with more convenient locations and lower prices. “These machines are to the video industry what
the Internet was to the music business – disaster,” commented Video Buyers Group’s Ted Engen. In
August 2008, Blockbuster announced a partnership with NCR to develop its own DVD rental kiosks as
it continued to close unprofitable stores. “We’re actually adding points of service rather than deleting,”
Keyes stated about the move to kiosks.

THE END FOR BLOCKBUSTER

Blockbuster filed for bankruptcy in September 2010. Dish Network acquired Blockbuster’s remain-
ing 1,700 operating stores in 2011 at auction. After the acquisition, Dish continued closing stores and
finally pulled the plug on physical locations in 2013. Fittingly, the last movie rented at a Blockbuster
was Seth Rogen’s apocalyptic comedy “This is the End.” Dish operated a Blockbuster branded stream-
ing service until it launched Sling TV in 2015.

Blockbuster turned out to be the worst investment I ever made. – Carl Icahn

QWIKSTER
While Netflix triumphed over Blockbuster, it was not immune to missteps. In 2011, Netflix announced
that it would split DVD and streaming subscriptions with a new entity, Qwikster, handling DVD by
mail. For customers subscribing to both services, prices would jump 60 percent. “I was obsessed with
not getting trapped by DVDs the way AOL got trapped, the way Kodak did…” explained Hastings.
Upset over the sudden price increase, 800,000 subscribers abandoned the service causing a massive
drop in Netflix’s stock price (Exhibit 3). Realizing the mistake, Netflix quickly reversed the decision
a few weeks later.

It is clear from the feedback over the past two months that many members felt we lacked respect and
humility in the way we announced the separation of DVD and streaming, and the price changes. That was
certainly not our intent, and I offer my sincere apology. – Reed Hastings, Netflix CEO

ORIGINAL CONTENT
Netflix released its first original series, “House of Cards,” in 2013. Netflix commissioned two seasons
upfront for $100 million, a bold move that was enabled by Netflix’s detailed knowledge of their
customers. Directed by David Fincher, the American adaptation of a British political drama by the
same name, stars Kevin Spacey and Robin Wright. Netflix’s data indicated that the original British
production of “House of Cards” was popular with Netflix users, as were director David Fincher’s films
like “Fight Club” and films starring Kevin Spacey. Ted Sarandos, Netflix’s Chief Content Officer
remarked, “I didn’t use data to make the show, but I used data to determine the potential audience.”

Netflix was the only network that said, ‘We believe in you. We’ve run our data and it tells us that our
audience would watch this series. We don’t need you to do a pilot. How many [episodes] do you wanna
do?’ – Kevin Spacey

Netflix followed “House of Cards” with other hits including “Orange is the New Black” and “Stranger
Things.” By 2016, Netflix had 30 films or shows in production and planned to release 600 hours of
original content, doubling its 2015 output.
 NETFLIX AND INTERNET SERVICE PROVIDERS
Netflix accounts for 35 percent of peak internet traffic, delivering over 125 million hours of video
per day. This heavy network usage has sometimes led to strained relationships with the Internet service
providers (ISPs) that carry Netflix’s data. To help alleviate traffic on ISP infrastructure, Netflix has
moved streaming content storage closer to customers. In 2011, Netflix developed its Open Connect
system. Netflix locates Open Connect content servers near or inside ISPs’ facilities to make
interconnection with the ISPs’ infrastructure simpler. Netflix distributes new content to select Open
Connect servers during off-peak times. The content is then automatically duplicated onto additional
adjacent Open Connect Servers. This provides the ISPs with several local copies of streaming content
and considerably reduces Netflix’s use of ISP infrastructure.

Throughout 2013 and into 2014, Netflix customers that used Comcast’s Internet service experienced
noticeably reduced video streaming quality. Comcast publicly blamed Netflix for the slow speeds
stating, “The only company who decides how Netflix traffic is delivered to us is Netflix. They choose
the path the traffic takes to us. They can choose to avoid congestion or inflict it.” In the spring of
2014, Netflix agreed to pay Comcast a carriage fee for handling its traffic. The payment resulted in
an almost immediate speed increase for the affected Netflix customers. Other ISPs including Time
Warner Cable, AT&T, and Verizon negotiated similar payment arrangements with Netflix.

Netflix prevailed over the ISPs in 2015 when the Federal Communications Commission voted to
regulate broadband as Title II telecommunications service under the 1934 Communications Act. This
“net neutrality” decision eliminated ISPs leverage over Netflix by requiring ISPs to treat all Internet
traffic equally. ISPs would no longer be permitted to throttle data or create paid fast lanes.

In the fourth quarter of 2016, Netflix launched offline viewing. The new feature allows users to
watch downloaded content on iOS and Android devices where broadband access is limited such as
subways, airplanes, and emerging market countries.

Competitors

REDBOX
Redbox rents new-release DVDs, Blu-ray discs, and video games from self-service kiosks located
near the entrances of grocery and drug stores. Devised as a way to increase traffic to McDonald’s
restaurants, Redbox thrived as bricks-and-mortar video stores floundered. Redbox parent company,
Outerwall (formerly Coinstar), runs several other kiosk-based businesses including coin counting and
electronics recycling. Redbox’s success has been attributed to their low rental prices, low cost
structure, and providing newer releases than streaming services.

Redbox’s meteoric rise flattened in 2014. In a move towards managing for efficiency, Redbox
removed 500 of its over 40,000 kiosks. Analyst Steven Frankel commented, “Redbox has definitely
reached full maturity. The only question is: how steep is the decline?” Redbox ceased Canadian
operations in 2015 to focus on the US market, “where demand for physical media remains strong.”
In April 2016, Redbox reported that rentals for the quarter had dropped to 137.7 million from 173
million the previous quarter and that quarterly revenues had fallen to $421.5 million from $519.5 mil-
lion. Apollo Global Management took Outerwall private in September 2016.

HBO NOW
In 1972, Home Box Office (HBO) launched its service in Wilkes-Barre, Pennsylvania. The pay-TV
channel split revenues with local cable affiliates to provide them an incentive to promote the service.
Three years later, HBO was transmitting to cable affiliates by satellite and had over 275,000
subscribes. In 1976, HBO began financing films in return for distribution rights to satisfy its growing
appetite for content at prices it could control. In the 1990s, HBO decided to compete based on
quality content resulting in award-winning series such as “The Sopranos.” This focus on content has
continued with current series like “Game of Thrones” and “Westworld.”

HBO entered the streaming market in 2008 with HBO Broadband. Access to the service, however,
was limited to HBO cable subscribers. In April 2015, HBO launched HBO Now, a stand-alone
streaming service. The move was announced during investor presentation for HBO’s parent
company, Time Warner. “It is time to remove all barriers to those who want HBO,” declared HBO
chairman and chief executive Richard Plepler. By February 2016, HBO Now counted over 800,000
subscribers, representing a growing portion of HBO’s 50 million U.S. subscribers. HBO budgeted
about $2 billion for content in 2015, with about half going towards originals.

We have a pretty hefty [content] budget, a couple of billion dollars. We’re not spending our programming
money on library product. We’re doing original shows. We’ve been increasing it, and we’ll keep increasing
it. – Jeff Bewkes, Time Warner CEO

HULU
In 2007, NBC and Fox teamed up to create Hulu. Hulu’s online service allows viewers to stream cur-
rent and past television shows as well as original content such as “The Awesomes.” Initially, Hulu was
free and supported by advertising revenue much like broadcast television. In 2010, Hulu introduced
Hulu Plus, a paid subscription version of the service offering additional content and fewer commercials.
Hulu announced the end of its free service in August 2015. Subscribers can now choose between a
$7.99 per month plan with commercials or an $11.99 per month plan without advertisements.

For the past couple years, we’ve been focused on building a subscription service that provides the
deepest, most personalized content experience possible to our viewers. As we have continued to enhance
that offering with new originals, exclusive acquisitions, and movies, the free service became very limited
and no longer aligned with the Hulu experience or content strategy. – Ben Smith, Hulu Senior VP

Hulu is now owned by Comcast, Time Warner, 21st Century Fox, and Walt Disney and has plans to
launch a live TV service in 2017 with channels from its parent companies. In 2016, Hulu had
approximately 12 million subscribers.

AMAZON VIDEO
Amazon entered the video-on-demand business in 2006 with Amazon Unbox. The service allowed
both rental and purchase of downloadable movies and television shows. In 2011, Amazon rebranded
the service as Instant Video and bundled it as an added perk with its $99 per year Prime member-
ship. In April 2016, Amazon announced that it would begin offering video as a standalone service
for $8.99 per month. An estimated 14.5 million of Amazon’s 40 million Prime members use Amazon
video. Amazon spends roughly $3 billion annually on streaming content including deals with HBO
and Epix. Amazon released its first original series “Alpha House” in 2013 and has since followed it
by many more including the Emmy Award-winning series “Transparent” and “Man in the High
Castle.”

When we win a Golden Globe, it helps us sell more shows…in a very direct way. Because if you look
at Prime members, they buy more on Amazon than non-Prime members, and one of the reasons they do
that is once they pay their annual fee, they’re looking around to see, ‘How can I get more value out of the
program?’ And so they look across more categories — they shop more. A lot of their behaviors change in
ways that are very attractive to us as a business. – Jeff Bezos, Amazon CEO

SLING TV
Dish Network launched Sling TV in January 2015 at the Consumer Electronics Show. Sling TV
reaches its audience over the local cable companies, delivering live shows and on-demand content
directly to subscribers via the Internet. Sling TV offers three different bundles that include popular
channels like ESPN, Disney, AMC, and Comedy Central as well as local content from ABC, NBC, and
Fox Stations. The bundles range in price from $20–$40 per month and subscribers are not required to
sign long-term contracts. Sling TV is estimated to have 700,000 paying subscribers.
 When we launched, we were focused on “cord nevers.” Now, we are a true full cable replacement. – Roger
Lynch, Sling TV CEO

YOUTUBE RED
Google’s youTube launched an advertisement-free subscription service dubbed Red in October
2015. The service allows users to save videos for offline viewing and includes access to Google Play
Music. Subscribers of the $9.99 per month service will also have access to premium original content
not available on the advertising supported side of youTube. youTube is pairing some of its most popular
video creators with Hollywood talent to create unique content. For example, youTube star Felix
“PewDiePie” Kjellberg has teamed up with the producer of the Walking dead to create the scripted
horror show scare pewdiepie.

To us what is important is we are not doing what everybody else is doing, competing for the same sources
of material, the same creative elements. We are looking for people who are proven to work really well on
our platform. – Robert Kyncl, youTube Chief Business Officer

Challenges

RELEVANT CONTENT
In 2017, Netflix plans to spend $6 billion on original and licensed content, up from $5 billion in 2016
(Exhibit 4). The majority of this spending goes towards television shows and movies licensed from
others. For example, Netflix has global licensing agreements for Fox’s “Gotham,” AMC’s “Breakin
Bad,” and ABC’s “How to Get Away with Murder.” Within the next few years, Netflix aims for half of its
content be original. “For a dollar spent and an hour viewed, you get more hours of viewing per dol-
lar spent on original programming versus licensed content,” noted Netflix’s Ted Sarandos in 2015.
As Netflix expands worldwide, it has invested in global originals such as: “The Crown,” “Marseille,”
and “Narcos.” Netflix is also making forays into unscripted (reality) television. “Ultimate Beastmaster,”
a global competition series produced by Sylvester Stallone is scheduled to debut in 2017. Netflix
has avoided sports and news content, but is pushing children’s programming. About 20 of Netflix’s 70
upcoming global originals are intended for children.

As competitors like Amazon and Hulu invest more in content, Sarandos will be competing not only
for viewers, but also for talent. “It’s a race, but there are going to be many winners,” opined Hastings.
“If you can build an iPhone app, you start a TV channel. We are going to have to see how that plays
out.”

INTERNATIONAL GROWTH
Of Netflix’s 93.8 million subscribers, 49.4 million (or 53 percent) are in the U.S. (Exhibit 5).
Netflix announced in January 2016 that it would be radically expanding its services internationally
from 60 to 190 countries. Netflix is noticeably absent from China, a market where Hastings com-
mented that Netflix is still, “in the relationship building phase.” Netflix is adding services in Arabic,
Korean, and Chinese to the 17 languages currently supported. Netflix’s original programming will be
available in all countries; however, the availability of licensed content varies by country. Netflix’s
expansion has drawn the attention of a number of government authorities. The European Commission,
for example, is considering a European content quota and subsidy pots for national production.

The big imbalance in Netflix is we’re majority US viewing and subscribers. And if you look at youTube,
Facebook, and others, they’re about 20 percent US and 80 percent international. – Reed Hastings, Netflix
CEO

RELATIONSHIPS WITH INTERNET SERVICE PROVIDERS

 The Federal Communications Commission’s net neutrality decision was a short-lived victory for
Netflix. To work around the new rules, ISPs have begun imposing “data caps” on users. Once users
exceed their data cap, additional data usage incurs added fees.119 Another ISP practice concerning
to Netflix is “zero-rating,” an arrangement where the ISP does not count traffic from preferred data
providers towards customers’ data caps. Netflix explained their concerns in a September 2016 FCC
filing, “Because of a low data cap, an online service [like Netflix] may need to pay an ISP to zero-rate
its traffic to enable that ISP’s customers to access the online service. Such arrangements create an
incentive for ISPs to maintain artificially low caps.” In January 2017, net neutrality opponent Ajit Pai
was appointed to head the FCC, calling into question the future of Netflix’s current relationships with
Internet service providers.

Decision Time
Hastings woke up early the next morning and caught a private jet back to San Francisco. As the jet
climbed over the California coastline, Hastings reflected on Netflix’s history. Netflix had successfully
taken on Blockbuster. Much like Blockbuster, Netflix had grown quickly and become a household
name. Hastings hoped that Netflix had learned from the mistakes of Blockbuster and would avoid the
same fate. Netflix needed to address the challenges of relevant content, international growth, and the
Netflix’s relationships with the Internet service providers in the face of rising competition. What could
he do to ensure that Netflix’s continued success?

ExHIBIT 1 Percent of U.S. Adults with Home Internet Access

Broadband Dial-up

100

80

60
%

40

20

2000 2001 2002 2003 2004 2005 2006 20072008 2009 2010 2011 2012 2013 2014 2015

Source: Adapted from “Three Technology Revolutions,” [Link]

ExHIBIT 2 Netflix Pre-IPO timeline

1997 1998 1999 2000 2001 2002

Netflix Netflix Netflix Netflix Blockbuster Netflix
founded website Marquee offers to writes off IPO
goes live Plan sell to $450
launched Blockbuster million
of VHS
inventory

Source: Depiction of publicly available data

ExHIBIT 3 Netflix Key Events and Stock Price vs. NASDAQ, 2002–2017

Netflix (NFLX) NASDAQ (IXIC)

FCC net
14,000% neutrality
decision
12,000%
“House of Cards”
released
10,000%
Netflix Qwickster
Streaming announced
8,000%
% Change

Blockbuster Blockbuster
Total Access bankruptcy
6,000%
Netflix Blockbuster
IPO Online Expansion to
190 countries
4,000% announced

2,000%

0%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Depiction of publicly available data

DISCUSSION QUESTIONS

1. Describe Netflix’s strategy process over time. What approach to the strategy process does Netflix
follow? What works well with this approach? What are some challenges with this process, especially
as Netflix continues to grow fast?

2. How was Netflix able to disrupt the U.S. home entertainment industry? Describe Netflix’s innovation
strategy over time. Also, how did Netflix’s business change over time? How did its business model
innovation support its technology strategy?

3. What are Netflix’s core competencies? How can they help Netflix to sustain its competitive
advantage? How must its core competencies be honed and modified?

4. International expansion appears to be a major growth opportunity for Netflix. What challenges does
Netflix face by going beyond the U.S. market? What can Netflix do to address some of the
challenges encountered when going internationally? And which international markets should Netflix
focus on, and why?
ExHIBIT 4 Netflix Key Financial Data 2012–2016

Income Statement (in millions, except per share data)

Fiscal Year 2012 2013 2014 2015 2016

Revenues 3,609 4,375 5,505 6,780 8,831
Cost of revenues 2,652 3,117 3,753 4,591 6,030
Gross profit 957 1,257 1,752 2,188 2,801

Marketing 439 470 607 824 991

Technology and development 329 379 472 651 852
General and administrative 139 180 270 407 578
Operating income 50 228 403 306 380

Interest expense (20) (29) (50) (133) (150)

Interest and other income (expense) 0 (3) (3) (31) 31
Loss on extinguishment of debt 0 (25) 0 0 0
Income before income taxes 30 171 349 142 261

Provision for income taxes 13 59 83 19 74

Net income 17 112 267 123 187
Earnings per share (adjusted for stock splits) 0.04 0.26 0.62 0.28 0.43

Excerpt from Statement of Cash Flows (in millions)

Fiscal Year 2012 2013 2014 2015 2016

Free cash flow (58) (16) (127) (921) (1,660)

Excerpts from Balance Sheet (in millions)

Fiscal Year 2012 2013 2014 2015 2016

Total content assets, net 2,934 3,838 4,939 7,219 11,001
Total content liabilities 2,443 3,122 3,693 4,815 6,527
Total assets 3,962 5,404 7,043 10,203 13,587
Total liabilities 3,217 4,070 5,185 7,979 10,907
Total stockholders' equity 745 1,334 1,858 2,223 2,680

Source: Netflix Annual Reports (various years).

ExHIBIT 5 Paid Netflix Subscriptions (in millions)

Domestic Streaming
International Streaming

50

40

30
Paid Subscriptions (in millions)

20

10

0
2012 2013 2014 2015 2016

Fiscal Year 2012 2013 2014 2015 2016

Domestic DVD 8.05 6.77 5.67 4.79 4.03
Domestic Streaming 25.47 31.71 37.70 43.40 47.91
International Streaming 4.89 9.72 16.78 27.44 41.19

Source: Netflix SEC filings