The story of Netflix’s founding sounds like an MBA student’s daydream. Already independently wealthy after the sale of his first company, Reed Hastings claims to have conceived of Netflix after in response to a $40 late fee on a Blockbuster rental of “Apollo 13.” He and co-founder Marc Randolph then tested the idea, buying a CD from a local music store and mailing it to Hastings’ nearby home, and the rest is history. If it were only so simple…
Like Blockbuster, but online
While Netflix originally made money through one-off DVD purchases and rentals, its growth took off in 1999 after debuting its subscription DVD rental offering. Netflix’s subscription offering appealed to customers thanks to its flexibility (users could have up to 3 DVDs at one time, with no late fees), reliability (shipment error rate was said to be below 1%) and depth of library (I personally never couldn’t find what I wanted). Netflix leveraged partnerships to stimulate demand and ensure supply.
Netflix capitalized on dissatisfaction and distrust of Blockbuster and other rental chains — selling itself to DVD player manufacturers and content creators as a driver of DVD adoption (stores such as Blockbuster initially saw DVDs as a threat to their VHS-centric business). These partners packaged Netflix promotions with DVD players and sold physical discs to Netflix at attractive prices. Logistically, Netflix leveraged the US Postal Service to physically deliver and pick up discs. They also amassed troves of user data which in turn fed predictive algorithms that dictated how fulfillment centers would be stocked — ensuring that there would always be enough popular DVDs to satisfy customer demand.
A steady stream
Netflix began to offer streaming in 2007. Hastings claimed that a shift away from physical discs was always in the cards, famously stating: “That’s why we named the company Netflix and not DVDs by Mail.” This shift required a complete overhaul of supply and, as a result, cost structure. Instead of relying on individual DVDs (variable costs), Netflix had to negotiate fixed licensing deals upfront with studios and other content providers. Knowing that it would take time to build up a compelling streaming content portfolio, Netflix initially made streaming a free add-on to DVD subscriptions, getting consumers accustomed to the new business model.
Similar to the craftiness Netflix showed in capitalizing on market dynamics to improve operations, Netflix’s streaming operations leveraged two critical trends as well. First, Netflix’s move into streaming followed and increase in broadband and 3G penetration — which in turn had prompted device manufacturers to improve streaming capabilities (e.g. XBOX360’s ability to stream to TV). Second, Netflix noticed that cable syndication deals had become less valuable and less reliable streams of revenue for studios. As such, licensing content to Netflix was a relatively painless way to for studios to plug revenue gaps. These deals could then be optimized by Netflix thanks to the rich data sets that they had accumulated via their DVD business.
Anything you can do…
Netflix’s next shift in business model came in response to trends impacting content acquisition costs. Netflix was very much a victim of its own success in this scenario – as studios were pressured to raise licensing costs due to declines in linear TV ratings and the rise of ‘cord cutting’ (both brought on in many ways by the popularity of Netflix). This pressure came from TV networks that were either corporate siblings of studios or their primary business partners. The price increases were further bid up by well-funded competitors such as Amazon Prime and Hulu (a joint venture of Disney, FOX and NBCU) while networks began to demand ‘stacking,’ full season windows for on-demand viewing (‘stacking’ in turn reduces the value of Netflix’s acquired content for subscribers).
Instead of paying more to studios for diminishing returns, Netflix instead moved to vertically integrate and produce content in-house. Once again armed with proprietary data – this time showing that subscribers ‘binged’ on smart, serialized TV series such as ‘Breaking Bad’ and ‘Parks and Recreation’ – Netflix set out to make the types of content its users would love. Seeing a high likelihood of success, Netflix felt comfortable offering high levels of artistic control and full season orders to high-profile content creators. Thus far, Netflix’s efforts in original content have been a smashing success, earning 79 Emmy nominations in three years. This move into originals will be even more pronounced in the future, with 16 shows, 10 films, 30 kids shows, 12 documentaries and 10 stand-up specials scheduled for 2016.