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Case 15 Netflix, Inc. The 2011 Rebranding/Price Increase Debacle Alan N. Hoffman Bentley University In 2011, Netflix was the world’s largest online movie rental service. Its subscribers paid to have DVDs delivered to their homes through the U.S. mail, or to access and watch unlimited TV shows and movies streamed over the Internet to their TVs, mobile devices, or computers. The company was founded by Marc Randolph and Reed Hastings in August, 1997 in Scotts Valley, California, after they had left Pure Software. Hastings was inspired to start Netflix after being charged US$40 for an overdue video.1 Initially, Netflix provided movies at US$6 per rental, but moved to a monthly subscription rate in 1999, dropping the single-rental model soon after. From then on, the company built its reputation on the business model of flat fee unlimited rentals per month without any late fees, or shipping and handling fees. In May 2002, Netflix went public with a successful IPO, selling 5.5 million shares of common stock at the IPO price of US$15 per share to raise US$82.5 million. After incurring substantial losses during its first few years of operations, Netflix turned a profit of US$6.5 million during the fiscal year 2003.2 The company’s subscriber base grew strongly and steadily from 1 million in the fourth quarter of 2002 to over 27 million in July 2012.3 By 2012, Netflix had over 100,000 titles distributed via more than 50 shipment centers, insuring customers received their DVDs in one to two business days, which made Netflix one of the most successful dotcom ventures in the past two decades. 4 The company employed almost 4100 people, 2200 of whom were part-time employees.5 In September 2010, Netflix began international operations by offering an unlimited streaming plan without DVDs in Canada. In September 2011, Netflix expanded its international operations to customers in the Caribbean, Mexico, and Central and South America. Key to Netflix’s success was its no late fee policy. Netflix’s profits were directly proportional to the number of days the customer kept a DVD. Most customers wanted to view a new DVD release as soon as possible. If Netflix imposed a late fee, it would have to have multiple copies of the new releases and find a way to remain profitable. However, because of the no-late-fee rule, the demand for the newer movies was spread over a period of time, ensuring an efficient circulation of movies.6 On September 18, 2011, Netflix CEO and co-founder Reed Hastings announced on the Netflix blog that the company was splitting its DVD delivery service from its online streaming service, rebranding its DVD delivery service Qwikster as a way to differentiate it from its online streaming service, and creating a new website for it. Three weeks later, in

response to customer outrage and confusion, Hastings rescinded rebranding the DVD delivery service Qwikster and reintegrating it into Netflix. Nevertheless, by October 24, 2011, only five weeks after the initial split, Netflix acknowledged that it had lost 800,000 U.S. subscribers and expected to lose yet more, thanks both to the Qwikster debacle and the price hike the company had decided was necessary to cover increasing content costs.7 Despite this setback, Netflix continued to believe that by providing the cheapest and best subscription-paid, commercial-free streaming of movies and TV shows it could still rapidly and profitably fulfill its envisioned goal to become the world’s best entertainment distribution platform.

Online Streaming By the end of 2011, Netflix had 24.4 million subscribers, making it the largest provider of online streaming content in the world.8 Subscription numbers had grown exponentially, increasing 250% from 9.3 million in 2008. At the same time, Netflix proactively recognized that the demand for DVDs by mail had peaked, and the future growth would be in online streaming. With 245 million Internet users in the United States, and 2.2 billion9 worldwide, Netflix saw the opportunity to expand its online streaming base both domestically and internationally to become a dominant world player. In 2011, Netflix expanded into Canada and Central America, and in 2012 into Ireland and the United Kingdom.10 The scarce resource for the online video industry was bandwidth, the amount of data that can be carried from one point to another in a given time period.11 With the introduction of Blu-ray discs, the demand for higher- and better-quality picture and sound streaming increased, which in turn increased the demand for higher bandwidths. At the same time, cheaper Internet connections and faster download speeds made it easier and more affordable for customers to take advantage of the services Netflix and its competitors offered. If the cost of Internet access was to increase, it would directly affect sales in the industry’s streaming segment. Netflix was a leader in developing streaming technologies, increasing its spending on technology and development from US$114 million (2009) to US$258 million in 201112 (8% of its revenue),13and initiating a US$1 million five-year prize in to improve the existing algorithm of Netflix’s recommendation service by at least 10%. Because Netflix had already developed proprietary streaming software and an extensive content library, it had a head start in the online streaming market, and with continued investments in technological enhancements, hoped to maintain its lead.14 However, increased competition in streaming, ISP fair-use charges, and piracy were some of the major challenges it faced. In March 2011, Netflix made its services readily available to consumers through Smart-phones, tablets and video game consoles when only 35% of the total U.S. market were using Internet-enabled Smartphones.15 Thus, the expansion potential for Netflix in this market was substantial. The Great Recession of 2008–2010 was a boon for Netflix as people cut down on high-value discretionary spending, choosing “value for money” Internet

offerings instead.16 However, in its annual letter to shareholders, Netflix acknowledged that many of its customers were among the highest users of data on an ISPs network and in the near future it expected that such users might be forced to pay extra for their data usage, which could be a major deterrent for the growth of Netflix because most of its customers are highly price sensitive.

Demographics The number of Internet users in the United States had increased from about 205 million in 2005 to 245 million in 2012.17 According to a research report by Mintel investment research database, the percentage of people using the Internet to stream video has jumped from 5% (2005) to 17% (2011), significantly growing the market for online streaming services such as Netflix. At the same time, the recession of 2008–2010, with its high unemployment and slow economic growth had a significant impact on the spending habits of U.S. consumers. More and more people chose to forego an evening at the movie theatre in favor of home movie rentals to save on costs.18 By 2011, the crucial 18- to 34-year-old demographic saw the Internet as its prime source of access to entertainment. However, this demographic, was particularly sensitive to price fluctuations. When Netflix changed its pricing structure in the third quarter of 2011, subscriptions immediately dropped off 3%. Mintel Research reported that only 15% of the under 18–25 age bracket of its customers were ready to pay US$16/month for premium content via Netflix. In addition, the proliferation of free content over the Internet—Mega video, for example, with around 81 million unique visitors and a maximum exposure in the 18–33 demographic became a strong competitor for Netflix, further limiting the pricing power Netflix could exercise.19 The Mintel report also found that American households with two or more children and a household income of US$50,000 or more had a very favorable attitude toward Netflix;20 Netflix fostered this trend by cutting a deal with Disney21 that gave it access to content exclusively targeting young children. At the same time that Netflix was increasing its customer base among the 18- to 34year-olds and households with young children, both of whom preferred streaming, it lost ground with affluent Baby Boomers who still preferred to rent the DVDs over the Internet. Thus, Netflix needed to fine-tune its strategy to include this older demographic since people over 60 had US$1 trillion in discretionary income per year, and fewer familial responsibilities, making them a prime target demographic for expanding Netflix’s customer base.22 The availability of high-speed Internet at home and the shift to online TVs created opportunities for Netflix. The company recognized that to fully leverage the current world of technological convergence, it needed to compete on as many platforms as possible, and created applications for the Xbox, Wii, PS3, iPad, Apple TV, Windows phone, and Android.

The company also collaborated with TV manufacturers to integrate Netflix directly into the latest televisions.23

Netflix’s Competitors Netflix’s great operational advantage in the DVD rental market was its nationwide distribution network, which prevented the entry of many of its potential competitors. While only Netflix provided both mail delivery and online rentals, with the growth of online streaming, Netflix’s advantage shrank and it faced increasing competition from Blockbuster, Wal-Mart, Amazon, Hulu, and Redbox. Netflix’s one-time strongest competitor, Blockbuster LLC, founded in 1985, and headquartered in McKinney, Texas, provided in-home movie and game entertainment, originally through over 5000 video rental stores throughout the Americas, Europe, Asia, and Australia, and later by adding DVD-by-mail, streaming video on demand, and kiosks. Its business model emphasized providing convenient access to media entertainment across multiple channels, recognizing that the same customer might choose different ways to access media entertainment on different nights. Competition from Netflix and other video rental companies forced Blockbuster to file for bankruptcy on September 23, 2010, and on April 6, 2011, satellite television provider Dish Network bought it at auction for US$233 million.24 Redbox Automated Retail, LLC, a wholly owned subsidiary of Coinstar Inc., specialized in DVD, Blu-ray, and rentals via automated retail kiosks. By June 2011, Redbox had over 33,000 kiosks in over 27,800 locations worldwide,25 and was considering launching an online streaming service, perhaps for as cheaply as US$3.95 per month. Vudu, Inc., formerly known as Marquee, Inc., founded in 2004, a content delivery media technology company acquired by Wal-Mart in March 2010, worked by allowing users to stream movies and TV shows to Sony PlayStation3, Blu-ray players, HDTVs, computers, or home theaters. VUDU Box and VUDU XL provided access to movies and television shows; users also needed a VUDU Wireless Kit to connect VUDU Box/VUDU XL to the Internet. Based in Santa Clara, California, the company was the third most popular online movie service, with a market share of 5.3%.26 Vudu had no monthly subscription fee, instead users deposited funds to an online account which was reduced depending on how many movies the user rented. In other words, you paid for only what you watched. In February 2011, Amazon.com, a multinational electronic commerce company, announced the launch for Amazon Prime members of unlimited, commercial-free instant streaming of all movies and TV shows to members’ computers or HDTVs. In addition, Amazon Prime members were given access to the Kindle Owners’ Lending Library, allowing them to borrow selected popular titles for free with no due date. For non-Amazon Prime

members, 48-hour on-demand rentals were available for US$3.99, or the title could be bought outright.27 Hulu Plus was the first ad-supported subscription service for TV shows and films that could be accessed by computers, television sets, mobile phone, or other digital devices. Like Netflix, the streaming service cost US$8 per month, but unlike Netflix, Hulu offered more recent TV episodes and seasons. However, subscribers had to put up with ads, and Hulu’s movie selection was much more limited than Netflix’s selection. Marc Schuh, an early financial backer of Netflix, observed that copying software was relatively simple.28 Anyone could buy the best servers, processors, operating systems, and databases—but timing was crucial.29 Barnes & Noble waited 17 months to enter the fray against Amazon, so that by 2012, Amazon had eight times the profit and 30 times the market capitalization of Barnes & Noble. Similarly, in the same year that Netflix’s profits increased sevenfold, Blockbuster lost over 1 billion dollars.30 Technology with correct timings can help a company gain competitive advantage over rivals. Other barriers to entry include investments in infrastructure aiding supply chain and delays from major production houses for gaining permission to stream their titles.

Rising Content Costs In the DVD rental business, the rental company had the first sale doctrine, in which the company was permitted to rent a single disc many times to recover the cost of the content. But this doctrine did not apply to digital content, and the technological shift away from the DVD rental business was in part responsible for the excessive increase in content cost for Netflix.31 In addition, Netflix’s dependence on outside content suppliers such as the six major movie studios and the top television networks contributed significantly to rising costs for the company. As an example, Liberty Media Corporation’s Starz LLC had been an early Netflix supplier. In 2011, Starz demanded US$300 million to renew its deal with Netflix, testament to the power of suppliers in relation to market demand from an increasing number of competitors. On September 1, 2011, Netflix customers learned they would lose access to newer films from the Walt Disney Company and the Sony Corporation after talks to obtain those movies from Starz broke down. The loss created the impression of a major setback, even though the films were making up a smaller share of viewing than previously. However, Netflix did sign new deals with the CW Network, DreamWorks Animation, and Discovery Communications in 2011.

Global Expansion Beginning in 2007, Netflix shifted its focus to its streaming business in response to their customers’ move to streaming in preference to DVD rentals and the rising cost of mailing DVDs. Conveniently, expanding its streaming business did not require expanding its physical infrastructure. This strategy has proven to be a major differentiator as it expands internationally in the Americas and Europe. By the end of 2011, the company had started operations in Canada and 43 countries in Latin America, and planned to start European operations in early 2012. At the end of the third quarter of 2011, Netflix had 1.48 million international subscribers with predictions of 2 million by the end of the year.32 The United Kingdom was considered a huge potential market. Twenty million UK households had broadband Internet, and 60% of those households subscribed to a paid movie service. In Latin America, four times that number had Internet access,33 making international expansion there especially attractive to subscriberhungry Netflix. However, international expansion was potentially risky, as Netflix faced rising content costs from higher studio charges. In addition, international expansion required both broadening its content offerings and tailoring those offerings to meet the specific needs of each of its international markets, which Netflix feared would further increase content costs. It was clear that the correct content mix was crucial, yet a huge challenge for Netflix. In addition, as Canada and the United Kingdom were already developed markets, Netflix faced local competition from a proliferation of DVD rental/streaming services. In the United Kingdom, for instance, Virgin and Sky already had strong brand recognition and balance sheets, and the Sky network had already contracted exclusive first-pay window rights to movies from all six major American studios, tough competition that could easily delay profitability from international operations. Lower per capita income and slower Internet speeds, especially in Latin America, were further potential problems for Netflix’s international expansion. In Canada, low data usage limits per subscriber were a concern for a data hungry service such as Netflix.

Financial Results In 2011, Netflix surpassed US$3.2 billion in sales, an annual revenue growth of 50% over 2010 (US$2.1 billion, see Exhibits 1–3). Subscriber growth was the most important metric for Netflix because its revenue growth was directly correlated to its subscriber growth. Netflix grew from 12 million subscribers in 2009 to 20 million in 2010, and then to 27 million in 2012. International operations were set to expand to become a major source of sales growth for the company in the coming years.

………… (see e-text). However, by 2012, Netflix faced challenges from its pricing changes in the United States and its expansion into international markets, even stating that it expected revenue per subscriber to drop from its 2011 level of US$11.5634 as subscribers choose the streaming only option of US$7.99 over the more expensive streaming and DVD delivery option. For future revenue growth, Netflix needed to increase its subscribers numbers both domestically and internationally. In terms of net income, Netflix had steadily improved its bottom line in conjunction with strong top line growth. The company had a net income of US$226 million in 2011 for a growth rate of 40% over the previous year’s US$160 million net income. Over the five years from 2006–2011, the company saw an average net income growth of 31% per year that, coupled with high revenue growth, was instrumental to Netflix’s high stock valuation. However, recently, its operating margin slid from 15% in 2010 to 2.9% in 2012, a drop directly attributable to the higher cost of content acquisition. Until the end of 2007, Netflix had no long-term debt on its books, but it began to acquire long-term debt in 2008 as a result of its decision to invest in building a strong content library and expand overseas. At the end of 2011, Netflix had US$508 million in cash and US$200 million in long-term debt.

Netflix’s Success Netflix went from being a company that exclusively mailed DVDs to the largest media delivery company in the world by making some smart strategic decisions. For instance, Netflix jumped on the streaming bandwagon even though it was not really ready. At the time, the online content available for streaming was extremely limited—less than 10% of the content that was available from Netflix’s DVDs holdings. At that time, Netflix’s mail-order DVD business was very popular, and customers did not seem to mind waiting a day or two for their DVDs. Netflix then went ahead and offered streaming content, a bold decision that anticipated an as yet unexpressed need for the immediate gratification of streaming, and made Netflix the first entrant into the market for streamed video. It was clear to Netflix that the use of DVDs would gradually decline, and Netflix’s aggressive adoption of streaming videos was a sharp marketing move, that gave it an edge in the global economy.

After its initial launch of online streaming, Netflix kept up to date with new trends and customer preferences, especially the quickly changing preferences of Generation Y, which were influenced by branding, social media, and media saturation. Netflix utilized all the platforms that Generation Y would find appealing, from computers and TVs, to Smartphones and tablets. Continually bearing in mind that the two most important things for Netflix’s customers were price per content, and quality of content, Netflix kept its priorities straight and never stopped improving the quality of its content, or the platforms for delivering that content. Netflix also focused on increasing customer engagement. It allowed customers to rate movies they viewed, thereby enhancing the customer experience and creating a community of viewers. And, by tracking the movies a customer viewed, Netflix was able to track customer preferences, and offer targeted recommendations for viewing. Netflix also exploited customer loyalty to attract new customers, for instance, through its “refer-a-friend” offer of one free month of service for both the new customer and the referrer to attract new users who wanted to try the service risk-free.

The 2011 Price Increase/Rebranding Debacle Netflix continued to grow robustly by offering a combined DVD mail and unlimited streaming service at a flat rate of US$9.99 a month, a rate that was key to Netflix’s ability to offer a great value for money service. But with increased competition and expensive new content deals, the company found it increasingly difficult to maintain its operating margin levels. In the third quarter of 2011, Netflix implemented a 60% price increase, from US$10 to US$16 a month for unlimited streaming and DVDs by mail, which immediately resulted in the loss of 800,000 subscribers, pointing to the company’s very limited latitude with regard to pricing.35 In response, Netflix took action that very shortly proved disastrous. In addition to raising its prices and shifting its business model to focus on online streaming. Netflix also attempted to restructure its operations by spinning off its DVD delivery service and rebranding it Qwikster. Rebranding a well-known product or service such as Netflix usually only works if a company was trying to simplify its brand, almost never the other way around, which was, unfortunately what Netflix tried to do. Netflix attempted to introduce a new entity, Qwikster, by splitting the old entity into two: with two separate websites, two separate queues, two separate sets of recommendations, two separate customer bases, two separate billing avenues, and two new sets of rules customer had to learn about. While Netflix had banked on the competitive advantage of offering “affordability, instant access and usability,” the introduction of a separate website undercut instant access and usability. Customers, critics, and Wall Street responded harshly.

Apart from losing over 800,000 subscribers after its price increase, and losing half of its market capitalization, Netflix’s rebranding strategy did not seem justifiable to its customers. Netflix botched the rebranding because it neglected due diligence prior to launching it and its price increases. Market research would surely have indicated customer resistance to both. Heavily focused on increasing profits, Netflix did not effectively strategize the rebranding/ repricing plan, nor did it anticipate resistance or prepare strategy implementation scenarios. A new strategy should not only increase revenues and profits, it should consider relationship and brand image gains and losses. In springing the rebranding on customers, Netflix undercut the quality of the experience it had previously offered, and the negative reaction was not mitigated by the company’s public apology or its rescinding of its decision to split its services. The botched rebranding led to a dilution of Netflix’s brand, and loss of customer trust. Re-establishing its brand image became a priority for Netflix, though it was not very easy to do. The company needed to offer something genuinely useful to its customers at just the right cost, while increasing the quality of the content offered and enhancing customer experience. Finally, in order for Netflix to expand internationally, it needed to invest in the technological infrastructure in the international markets that it lacked but which it desperately needs due to heavy competitions and other legal concerns that appear there.

Strategic Challenges Ahead for Netflix Netflix’s top management needed to address many issues to maintain the company’s leading position in the home video market. A strategic plan was needed to: 1. 2. 3. 4.

Repair the PR damage from the rebranding and price increases of 2011. Focus on growing its subscriber base both at home and abroad. Maintain a healthy cash position to meet the growing content cost obligations. Invest in innovative user interface and streaming technologies to create a solid platform for the shift from DVD delivery to streaming.

NOTES – CLASS DISCUSSION