In July 2000. Reed Hastings. president and CEO of NetFlix. com. Inc. . faced a critical determination. Three months before. following one of the worst episodes on record for the NASDAQ market. NetFlix had submitted its S-1 filing for its initial public offering ( IPO ) . 1 As a consequence of the market downswing. many Internet companies had been forced to retreat their IPOs. Investment bankers indicated to Hastings that NetFlix would necessitate to demo positive hard currency flows within a twelve-month skyline in order to hold a successful offering. Hastings knew that NetFlix was at a important phase. With grosss duplicating every six months. NetFlix was basking enormous success. But continued success depended on the company’s ability to prolong triple-digit growing for the foreseeable hereafter. Soon. Hastings would hold to make up one’s mind whether or non to continue with the company’s anticipated IPO. Hastings asked Barry McCarthy. the main fiscal officer. to re-evaluate the hard currency flow demands of the company’s current concern program. to propose alterations that would better the company’s projected hard currency flows. and to do a recommendation on whether the company should travel frontward with its planned offering.
As McCarthy reviewed the bing NetFlix concern theoretical account. he considered possible alterations that might let the company to continue with its planned IPO and yet prolong the type of future growing that would be necessary for the company to accomplish its long-term aims. McCarthy was acutely cognizant of the company’s current funding demand. but he worried about the consequence that changes to the concern program might hold on the company’s current operations.
The CompanyNetFlix. com. Inc. was founded in 1997 by Reed Hastings and Marc Randolph. NetFlix operated an Internet-based limitless rental subscription service for digital picture phonograph record ( DVD ) formatted films. The DVD provided a new engineering for hive awaying and playing films with image and sound quality transcending that of traditional videocassettes. A DVD was similar in size to an audio compact phonograph record and was capable of keeping an full feature-length movie. every bit good as extra information such as captions in different linguistic communications. extra shorter picture about the devising of the movie or other related capable affair. and information about the histrions. manager. and manufacturers. With its highquality and extra characteristics. the new DVD engineering provided an attractive option to traditional videocassettes for the place picture market. By uniting the high quality of the new DVD
HBS instances are developed entirely as the footing for category treatment. Cases are non intended to function as indorsements. beginnings of primary informations. or illustrations of effectual or uneffective direction. Copyright © 2000 President and Fellows of Harvard College. To order transcripts or bespeak permission to reproduce stuffs. name 1-800-545-7685. write Harvard Business School Publishing. Boston. MA 02163. or travel to http: //www. hbsp. Harvard University. edu. No portion of this publication may be reproduced. stored in a retrieval system. used in a spreadsheet. or transmitted in any signifier or by any means—electronic. mechanical. run offing. entering. or otherwise—without the permission of engineering with the convenience of the Internet. NetFlix provided a new manner to choose and to lease place films. Randolph managed production of the NetFlix web site. including the characteristics. functionality. and content on the site. Randolph believed that consumers were frequently frustrated in their attempts to choose and see films at traditional picture shops because of limited choices and a focal point on new release films. With its limitless “virtual” shelf infinite for carrying picture. the NetFlix web site focused on bettering the experience of choosing a film to watch by supplying an intelligent interface for shoping. seeking. and measuring possible films.
The NetFlix web site besides incorporate films presently demoing in theatres by supplying the ability to look into local listings and show times. every bit good as the ability to see film dawdlers on its web site. In add-on. the NetFlix web site kept path of each subscriber’s penchant for assorted types of films and provided an individualised predicted evaluation for all of the films on the web site. Since establishing its web site in April 1998. NetFlix had experienced rapid growing. Grosss had grown from $ 1. 4 million in 1998 to $ 5. 0 million in 1999. The figure of full-time employees increased from 46 in December 1998 to 270 in December 1999. By March 31. 2000. NetFlix had over 120. 000 paying endorsers. Typical of most Internet startups. nevertheless. NetFlix had non yet earned a net income. reporting net losingss of $ 11. 1 and $ 29. 8 million in 1998 and 1999. severally. Exhibit 1 and Exhibit 2 provide one-year fiscal statements for 1998 and 1999. Exhibit 3 provides quarterly operating consequences for 1999. The NetFlix concern theoretical account focused entirely on the new DVD format engineering.
Management had four chief grounds for concentrating on this specific section of the place picture market. • DVD participants were the fastest turning section of the picture participant market. Because of the rapid acceptance of the new DVD engineering. gross revenues were forecast to turn at a 49 % compound one-year rate over the following five old ages. 2 Exhibit 4 provides a comparing of DVD participant and videocassette recording equipment gross revenues during the first five old ages after their several debuts.
Because of their little size. light weight. and lastingness. DVDs could be distributed to endorsers on a cost effectual footing via regular U. S. mail. Including the costs associated with treating the order. McCarthy estimated the round-trip cost of transporting a DVD to a endorser and back to NetFlix to be about $ 1. 00. In order to advance gross revenues of DVD participants. makers were willing to include NetFlix promotional offers with their packaging stuffs at basically no cost. which allowed client acquisition costs to be kept to a lower limit. Management had negotiated understandings with most of the taking DVD makers. including Sony. Toshiba. Panasonic. and RCA. These makers accounted for over 90 % of the DVD participants sold in the United States in 1999. Management believed that early adoptive parents of DVD engineering were likely to hold a computing machine with an already bing internet connexion and were likely to be willing to carry on commercialism over the cyberspace.
Hastings viewed NetFlix as a combination of a traditional picture shop. such as Blockbuster or Hollywood Video. and a subscription overseas telegram Television service. such as HBO. Cinemax. or Showtime. By paying a individual monthly subscription fee runing from $ 15. 95 to $ 19. 95. a NetFlix endorser could lease an limitless figure of DVDs each month and could maintain a DVD every bit long as desired. 3 Because NetFlix did non enforce a specific day of the month on which a DVD was to be returned. endorsers did non hold to worry about paying extra fees for pictures that were returned tardily. In order to pull new endorsers to the NetFlix web site. NetFlix distributed vouchers for a free month of service with new DVD participants. The costs associated with these free months of service to new endorsers made up the bulk of gross revenues and selling disbursals. In 1999 entirely. NetFlix recorded over $ 16. 4 million in gross revenues and selling disbursal.
Once a endorser had signed up for the free month of service. the aim was to acquire the endorser to change over from free- to paid-status and so to retain that endorser for every bit long as possible. In order to analyze the consequence of the subscription fee on transition and keeping rates. direction had tested a assortment of different monetary value points. Based on analyses of informations from these market trials. McCarthy believed that his company’s ability to retain endorsers was comparable to that of successful subscription overseas telegram services. McCarthy estimated that about 70 % of new endorsers converted to paid-status and that 40 % of endorsers that converted to paid-status continued to subscribe after six months.
McCarthy expected keeping rates for endorsers that subscribed more than six months to be rather high. Because the NetFlix concern theoretical account focused on the acquisition and keeping of single endorsers. McCarthy projected future NetFlix funding demands utilizing a subscriber theoretical account. First. McCarthy modeled the expected hard currency flows from a freshly acquired subscriber. including the subscription fees paid. the expected figure of phonograph record rented. the costs associated with transportation and disc acquisition. and any other hard currency flows that varied straight with the acquisition or loss of an single endorser. Second. McCarthy modeled the likeliness that any given endorser would be retained over the prognosis skyline. And last. McCarthy used the jutting figure of future new endorsers together with the figure of bing endorsers to calculate the company’s expected aggregative hard currency flows.
The Marquee QueueA cardinal facet of the NetFlix concern theoretical account was the “Marquee Queue” construct. The “Marquee Queue” allowed a endorser to hold several films on manus for sing at all times. A subscriber’s waiting line was merely a list of all the films that the endorser had selected. but which had non yet been sent to the endorser. After logging on to the NetFlix Web site. a new endorser would shop the practical aisles and choice films that he or she wanted to watch. These films would be used to construct the subscriber’s waiting line. The NetFlix web site made it easy for the endorser to redact the waiting line. such that the list could be arranged in the coveted order. NetFlix would so transport the DVDs at the top of the waiting line to the endorser.
Since establishing its Web site. direction had tested a assortment of different pricing programs. From February 1999 through October 1999. NetFlix generated most of its grosss from single DVD leases and associated transportation charges. In September 1999. NetFlix launched its subscription rental service for a fixed monthly fee of $ 15. 95. Under this program. endorsers could lease up to four DVDs per month. In February 2000. NetFlix modified its subscription rental service to supply limitless leases for a fixed monthly fee of $ 19. 95. At that clip. bing endorsers were migrated to the limitless rental service at their original fee of $ 15. 95.
NetFlix allowed a endorser to hold up to four DVDs in his or her ownership at one clip. Once a endorser had viewed a film and returned the DVD to NetFlix. the following DVD in the waiting line was automatically sent to the endorser. In this manner. a endorser could ever hold films in his or her ownership for immediate screening. In order to carry through subscriber petitions — an norm of 4. 3 per month — Netflix maintained an extended DVD library. 4 As of December 1999. the Netflix DVD library contained about 5800 rubrics and over 620. 000 single phonograph record. For each new endorser. Netflix would ab initio hold to buy about 5. 6 new DVDs from sweeping distributers to fulfill client petitions at an mean cost of $ 17. 55 per DVD. About 20 % of these DVDs would be new release rubrics. those released by the studios in the last two months.
In each month. half of these new releases would go disused and enter the back catalogue. Therefore. Netflix would hold to purchase an mean 0. 56 new releases each month to fulfill subscriber demand for new releases. However. if a endorser terminated his or her subscription. the DVDs would cut down the demand to stock the DVD library for new endorsers. 5 As of the terminal of 1999. the net book value of the DVD library was about $ 8. 7 million. Exhibit 5 provides information on the accounting intervention of the DVD library. For fiscal coverage intents. NetFlix depreciated its DVD library over three old ages. However. because of their digital engineering. McCarthy expected the existent DVD library to last an indefinite length of clip without any impairment in quality except for harm ensuing from transporting or abuse. For this ground. NetFlix did non sell its older DVDs. Alternatively. discs of course migrated into the back catalogue as they aged.
The Personal Movie Finder ServiceIn add-on to supplying a “storefront” for leasing films. NetFlix offered individualised film recommendations as portion of its Personal Movie Finder Service. NetFlix asked its endorsers to measure the films they rented utilizing a simple point-and-click marking system. Using this information. NetFlix constructed a penchant profile for each endorser. These profiles were used to provide a predicted evaluation for every film on the NetFlix web site that was alone to each NetFlix endorser. As more endorsers were added to the database and as bing endorsers rated more films. NetFlix expected the quality of its film recommendations to better. By supplying dependable recommendations for choosing films. NetFlix sought to develop sufficient trade name trueness to vie efficaciously against possible hereafter entrants every bit good as bing picture rental retail merchants.
In add-on. NetFlix anticipated that the information collected from its endorsers would besides be utile to film studios for advancing films demoing in theatres. Harmonizing to the Motion Picture Association of America. the industry spent an norm of $ 21. 4 million per film to market and advance the theatrical release of new characteristic movies. Management believed that their quickly turning subscriber base and Movie Finder database could supply the industry with an effectual agencies to market films to a targeted audience on a individualized footing. Finally. as Internet engineering developed. NetFlix was hopeful that its engineering could be used as a scheduling usher to Internet delivered picture. Through the development of its Personal Movie Finder service and the growing of its subscriber base. NetFlix hoped to go the unequivocal online mediator for taking films and other picture amusement.
In the first subscription month. Netflix would transport four DVDs to get down and an extra 4. 3 DVDs on norm during the balance of the month.
Consolidation and Innovation in the Home Video MarketAnalysts estimated that U. S. consumers spent about $ 25. 6 billion on film theatre tickets and place pictures. with place picture leases accounting for approximately 32 % or $ 8. 3 billion. 6 Although success at the box office was of import to film studios. profitableness frequently depended on grosss from alternate markets. such as place picture. pay-per-view. and telecasting. In 1999. grosss from the place picture market were estimated to account for about 50 % of domestic film studio grosss. 7 The place picture industry was extremely disconnected. However. with a 14 % lessening in the figure of picture shops runing in the United States since 1997. the industry was consolidating quickly. 8 In 1999. Blockbuster. Inc. was the world’s largest picture retail merchant with a 30 % gross portion of the place picture rental market. 9 Having about three times as many domestic shops as its nearest rival. Blockbuster estimated that approximately 60 % of the U. S. population lived within three stat mis of a Blockbuster shop.
The typical Blockbuster shop carried 4. 500 different film rubrics. 500 of which were new release rubrics. In 1999. about 78 % of Blockbuster domestic rental gross was from new release films. Blockbuster besides had begun to lease films in DVD format. In 1999. most Blockbuster shops stocked between 200 and 300 different DVD rubrics. 10 Traditionally. films were made available for distribution in the place picture market about two months after the terminal of their theatrical release. Video rental retail merchants typically purchased transcripts of picture from distributers and so rented them to their clients. maintaining the gross generated from the rental and/or sale of the tapes. However. two major inventions were anticipated to hold a lasting impact on the manner in which the industry distributed films. They were: ( 1 ) gross sharing and ( 2 ) video-on-demand.
Gross sharing With the consolidation of the place picture market and the increased importance of the place picture to film studios. gross sharing understandings between film studios and major retail merchants were going more common. Under a gross sharing understanding. a retail merchant paid a lower monetary value for each videocassette in exchange for sharing a part of the rental gross with the film studio. 11 Because gross sharing reduced a retailer’s required stock list investing. retail merchants were willing to stock more transcripts of each new release rubric and clients were more likely to happen a transcript of the film they wanted to lease. Since implementing gross sharing in 1997. the typical Blockbuster shop carried 60 % more film rubrics and stocked about four times the figure of videocassettes. Video-on-demand With the widespread acceptance of the cyberspace. analysts believed that place picture would finally be delivered straight to consumers over high-velocity internet connexions. The eventual coming of video-on-demand meant that picture retail merchants had a limited clip frame in which to place themselves for this new environment. Although it was by and large agreed that such a alteration would take topographic point. there was less understanding on the length of clip it would take for the
Paul Kagan Associates. Inc. . as cited in NetFlix S-1 filing. 7 Paul Kagan Associates. Inc. . as cited in Blockbuster 1999 Annual Report 8 Blockbuster 1999 Annual Report. 9 Casewriter estimation. 10 Blockbuster 1999 Annual Report. 11 In a typical revenue-sharing understanding. a retail merchant might buy a new release videocassette for less than $ 10 in exchange for returning 40 % of the rental gross generated during the first six months to the film studio.
DecisionKnowing that NetFlix had a limited clip frame in which to piece a “critical mass” of endorsers. McCarthy considered the consequence that come ining into revenue-sharing understandings with film studios might hold on projected NetFlix hard currency flows. He besides wondered whether the major film studios that had already signed understandings with Blockbuster would be willing to subscribe similar understandings with a comparatively new Internet startup such as NetFlix. Sing the tremendous growing demands confronting NetFlix. McCarthy was concerned that revenue-sharing understandings entirely might non liberate up adequate on the job capital to let for a successful offering later in the twelvemonth. McCarthy besides considered whether NetFlix could afford to go on offering a free month of service in order to pull possible new endorsers. At the same clip. he wondered whether the company could afford non to make so.