Netflix in 2012 can it recover from its strategy missteps

T hroughout 2010 and the first six months of 2011, Netflix was on a roll. Movie enthusiasts were flocking to become Netflix subscribers

in unprecedented numbers, and shareholders were exceptionally pleased with Netflix’s skyrocketing stock price. During those 18 months from January 1, 2010 through June 30, 2011, the number of domestic Netflix subscribers doubled from 12.3 million to 24.6 million, quarterly revenues climbed from $445 million to $770 million, and quarterly operating income climbed from $53 million to $125 million. Netflix’s swift growth in the U.S. and its promising potential for expanding internationally pushed the company’s stock price to an all-time high of $304.79 on July 13, 2011, up from a close of $55.19 on December 31, 2009. Already sol- idly entrenched as the biggest and best-known Inter- net subscription service for watching TV shows and movies, the only question in mid-2011 seemed to be how big and pervasive Netflix’s service might one day become in the larger world market for renting movies and TV episodes.

Then, over the next four months, Netflix announ- ced a series of strategy changes and new initiatives that tarnished the company’s reputation and sent the company’s stock price into a tailspin:

• In mid-July 2011, Netflix announced a new pric- ing plan that effectively raised the monthly sub- scription price by 60 percent for customers who were paying $9.99 per month for the ability to (1) receive an unlimited number of DVDs each month (delivered and returned by mail with one title out at a time), and (2) watch an unlimited number of movies and TV episodes streamed over the Inter- net. The new arrangement called for a total separa- tion of unlimited DVDs and unlimited streaming to better reflect the different costs associated with

the two delivery methods and to give members a choice: a DVD-only plan, a streaming-only plan, or the option to subscribe to both. The monthly subscription price for the unlimited streaming plan was set at $7.99 a month. The monthly subscrip- tion price for DVDs only—one out at a time—was also set at $7.99 a month. If customers wanted both unlimited streaming and unlimited DVDs, they had to sign up for both plans and pay a total of $15.98 a month ($7.99 1 $7.99)—Netflix said it was discontinuing all plans that included both streaming and DVDs by mail. For new Netflix members, the changes were effective immediately. For existing members, the new pricing started for charges on or after September 1, 2011.

Customer reaction was decidedly negative. Unhappy subscribers posted thousands of comments on Netflix’s site and Facebook page. Over the next eight weeks, Netflix’s stock price dropped steadily to around $210– $220 per share, partly because of rumors that perhaps as many as 600,000 Netflix customers had canceled their subscriptions.

The stock price slide was exacerbated by media reports that Starz, a premium movie channel offered by many multichannel TV providers, had bro- ken off talks with Netflix regarding renewal of the contract whereby Starz supplied Netflix with cer- tain Starz-controlled movies and TV shows that Netflix could then provide either on DVDs or via streaming to its subscribers. The substance of the breakdown in negotiations centered on the much higher price that Starz was asking Netflix to pay to renew its rights to distribute Starz content to Netflix subscribers—Starz was rumored to have

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Netflix in 2012: Can It Recover from Its Strategy Missteps?

Arthur A. Thompson The University of Alabama

Copyright © 2012 by Arthur A. Thompson. All rights reserved.

C-128 Part 2 Cases in Crafting and Executing Strategy

then, in something of a bombshell, went on to reveal that Netflix was separating its DVD-by-mail subscription service and its unlimited streaming subscription service into two businesses operating at different websites. Hastings said the DVD-by- mail service would be renamed Qwikster, with its own website ( www.qwikster.com ) and its own billing. Current Netflix subscribers who wanted DVDs by mail would have to go to www.qwikster .com and sign up for the plan. He indicated that the Qwikster website would be operational in a matter of weeks—see Exhibit 1 for the full text of the post by Hastings.

demanded as much as $300 million annually to renew its license with Netflix, versus the $30 million annually that Netflix had been paying. 1 (Netflix’s licensing agreement with Starz later expired in March 2012, and the content was removed from its library of offerings to subscribers.)

• On September 18, 2011, in an attempt at dam- age control, Netflix CEO Reed Hastings in a post on the Netflix blog at http://blog.netflix.com/ apologetically said that the basis for the new pric- ing had been poorly communicated and person- ally took the blame for the miscue. He elaborated on the rationale behind the new pricing plans and

An Explanation and Some Re! ections

I messed up. I owe everyone an explanation.

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. I’ll try to explain how this happened.

For the past ! ve years, my greatest fear at Net" ix has been that we wouldn’t make the leap from success in DVDs to success in streaming. Most companies that are great at something – like AOL dialup or Borders bookstores – do not become great at new things people want (streaming for us) because they are afraid to hurt their initial business. Eventually these companies realize their error of not focusing enough on the new thing, and then the company ! ghts desperately and hopelessly to recover. Companies rarely die from moving too fast, and they frequently die from moving too slowly.

When Net" ix is evolving rapidly, however, I need to be extra-communicative. This is the key thing I got wrong.

In hindsight, I slid into arrogance based upon past success. We have done very well for a long time by steadily improving our service, without doing much CEO communication. Inside Net" ix I say, “Actions speak louder than words,” and we should just keep improving our service.

But now I see that given the huge changes we have been recently making, I should have personally given a full justi! cation to our members of why we are separating DVD and streaming, and charging for both. It wouldn’t have changed the price increase, but it would have been the right thing to do.

So here is what we are doing and why:

Many members love our DVD service, as I do, because nearly every movie ever made is published on DVD, plus lots of TV series. We want to advertise the breadth of our incredible DVD offering so that as many people as possible know it still exists, and it is a great option for those who want the huge and comprehensive selection on DVD. DVD by mail may not last forever, but we want it to last as long as possible.

I also love our streaming service because it is integrated into my TV, and I can watch anytime I want. The bene! ts of our streaming service are really quite different from the bene! ts of DVD by mail. We feel we need to focus on rapid improvement as streaming technology and the market evolve, without having to maintain compatibility with our DVD by mail service.

So we realized that streaming and DVD by mail are becoming two quite different businesses, with very different cost structures, different bene! ts that need to be marketed differently, and we need to let each grow and operate independently. It’s hard for me to write this after over 10 years of mailing DVDs with pride, but we think it is necessary and best: In a few weeks, we will rename our DVD by mail service to “Qwikster”.

We chose the name Qwikster because it refers to quick delivery. We will keep the name “Net" ix” for streaming.

EXHIBIT 1 Reed Hastings’s Blog Posting, September 18, 2011

(Continued)

Case 11 Netflix in 2012: Can It Recover from Its Strategy Missteps? C-129

standalone businesses, Netflix sent personal e-mails to all U.S. subscribers stating that it was scrapping its Qwikster proposal and that U.S. members would continue to use one website, one account, and one password for their movie and TV watching enjoy- ment under the Netflix brand. Simultaneously, Net- flix issued a press release and posted statements on the Netflix blog at http://blog.netflix.com/ say- ing it was abandoning the Qwikster strategy. In the blog, Reed Hastings said, “It is clear that for many of our members two websites would make things more difficult. So we are going to keep Netflix as one place to go for streaming and DVDs.”

• On October 24, 2011, Netflix announced that in early 2012 it would begin offering unlimited TV

Hastings’s announcement about Netflix’s strat- egy to split the DVDs-by-mail business from the Internet streaming business and to create Qwikster sparked a second furor from already disgruntled subscribers and further adverse investor reaction (the stock price plunged from around $208 per share to about $115 per share over the next three weeks). Netflix’s strategy to split the DVDs-by-mail business from the Internet streaming business drew harsh criticism from Wall Street analysts and busi- ness commentators; virtually all knowledgeable industry observers expressed amazement that Netf- lix executives would even contemplate such a move.

• On October 10, 2011, three weeks after Hast- ings disclosed the plan to divide Netflix into two

Source: Posting at Net! ix Blog, http://blog.netflix.com/ , September 18, 2011, accessed March 6, 2012.

Qwikster will be the same website and DVD service that everyone is used to. It is just a new name, and DVD members will go to qwikster.com to access their DVD queues and choose movies. One improvement we will make at launch is to add a video games upgrade option, similar to our upgrade option for Blu-ray, for those who want to rent Wii, PS3 and Xbox 360 games. Members have been asking for video games for many years, and now that DVD by mail has its own team, we are " nally getting it done. Other improvements will follow. Another advantage of separate websites is simplicity for our members. Each website will be focused on just one thing (DVDs or streaming) and will be even easier to use. A negative of the renaming and separation is that the Qwikster.com and Net! ix.com websites will not be integrated. So if you subscribe to both services, and if you need to change your credit card or email address, you would need to do it in two places. Similarly, if you rate or review a movie on Qwikster, it doesn’t show up on Net! ix, and vice-versa.

There are no pricing changes (we’re done with that!). Members who subscribe to both services will have two entries on their credit card statements, one for Qwikster and one for Net! ix. The total will be the same as the current charges.

Andy Rendich, who has been working on our DVD service for 12 years, and leading it for the last 4 years, will be the CEO of Qwikster. Andy and I made a short welcome video. (You’ll probably say we should avoid going into movie making after watching it.) We will let you know in a few weeks when the Qwikster.com website is up and ready. It is merely a renamed version of the Net! ix DVD website, but with the addition of video games. You won’t have to do anything special if you subscribe to our DVD by mail service.

For me the Net! ix red envelope has always been a source of joy. The new envelope is still that distinctive red, but now it will have a Qwikster logo. I know that logo will grow on me over time, but still, it is hard. I imagine it will be the same for many of you. We’ll also return to marketing our DVD by mail service, with its amazing selection, now with the Qwikster brand.

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. But going forward, Qwikster will continue to run the best DVD by mail service ever, throughout the United States. Net! ix will offer the best streaming service for TV shows and movies, hopefully on a global basis. The additional streaming content we have coming in the next few months is substantial, and we are always working to improve our service further.

I want to acknowledge and thank our many members that stuck with us, and to apologize again to those members, both current and former, who felt we treated them thoughtlessly.

Both the Qwikster and Net! ix teams will work hard to regain your trust. We know it will not be overnight. Actions speak louder than words. But words help people to understand actions.

Respectfully yours,

Reed Hastings, Co-Founder and CEO, Net! ix

EXHIBIT 1 (Concluded)

C-130 Part 2 Cases in Crafting and Executing Strategy

subscribers in Canada and that member counts in Latin America and the Caribbean should exceed 500,000 by year-end 2011. However, Netflix’s con- tribution losses from international operations jumped from $9.3 million in the second quarter of 2011 to $23.3 million in the third quarter of 2011, owing to increased expenses associated with the startup of operations in Latin America and the Caribbean.

On the day following the release of Netflix’s third quarter financial results, the company’s stock price dropped from $118.84 to close at $77.37.

• On November 21, 2011, Netflix announced that it had raised $400 million in new capital by (1) sell- ing 2.86 million shares of common stock to certain mutual funds and accounts managed by T. Rowe Price Associates for $70 per share (which generated proceeds of $200 million) and (2) selling a $200 million aggregate principal amount of Zero Cou- pon Convertible Senior Notes due December 1, 2018 to a private party. Any time after six months, Netflix had the option of converting the Zero Cou- pon Notes into shares of Netflix common stock at an initial conversion rate of 11.6533 shares of com- mon stock per $1,000 principal amount, subject to the satisfaction of certain conditions. Netflix executives said that the company did not intend to spend any of the newly raised capital. Rather, the company intended to use the capital as a safety net since the company’s cash on hand and future cash flows from operations would likely be squeezed in upcoming quarters by the ongoing need to:

• Make cash payments for additions to its library of titles available for streaming.

• Absorb the expected contribution losses from international operations over the next five to seven quarters.

In the weeks following the announcement of the $400 million in new financing, Netflix’s stock price dropped to as low as $62.37 and traded in the range of $65 to $71 for most all of December 2011.

Financial statement data for Netflix for 2000–2011 are shown in Exhibits 2 and 3 .

INDUSTRY ENVIRONMENT Since 2000, the introduction of new technologies and electronics products had rapidly multiplied consumer opportunities to view movies. It was commonplace

shows and movies instantly streamed over the Internet to some 26 million households in the United Kingdom and Ireland—20 million of these households had high-speed broadband Internet service and thus could stream movies to their TVs, computers, or other devices. This move repre- sented the third strategic initiative to expand Net- flix’s international reach. Netflix began streaming to members in Canada in 2010, and in September 2011 it initiated streaming services to 43 countries in Latin America and the Caribbean; there were four times as many households with high-speed broadband service in these 43 countries as there were in Canada. In all three cases, Netflix estimated that it would take about two years after the initial launch to attract sufficient subscribers to generate a positive “contribution profit”—Netflix defined “contribution profit (loss)” as revenues less cost of revenues and marketing expenses; cost of revenues included subscription costs and order fulfillment costs.

In announcing the company’s entry into Latin America and the Caribbean, Netflix said it was establishing a single low monthly price of 99 pesos for subscribers in Mexico and a price of US$7.99 for customers in the 42 countries in Central America, South America, and the Caribbean. In Brazil, Netflix content was available in Portu- guese; in eight other South American countries and all of the Central America countries, Netf- lix content was made available in Spanish; in the Caribbean, Netflix was available in English and Spanish. As part of its September entry into Latin America and the Caribbean, Netflix had entered into regional license agreements to obtain movies and TV shows in Spanish and Portuguese from a large variety of major motion picture and television studios, including Walt Disney Studios, Paramount Studios, Sony Pictures Television, NBCUniversal International Television, CBS Television, MGM, Lionsgate, Summit, Relativity, BBC Worldwide, TV Bandeirantes, Televisa, Telemundo, TV Azteca, TV Globo, Caracol, Telefe, and RCTV.

Also, on October 24, Netflix announced that the number of domestic subscribers dropped by a net of 810,000 during the third quarter of 2011, thus resulting in operating profits, a net income, and earnings per share that were below Wall Street estimates and investor expectations. Internation- ally, the company said it had reached 1 million

Case 11 Netflix in 2012: Can It Recover from Its Strategy Missteps? C-131

2000 2005 2007 2009 2010 2011

Revenues $ 35.9 $682.2 $1,205.3 $1,670.3 $2,162.6 $3,205.6

Cost of revenues:

Subscription costs 24.9 393.8 664.4 909.5 1,154.1 1,789.6

Ful! llment expenses 10.2 72.0 121.3 169.8 203.2 250.3

Total cost of revenues 35.1 465.8 786.2 1,079.3 1,357.4 2,039.9

Gross pro! t 0.8 216.4 419.2 591.0 805.3 1,164.7

Operating expenses

Technology and development 16.8 35.4 71.0 114.5 163.3 259.0

Marketing 25.7 144.6 218.2 237.7 293.8 402.6

General and administrative 7.0 35.5 52.4 51.3 64.5 117.9

Other 9.7 (2.0) (14.2) (4.6) — 9.0

Total operating expenses 59.2 213.4 327.4 399.1 521.6 788.8

Operating income (58.4) 3.0 91.8 191.9 283.6 376.1

Interest and other income (expense) (0.2) 5.3 20.1 0.3 (15.9) (16.5)

Income before income taxes — 8.3 110.9 192.2 267.7 359.5

Provision for (bene! t from) income taxes — (33.7) 44.3 76.3 106.8 133.4

Net income $ (58.5) $ 42.0 $ 66.7 $ 115.9 $ 160.8 $ 226.1

Net income per share:

Basic $(20.61) $0.79 $0.99 $2.05 $3.06 $4.28

Diluted (20.61) 0.64 0.97 1.98 2.96 4.16

Weighted average common shares outstanding:

Basic 2.8 53.5 67.1 56.6 52.5 52.8

Diluted 2.8 65.5 68.9 58.4 54.3 54.4

Note: Totals may not add due to rounding.

Source: Company 10-K reports for 2003, 2006, and 2009.

EXHIBIT 2 Netflix’s Consolidated Statements of Operations, 2000–2011 (in millions, except per share data)

2000 2005 2007 2009 2010 2011

Selected Balance Sheet Data:

Cash and cash equivalents $ 14.9 $212.3 $177.4 $134.2 $194.5 $ 508.1

Short-term investments — — 207.7 186.0 155.9 290.0

Current assets n.a. 243.7 432.4 416.5 637.2 1,830.9

Net investment in content library n.a. 57.0 128.4 146.1 362.0 1,966.6

Total assets 52.5 364.7 679.0 679.7 982.1 3,069.2

Current liabilities n.a. 137.6 208.9 226.4 388.6 1,225.1

Working capital* (1.7) 106.1 223.5 190.1 248.6 605.8

Stockholders’ equity (73.3) 226.3 429.8 199.1 290.2 642.8

Cash Flow Data:

Net cash provided by operating activities $(22.7) $157.5 $277.4 $325.1 $276.4 $ 317.7

Net cash used in investing activities (25.0) (133.2) (436.0) (246.1) (116.1) (265.8)

Net cash provided by (used in) ! nancing activities 48.4 13.3 (64.4) (84.6) (100.0) 261.6

EXHIBIT 3 Selected Balance Sheet and Cash Flow Data for Netflix, 2000–2011 (in millions of $)

* De! ned as current assets minus current liabilities.

Sources: Company 10-K reports for 2003, 2005, 2007, 2008, 2009, and 2011.

C-132 Part 2 Cases in Crafting and Executing Strategy

• Using a TV remote to order movies instantly streamed directly to a TV on a pay-per-view basis (generally referred to as “video-on-demand” or VOD). Cable, satellite, and fiber-optic providers of multichannel TV packages were promoting their VOD services and making more movie titles avail- able to their customers. In 2011, roughly 40 million U.S. households (15 percent) spent about $1.3 billion on VOD movie rentals. 2

• Purchasing DVDs from such retailers as Walmart, Target, Best Buy, Toys “R” Us, and Amazon.com . DVD sales, however, had declined for the past three years, partially a reflection of growing consumer preferences to rent rather than purchase DVDs of movies and TV episodes.

• Renting DVDs from Blockbuster and other local retail stores or from standalone rental kiosks like Redbox and Blockbuster Express. Physical-disc ren- tals at traditional brick-and-mortar locations had been trending downward for five to eight years, but the downward spiral accelerated in 2010–2011. Blockbuster’s share of physical disc rentals dropped from 23 percent in 2010 to 17 percent in 2011. 3 The chief beneficiary of declining rentals at brick- and-mortar movie rental locations was Redbox. Since 2007, when Redbox first began deploying its distinctive red vending machine kiosks, Redbox’s share of physical-disc DVD and Blu-ray movie rentals in the U.S. had mushroomed to 37 percent as of 2011 (up from 25 percent in 2010).

• Renting DVDs online from Netflix, Blockbuster, and several other subscription services that either mailed DVDs directly to subscribers’ homes or streamed the content to subscribers via broadband Internet connections. In 2011, Netflix had about a 30 percent share of the physical DVD rental market and about a 56 percent share of streaming rentals. 4

• Utilizing the rental or download services of such providers as Apple’s iTunes store, Amazon Instant Video, Hulu.com , VUDU.com , Best Buy Cinema Now, Sony PlayStation Network, and Google’s YouTube.

• Most recently, a new class of user interface apps had become available that enabled sub- scribers to the services of multichannel TV providers (like cable or satellite operators) to watch certain TV shows, movies, and other programs at their convenience rather than at scheduled broadcast times. This service— called TV Everywhere—gave subscribers the

in 2012 for movies to be viewed at theaters, on air- line flights, in hotels, from the rear seats of motor vehicles equipped with video consoles, in homes, or most anywhere on a laptop PC or handheld device like an Apple iPhone, iPad, or iPod touch. Home viewing was possible on PCs, televisions connected to a digital video disc (DVD) player, and video game consoles. As of 2012, more than 90 percent of U.S. households had DVD players connected to their TVs, enabling them to play movie DVDs. Households with big-screen high-definition TVs and a Blu-ray player could rent a Blu-ray DVD and enjoy a significantly higher picture quality. In recent years, millions of households had upgraded to high-speed or broadband Internet service and purchased Blu-ray DVD devices, video game con- soles, and/or televisions with built-in connectivity to the Internet, enabling them to view content streamed over the Internet. However, heading into 2012, it was clear that the 134 million U.S. households with high- speed Internet service and Internet-connected Blu-ray players, video game consoles, TVs, computers, tab- lets, and/or smartphones were rapidly shifting from renting physical DVDs to watching movies and TV episodes streamed over the Internet.

Increasing numbers of devices had recently app- eared in electronics stores (or become available from cable, satellite, and fiber-optic TV providers) that enabled TVs to be connected to the Internet and receive streamed content from online providers with no hassle. These devices made it simple for households to order streamed movies with just a few clicks instead of travel- ing to a video rental store or waiting for a disk to be deliv- ered through the mail. In 2012, more than 700 different devices were capable of streaming content from Netflix.

Consumers could obtain or view movie DVDs and TV episodes through a wide variety of distribu- tion channels and providers. The options included:

• Watching movies on assorted cable channels included in the TV and entertainment packages provided by traditional cable providers (such as Time Warner, Comcast, Cox, and Charter), direct broadcast satellite providers (such as DIRECTV and DISH Network), or fiber-optics providers (like AT&T and Verizon that had installed thousands of miles of fiber-optic cable that enabled them to simultaneously provide TV packages, telephone, and Internet services to customers).

• Subscribing to any of several movie-only channels (such as HBO, Showtime, and Starz) through a cable, satellite, or fiber-optics provider.

Case 11 Netflix in 2012: Can It Recover from Its Strategy Missteps? C-133

from renting movie DVDs until 30 to 60 days follow- ing the date DVD titles could be sold by retailers. For example, in January 2012, Warner Home Entertain- ment increased the availability date for rental DVDs top kiosks and subscription-by-mail services to 58 days. Movie studios and TV networks were expected to continue to experiment with the timing of the releases to various distribution channels and providers, in an ongoing effort to discover how best to maximize revenues.

Market Trends in Home Viewing of Movies The wave of the future in the market for renting mov- ies and TV content was unquestionably in streaming movies and TV shows to Internet-connected TVs, computers, and mobile devices. Streaming had the advantage of allowing household members to order and instantly watch the movies and TV programs they wanted to see. Renting a streamed movie could be done either by utilizing the services of Netflix, Block- buster Online, Amazon Instant Video, Apple’s iTunes, and other streaming video providers or by using a TV remote to place orders with a cable, satellite, or fiber- optics provider to instantly watch a movie from a list of several hundred selections that changed periodi- cally. With a few exceptions, rental prices for pay-per- view and VOD movies ranged from $1 to $6, but the rental price for popular recently released movies was usually $3.99 to $5.99. During 2011, several movie studios had experimented with charging up to $30 for films released to pay-per-view and VOD providers for showing after eight weeks in theaters, but disap- pointingly small viewer response to such high-priced rentals quickly put an end to this strategy. 7 In 2012, many in-home movie viewers saw unlimited Internet streaming from subscription services as a better value than pay-per-view—the rental costs for two pay-per- view movies usually exceeded the $7.99 monthly price for unlimited streaming currently being charged by Netflix.

Several strategic initiatives to promote increased use of streaming video were underway in 2012.

• The owners of Hulu—Providence Equity Partners, The Walt Disney Company (owner of the ABC net- work), News Corp. (the parent of Fox Broadcasting and Fox Entertainment) and Comcast (the owner of NBCUniversal)—had for several years offered a free online video service at www.hulu.com where

option to watch programs on Internet-connected TVs and computers, iPads, iPhones, Android phones, and other devices. HBO’s TV Every- where application—called HBO GO—enabled HBO subscribers to have anytime, anywhere access to all HBO shows, hit movies, and other programs through participating multichannel TV providers. In 2012, most multichannel TV pro- viders and the owners of most channels carried on cable and satellite networks were exploring TV Everywhere options and packages for inter- ested viewers.

• Pirating files of movies and other content from Internet sources via the use of illegal file-sharing software. Piracy was widely thought to be a con- tributing factor to declining sales of movie DVDs. In 2011–2012, movie studios were becom- ing increasingly concerned that digital piracy could become a tidal wave. 5 Much of Netflix’s streaming library was rumored to be available through online piracy.