Netflix: Finding the Next Hit Business Model

Companies struggle to successfully reinvent biz model once, let alone twice in 5 years. Netflix’s successful shifts — from DVDs to streaming to originals — have largely been in response to to trends impacting its content supply chain.

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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While Netflix originally made money through one-off DVD purchases and rentals, its growth took off in 1999 after debuting its subscription DVD rental offering.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.

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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).

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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.

 

Sources:

http://ir.netflix.com/secfiling.cfm?filingID=1065280-15-6&CIK=1065280

https://www.washingtonpost.com/opinions/five-myths-about-netflix/2014/02/21/787c7c8e-9a3f-11e3-b931-0204122c514b_story.html

http://www.fundinguniverse.com/company-histories/netflix-inc-history/

http://mhlnews.com/facilities-management/all-queued-netflix

http://faculty.tuck.dartmouth.edu/images/uploads/faculty/ron-adner/11EIS_Main_Project_-_Netflix_Paper.pdf

https://pr.netflix.com/WebClient/loginPageSalesNetWorksAction.do?contentGroupId=10477

http://www.vulture.com/2013/10/fx-turner-netflix-battle-for-tv-streaming-rights.html#

http://www.vulture.com/2015/07/netflix-original-programming-hbo-fx.html

http://www.vanityfair.com/hollywood/2015/12/netflix-double-content-2016

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6 thoughts on “Netflix: Finding the Next Hit Business Model

  1. Very interesting story on Netflix’s methods of biz model reinvention and how it was essentially a victim of its own success. The move to vertically integrate and produce content in-house was HUGE. As the cable companies and networks continue to unbundle, it will be interesting to see how (and if) Netflix evolves and if they are able to continue producing such great content.

  2. Great post Andrew, it’s impressive how agile Netflix has been. The speed at which they are able to execute these strategy shifts seems to have really helped separate them from their competition. Comparing their trajectory with Amazon Prime or Hulu really puts it into perspective.

  3. As a “semi frequent” user of Netflix I enjoyed your post. Really liked the connection between their impact on TV ratings/studio licensing costs and the resulting impact on their own economics.

    I’m curious to hear what you think about how else they do/should use their predictive algorithms/propriety data keep subscribers engaged. Their decision to create “smart, serialized TV series” content was spot-on IMO, but does the “Because you watched [x]…” keep people sufficiently entertained before the next season of House of Cards comes out? Some people (…obviously not me) can binge-watch a HoC season in one weekend (then wait impatiently for new content, becoming less happy about the monthly fee).

    I’m also interested to see how the market changes as more networks provide their own streaming services (e.g., HBO GO) – seems like Netflix might end up depending more fully on their own generated content.

  4. Great article! As a Netflix user, I found your post very interesting. As business school students, I think we have a lot to learn from the way Netflix has been able to successfully, repeatedly reinvent its own business model.
    I also think Netflix has been able to leverage the boom of smartphones, tablets, and smart TVs better than anyone else in the industry. Now we have Netflix embedded in our TVs and our phones, easily accessible at all times in high definition screens.
    As you point out in your post, Netflix has been smart at offering high levels of artistic control and full-season orders to its content creators. If I were a content creator, I’d like to have my show on Netflix. The vertical integration has been key.
    I’m curious about Netflix evolution in the coming years, as more competitors start to offer high-quality content on our smart TVs. Should Netflix keep moving so nimbly and continue being able to self-generate smart content, I’m sure the company will remain competitive.

  5. Very cool post. I’m curious about how Netflix’s success may lead to a snowball effect in the entertainment industry – has their success with in-house content led them to develop better capabilities? Further than that, has it made them more attractive for some of the best actors and writers to take part in a Netflix show (vs traditional prime-time TV)? Their adaptability is impressive, and I have noticed a suprising uptick in strong content ever since they succeeded with House of Cards.

  6. Great post, Andrew! Impressive that Netflix has continued to adapt and remain relevant from moving to digital to producing in-house content. My only question going forward is how they will approach mobile as streaming remains challenging on mobile devices in the current data market. Netflix is so seamlessly integrated in smart TVs, etc. but as people move towards consuming content such as shows and movies on their phones or tablets, is there a vision to make this easier or is Netflix waiting for the data service providers to fill this gap?

    Well done!

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