How netflix lost 800000 members

Journal of the International Academy for Case Studies, Volume 20, Number 1, 2014

THE RISE AND FALL OF NETFLIX: WHAT HAPPENED AND WHERE WILL IT GO FROM HERE?

Grace Allen, Western Carolina University

Dorothee Feils, University of Alberta Holly Disbrow, Western Carolina University

CASE DESCRIPTION

The primary subject matter of this case concerns company analysis. Secondary issues

include financial statement analysis, corporate strategy and international expansion. The case has a difficulty level of three and should be appropriate for undergraduate and graduate courses in investments and financial and strategic management. The case is designed to be taught in one to two class hours, with three hours of outside preparation by students.

CASE SYNOPSIS

Netflix is an innovative company that has changed the way we rent movies and watch TV

shows. Its business model is based on a subscription service that provides home-delivery of DVD rentals and streaming of movies and TV shows. The company took advantage of the rapid growth in the DVD rental market, the internet and e-commerce by providing a service that the traditional brick-and-mortar retailers, such as Blockbuster, could not compete with. In 2011, however, a price hike, poor management decisions, changes in technology, and increased competition threatened Netflix, leading to a sharp decline in its share price. In this case, students analyze the fundamentals of Netflix including its financials and management decisions to help determine if Netflix’s poor stock performance in 2011 was predictable as well as what the future might hold for this company.

INTRODUCTION

Rushing into the offices of Horizon Capital Invest (Note that Horizon Capital Invest,

Brighton Portfolio, and the characters are fictitious) , Chris Thompson almost knocked into the CEO, Ms. Steinberg. “Whew” said Chris under his breath after apologizing to the CEO. It was the last week of April 2012 and Chris had one week left in a four month internship for this prestigious money management firm. He had spent his internship learning how to research companies for two senior analysts to whom he reported. It had been a steep learning curve for Chris, a finance major in his senior year at an East Coast university. He had been lucky to land the internship and was determined to impress the analysts at Horizon Capital Invest, a place he dreamed of working after graduation. He certainly didn’t want to be late for the morning briefing. With his iPad in one hand and his coffee in the other, he glanced at the clock as he entered the conference room. Chris had 30 seconds to spare and thought to himself, “another close call. Maybe this will be my

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lucky day and I finally get to show what I can do.” Chris greeted both analysts as he took a seat at the long table, “Good morning Ms. Hunter”, “Good morning Mr. Richardson”. After some pleasantries they got right to work. Ms. Hunter told Chris that they were considering purchasing Netflix for the Brighton Portfolio. Abruptly, Mr. Richardson broke in and said “I don’t feel this is a good investment. The stock has plummeted over the past ten months and I would not consider it a value play.” Before Chris could even begin taking notes Ms. Hunter said pretty forcefully “Come on Joe, this is a great company. Management may have made some mistakes recently but this leads to a great buying opportunity. I feel certain we will have a double digit return from this one.” Mr. Richardson, a very head strong individual, wasn’t about to let Ms. Hunter have the last say. He quickly responded “Maria, you’re really off base with Netflix. It would be against our fiduciary responsibility to add it to the portfolio.” You could see that Ms. Hunter was not going to take this lightly. Her face was red and she raised her voice a couple of levels and said “Joe, you have to trust me on this one. I know management will get its act together and we’ll see a reversal in the stock price within the next quarter.” Chris had been frantically taking notes but was beginning to get a bit nervous sitting between the two arguing analysts. Then they dropped the bomb shell. Mr. Richardson said “alright Maria, let’s get Chris to pull together a report covering Netflix’s background and the factors affecting the company this past year that could help us make a decision. I really am doubtful but I am willing to see details that will allow us to make a more informed decision.” “Chris” said Ms. Hunter “can you do a report on Netflix by 9:00 am tomorrow?” Chris eagerly agreed to tackle the Netflix case knowing this might be his opportunity to show both, Ms. Hunter and Mr. Richardson, his recently enhanced research skills. After excusing himself, Chris left and headed to his cubicle with butterflies in his stomach and thought “yep this is my lucky day!”

What made this assignment even more interesting to Chris was that Netflix was a company he knew quite well. Many times he had watched a movie with his family or friends that had arrived via mail in the little red envelope. Since going to college, instead of ordering movies, he would just plug-in his iPod and stream a movie or a TV show. Chris had remembered discussing the stock in class. It was a company that had seen very impressive growth over the years because of its ability to provide what many Americans want in a fast and convenient manner: unlimited rental access to movies and TV shows via mail or on-line streaming for a low monthly subscription rate. Its’ price had soared from about $180 per share in January 2011 to over $300 per share in July (Yahoo, nd). However, by the end of 2011 the price per share had dropped to $69 (Yahoo, nd) and Netflix had lost 800,000 domestic members (Form 10-K, 2012). “Wow” thought Chris “this is going to be interesting. My two bosses are at odds with each other, a company that has taken an abrupt turnaround, and less than 24 hours to prepare the report.”

Since yesterday, Chris had been working nonstop with only a few hours of sleep. His cubicle was littered with pizza and donut boxes and half empty coffee cups. He believed he had done a thorough job researching Netflix and that Ms. Hunter and Mr. Richardson would be impressed with his report. He took one more look at the document checking to make sure that he had organized it well and there were no spelling or typo errors. Satisfied, Chris hit the print button and swung by the office to pick up the copies before heading into the conference room. Chris, a little jittery and tired from lack of sleep, took a deep breath to get his second wind and

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greeted his bosses cheerfully “Good Morning Ms. Hunter and Mr. Richardson. I hope you both will be pleased with my report on Netflix and that it will help you agree on whether to add it to the Brighton Portfolio. I made copies for both of you and would like to go through it with you now.”

REPORT ON NETFLIX, INC.: PREPARED BY CHRIS THOMPSON

BACKGROUND

Netflix was founded by Reed Hastings and Marc Randolph in 1997 and is headquartered in Los Gatos, California. Netflix originally operated as an online movie rental store which included per rental fees and late fees. In 1999, Netflix initiated its subscription service which provided unlimited DVD rentals for a monthly fee after the company received a $30 million investment from the Group Arnault (Netflix Inc. Company Profile, 2011). Netflix began its movie recommendation system in 2000 where subscribers rate movies and Netflix used the information to suggest selections to its members. Netflix’s reputation was built on its unique business model: unlimited rentals with no due date, no shipping and handling fees and no late fees. Netflix went public on May 22, 2002 with an IPO of 5,500,000 shares at price of $15.00 per share. It is listed on the Nasdaq under the ticker symbol “NFLX” (Netflix Company Timeline, nd). Reed Hastings, one of the founders of Netflix, has stayed on as the CEO of Netflix (Form 10-K, 2012). Netflix’s total number of suscribers, at the time of the IPO, was 600,000 (Netflix Company Timeline, nd). The little red envelopes that became the trademark of the DVD subscription continued to pull large numbers of new subscribers into the fold year after year. In 2003, Netflix reported its first profit of $6.5 million after years of losses (Netflix, Inc., 2003). By the end of 2006, Netflix had 6.3 million members (Netflix Company Timeline, nd).

Netflix began to offer streaming as an added feature with its DVD subscriptions in 2007. Streaming, which allows movies or TV shows to be watched instantly over the internet, became increasingly popular as Netflix teamed up with electronic companies to broaden the scope of devices that could stream. At that time, streaming was available only for personal computers, but by 2008 devices such as the Xbox 360, Blu-ray disc players, TV set-top boxes and the Macintosh computer could stream. By 2009, PS3 and internet connected TVs were among the devices able to stream (Netflix Company Timeline, nd). At the end of 2009, Netflix had 12.3 million members (Form 10-K, 2012). In 2010, streaming Netflix content became available “on Apple’s iPad, iPhone, iPod Touch, the Nintendo Wii and other internet connected devices” (Netflix Company Timeline, nd). In 2010 Netflix took its streaming content international by expanding into Canada. By the end of 2010, Netflix reported almost 20 million members up from 12.3 million in 2009 (Form 10-K, 2012).

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source: Form 10-K (2012). *Note that there is a considerable overlap between streaming and DVD subscribers. Therefore, the number of total unique subscribers is less than the sum of domestic streaming and domestic DVD subscribers. Prior to 2011, Netflix provided only a combined streaming and DVD service.

FACTORS AFFECTING NETFLIX, INC. IN 2011

INCREASED COMPETITION AND CONTENT COSTS

By 2011, Netflix began to see competitors aggressively competing for market share (Q1

Publishing, 2011). Companies such as Hulu.com, Google TV, Apple TV, various cable companies and others were getting in on the rivalry by offering streaming. For instance, Comcast offered Streampix to its Xfinity subscribers with a base price of $4.99 per month (Gorman, 2012). Dish network and Blockbuster joined in, as did Verizon and Redbox, to offer movies and TV shows on the internet. Hulu Plus cost $7.99 per month, the same as Netflix, but also offered a limited selection of free previously run TV shows (Gadget Review, 2012). Since there are more alternatives for consumers, Netflix no longer has as large a hold on the market as it once had.

The cost of acquiring content differs for the streaming and the DVD segment. To acquire content for streaming, Netflix typically acquires and licenses content on a fixed cost basis (Form 10-K, 2012). Movie studios have been benefitting from more competitors entering the market since they have been able to charge more for the rights to stream movies and shows and thus for Netflix, the fixed cost of acquiring content for streaming is likely going to increase. Netflix likely will have to deal with rival companies as its content contracts come up for renewal and as it looks to expand its limited libraries. “Netflix’s content costs have jumped to $3.5 billion over the past several years, up from the $2.4 billion reported previously…” (Lang, 2011). The

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Total Unique Subscribers

Domestic Streaming

Domestic DVD International Streaming

Subscribers by Segment and Location (in thousands)*

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potentially severe increase in the cost of content could have a major impact on Netflix’s ability to generate profits in the future.

However, the cost structure differs for the DVD segment. In the DVD segment, Netflix has many revenue sharing arrangements (Netflix, Inc. Company Profile, 2011), resulting in a variable cost model (Form 10-K, 2012). Due to the "mature state of the business" (Form 10-K, 2012), Netflix does expect healthy contribution margins from the DVD business, but also not much growth. The company expects that growth will come mainly from streaming (Wingfield, 2011b).

MANAGERIAL DECISIONS

Netflix’s loyal and growing customer base was upset in July 2011 when Netflix decided to change its subscription plans and rates to better match them to the company’s business segments: streaming and DVD rentals (Form 10-K, 2012). The existing subscription plans included a $7.99 per month plan for unlimited streaming and a $9.99 per month for unlimited streaming and unlimited DVDs sent one at a time. Starting July 2011, subscribers could subscribe separately to a streaming only or a DVD only plan for $7.99 each. If subscribers wanted to subscribe to both, streaming and DVDs, the subscription price increased to $15.98 per month, starting immediately for new subscribers and in September for existing subscribers (Netflix Company Website, 2011a). This change implied a 60 percent price hike for those subscribers that wanted to maintain the same level of service provided by the $9.99 plan previously upsetting many members (Wingfield, 2011a). Since many current and potential subscribers felt that the online library wasn’t up to par as it lacked a wide array of new content, subscribers who preferred to stream still tended to order DVDs when they could not get a specific movie or show from the online library. Many subscribers felt that Netflix was being greedy although the price increase was a way to raise cash to increase the online library for streaming (Barnes and Stelter, 2011).

In addition, Netflix faces problems securing content for its streaming services. Negotiations with Starz failed in September, 2011 (Hollister, 2011), which meant that as of February 28, 2012 “Netflix’s three-and-a-half-year-old deal with Starz …[came] to an end, and Starz’s roster of classic and newer films …[disappeared] from the Netflix portfolio”(NYTBits, 2012). These films include movies from Walt Disney Studios and Sony Pictures Entertainment and were taken out of the library by the end of February 2012. The loss was a blow but Netflix has made a deal with Dreamworks for its films and television specials beginning in 2013 when Dreamworks’ contract with HBO is due to expire. “The Netflix accord, which analysts estimate is worth $30 million per picture to Dreamworks over an unspecified period of years, is billed by the companies as the first time a major Hollywood supplier has chosen Web streaming over pay television” (Barnes and Stelter, 2011). The company has also been increasing its television content; however, it is not clear how well these changes will be accepted by consumers.

On September 18th 2011 Reed Hastings, CEO and Cofounder, posted a blog apologizing for not communicating the reasons behind the price hike but also announcing the splitting of Netflix into two companies. The DVD by mail service would be renamed Qwickster and would offer video games for an additional charge and the streaming component of the company would

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take the Netflix name. The two companies would have separate websites that would not be integrated. Reed stated, “Some members will likely feel that we shouldn’t split the businesses, and that we shouldn’t rename our DVD by mail service. Our view is with this split of the businesses, we will be better at streaming, and we will be better at DVD by mail. It is possible we are moving too fast – it is hard to say” (Netflix Company Website, 2011b). On October 10th, after a severe backlash, including a loss of 800,000 subscribers in the third quarter, Mr. Hasting reversed his decision to split the company. “The now aborted plan by the Netflix co-founder and chief executive to distance the Netflix brand from its DVD rental business has gone down as one of the year’s biggest business blunders”(Wingfield and Stelter, 2011).

Finally, the United States Postal Service announced in December that it hopes to get rid of next day delivery for first class mail. This might cause issues for Netflix as it could slow down deliveries of its DVDs. Management will have to think about a way to deal with this potential problem, since customers might decide to go elsewhere if the DVD service were to become less convenient. Consumers are already upset about the price hike and it seems as if Netflix’s focus for the future is on streaming at any cost (Wingfield, 2011b).

INTERNATIONAL EXPANSION

In 2010, Netflix decided to go international by offering streaming services in Canada. International expansion continued in 2011 as Netflix moved into 42 countries in Latin America and the Caribbean including Brazil, Chile, Columbia, Ecuador, Peru, Venezuela, Mexico, and Central America (Team, 2011). Netflix is looking for new subscribers outside the borders of the U.S. as competition is heating up in the U.S. but this move faces challenges of its own.

First, Netflix has to create an international library that would have enough content to be appealing in each country. As streaming content needs to be licensed separately for each market, Netflix faces difficulty in providing foreign subscribers access to comparable content available to US subscribers (Warren, 2011). For example, Netflix Canada has only about one third of the titles offered by Netflix USA (Huffington Post, 2011). In addition, Netflix will have to make some country specific content available. For example, Netflix would have to increase its French language content to be able to attract the francophone market in Canada.

Second, the existing digital infrastructure varies greatly from country to country but is of critical importance as a minimum of 800 kbps were required to stream movies (Team, 2011). “A MSNBC article sourcing Ibope Nielsen’s report says that only 20% of Brazil’s 42 million Internet users have a connection speed above 500 kbps…Latin America is also plagued by rampant video piracy…”(Team, 2011) Netflix might have issues being able to reach its full potential in these countries as its services might not be available to all interested consumers. Not only does the infrastructure vary, but also the design of the internet plans. For example, some Canadian internet providers introduced usage-based billing, or data caps. These are imposed to limit the amount that subscribers can download per month. Netflix's response to this has been to reduce the quality of videos it streams to Canadians, meaning that on average content will use up two-thirds less data to stream. (El Akkad, Krashinsky and Marlow, 2011).

Third, Netflix has to deal with regulatory uncertainty in foreign markets. For example, at the end of 2011, Canadian regulators did not require Netflix, or other internet-based movie

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distributors, to fund Canadian broadcast content or to adhere to other regulations required by cable and satellite companies. Not surprisingly, the competitors argued that Netflix had a competitive advantage that needed to be addressed (Argitis, 2011). The cost of operating in Canada could increase significantly, should the Canadian Radio-television and Telecommunications Commission change the regulations for internet-based movie distributors.

Finally, the international expansion has been costly, in no insignificant part due to the fact that streaming content licenses has to be paid for on a national basis. Thus, Netflix expects to run losses in the foreign markets in the short-term until a sufficiently large foreign subscriber base can be established (Form 10-K, 2012). The capital used to finance the international expansion could have been used to increase Netflix’s library in the U.S. “Wedbush analyst Michael Pachter, a well-known digital-entertainment analyst, criticized what he saw as Netflix’s “growth at all costs business model, ”….adding that its desire to expand internationally will only cause it to incur losses for years” (Reisinger, 2012). The company’s extensive “push to go international” is a risky move for Netflix. Only the future will tell whether the international expansion strategy will pay off in the long-run.

FOLLOW-UP MEETING

After going through his report, Chris sensed that Ms. Hunter and Mr. Richardson were

still not on the same page. Ms. Hunter had a smile on her face and Mr. Richardson was frowning. Immediately, Ms. Hunter said “so Joe, Chris’s research shows, as I have been telling you all along, that Netflix is a great company and we should add it to the Brighton Portfolio. Netflix is facing some challenges but the company is well positioned for the future.” Mr. Richardson responded emphatically with “hold on a minute Maria, I am still leaning towards the opposite. In fact, I cannot even consider the purchase without a more in depth analysis. Chris, you have done an outstanding job but you need to take it a step further. Are you up to spending another day on Netflix? By the way, we don’t have a lot of time to make this decision. We are meeting with the Brighton representatives next week and we want to make sure that we can justify our holdings and the portfolio is positioned to outperform our benchmark in the forward twelve months. Please summarize your analysis with your own prognosis of Netflix and be sure to back-up your opinion with facts.” Chris was delighted to get such positive feedback from Mr. Richardson, someone who gave praise sparingly, but was also a bit nervous about his new assignment. He knew he could dig deeper and had the skills to synthesize the data but a lot hinged on the outcome. An exceptional job would set him up for a potential job offer from Horizon Capital Invest, a dream come true.

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Wingfield, Nick (December 6, 2011b), Postal Service Cutbacks Add New Light to Netflix Saga. NYTimes.com:Bits. Retrieved July 3, 2012 from http://bits.blogs.nytimes.com/?s=postal+service+cutbacks++add+new+light+to+netflix+saga

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