Netflix is a global provider of streaming films and television series. It started as a DVD-by-mail service in 1998 and began streaming in 2007. (Pogue, 2007) In 2010, it crossed the borders of the U.S. and expanded its streaming to Canada, and today, after 6 years, it serves over 190 countries (Minaya & Sharma, 2016). As of April 2016, Netflix reported over 81 million subscribers worldwide, including more than 46 million in the U.S. (Netflix, 2016). This essay will analyse the driving forces that transformed Netflix from an idea to a widely adopted innovation. It will examine how technology helped it to create competitive advantage and how it developed assets such as scale, brand and switching costs, and also how its brilliant founders leveraged this technology and timing to create valuable assets.
Netflix was founded by Reed Hastings and Marc Randolph in Scotts Valley, California, in August 1997. Randolph had been previously involved in the funding of a computer mail order company called MicroWarehouse and served as vice-president of Marketing for Borland International. One-time math teacher Hastings, the man with the idea, has founded Pure Software which he recently sold for $700 million. Hastings was struck by the idea for rental-by-mail when he was forced to pay $40 fines, which was enough to have bought the video outright with some money left over, after returning an overdue videotape of the film Apollo 13. (fundinguniverse.com, 2016)
Netflix opened for business on April 14, 1998, with a workforce of 30 people and 925 titles to rent. The company's initial model for success was a DVD-by-mail service, provided via an internet website, that charged a flat-rate monthly subscription rather than per-disc rental fees and offered its subscribers unlimited rentals without due dates, late fees, shipping and handling fees. Videos were sent in envelopes that were addressed and postage-paid for reuse in disc returns. After consumers watched the movie, they just slipped the DVD back into the envelope and dropped it in the mail (see Figure 1). Users were choosing their videos in their ‘request queue' at Netflix.com and also used the website to rate videos they have watched, specify their viewing preferences, get recommendations and even share their viewing habits and reviews. (act1)
This was a very innovative business model and a disruptive digital innovation as, with the emergence of Netflix.com, the movie rental business has taken a turn towards the digital world. The driving forces that enabled it to evolve from an idea into a widely adopted innovation are technology and timing. However, the creativity of Hastings and Randolph, who knew how to use these two elements for the benefit of the company, should not be underestimated.
The dynamics of the movie industry were drastically changed in 1997 when the DVD-video format was introduced. The DVD is one of the most rapidly adopted consumer electronics products in history, managing to dominate the global recorded video sales and rental market with 91.8% market share by 2005(Datamonitor, 2006) Perfect timing for Hastings and Randolph to leverage this new technology that, due to its size and weight, facilitated shipping videos straight to customers' doors and to create a new branch of the video retailing industry through founding Netflix. (strategic innovation)
In contrast to the already existing players in the market of movie rentals (e.g. Blockbuster, Walmart), Netflix was an Internet pure play without a physical storefront, but a digital one. Leveraging the advancements in technology, such as the internet and the emergence of DVDs, the company managed to develop a virtual storefront that offered several advantages over the brick-and-mortar rental store model that has been predominant in the industry. By having a few centralized shipping centres as opposed to a large number of storefronts such as Blockbuster, Netflix was able to pool resources and offer a wider range of titles than possible at a single rental store. Moreover, operating a few centralized shipping centres also offered several cost advantages over operating stores in every neighbourhood. (strategic innovation)
Digital technology enabled Netflix to offer its customers a staggering selection of videos. While the traditional video store (and Blockbuster had around 7,800) could stock roughly 3,000 DVD titles on its shelves, Netflix was offering its subscribers a selection of over 125,000 titles. (act1) Traditional retailers had big shelf space constraints, which limited their ability to offer their consumers what they wanted and when they wanted it. As the space was limited, the choice of which titles were chosen to be displayed in store was dictated by the preferences of the average consumer (therefore, Blockbuster was literally stocking blockbusters).
Moreover, offering an almost limitless selection enabled Netflix to actually enjoy higher revenues from selling the ‘obscure stuff' rather than the hits. (act1) McCarthy (2009) stated that 75 percent of DVD titles that were shipped by Netflix to its customers were from back-catalogue titles, not new releases. This phenomenon whereby companies can earn high revenues by selling a nearly limitless selection of less-popular products was named by Anderson (2006) the ‘long tail' (see Figure 2). The long tail works due to the production and distribution cost that drop to the point where it becomes economically viable to offer a large selection. With the help of technology, Netflix's cost of stocking and shipping an obscure film was the same as sending out the latest hit, and thus, the long tail gave the company a selection advantage that traditional stores could not match. (act1)
Searching for a solution to the biggest inefficiency in the movie industry, that of matching content with customers, Netflix leveraged the industry's newest and most sophisticated technology to develop a recommendation system called Cinematch. (act1) Cinematch was also a result of the two founders and their ability to match new technology with the perfect timing. The recommendation engine helps customers to identify which titles may interest them by developing a map of user ratings and steering users towards titles preferred by customers with similar tastes. This software coupled with the early-mover advantage led Netflix to a huge data advantage that is valuable, that brings results, and is impossible for new entrants to match. (act1)
Furthermore, Cinematch does not only use data and algorithms to improve the service and fortify the Netflix brand, but it also serves as a switching cost. It makes it hard for a customer to switch Netflix for another service because that would mean abandoning all his/her rated movies, and should that happen, the rival would never make recommendations with the same level of accuracy due to the fewer users and thus less data to draw similarities from. (act1) Around 60% of Netflix requested movies were identified through Cinematch (Netflix, 2007), and this shows how trusted and valued was Cinematch by users. Moreover, the combination of countless movie titles and the recommendation system appeared to increase the number of rented titles. (strategic innovation)
In the pursuit of improving their source of competitive advantage – Cinematch, Hastings and Randolph pulled another brilliant move. They engaged Netflix in open innovation by launching a crowdsourcing effort known as The Netflix Prize. The Prize was $1 million for the one who could make Cinematch's ratings 10% more accurate. The contest attracted over 30,000 teams from 170 countries, enabling Netflix to gain access to a huge amount of code and to improve Cinematch even before the prize was won. Moreover, The Netflix Prize enjoyed a significant amount of publicity, which contributed to the firm's brand image. (act1)
Who would have ever thought that simply providing movie rentals would become such a complex and technology driven business? However, even from that strong position of power, Hastings and Randolph never made the Kodak mistake. They were aware that Netflix must be constantly improving and evolving if it was going to be a business with a long future. They initially leveraged the new technology available and managed to build an internet retailer that served a large geographic area with few staff and smaller infrastructure, and they were ready to do it again. This time, they saw the potential in providing digital goods, which offered opportunities for reducing the inventory costs entirely and for a more scalable business.
Again, the two founders took the business to the next level by matching the emergence of new technology with a perfect timing to redesign the business model of their company. The shift from atoms to bits, as Negroponte (1995) argued, was realigning the whole media industry and Hastings and Randolph were ready to embrace the change. In June 2007, Netflix added a ‘Watch Now' feature to their website. This allowed its users to stream movies to their computer to watch instantly. (strategic innovation) Although, at launch, there were only about 2,000 non recent titles, and users rebelled when the single fee for the $10 base Netflix service was unbundled into two separate $8 plans for DVD-by-mail and Watch Now, the founders firmly held their ground as they knew that streaming was the future for the industry. The potential for providing digital products was crystal clear: eliminating costs associated with handling and shipping. (act1)
Netflix was spending about one-third of the firm's expenses on postage (act1). The company states, in a hand-out for its shareholders (Netflix, 2011), that it was spending more than $500 million per year on mailing DVDs. However, the firm predicted that more and more content will be consumed via streaming, which will reduce costs. Additionally, streaming was also scalable, which meant that titles were licensed from studios at a fixed cost, and therefore, as Netflix expanded its subscriber base, the cost of content per subscriber was falling. (Netflix, 2011)
Although it seemed that Netflix was untouchable, two major problems appeared. Initially Netflix's revenue was driven by its DVD-by-mail service, which faced little competition. However, this was changing, with revenue coming principally from streaming. Thus, in addition to cannibalizing its core business, streaming technology allowed Netflix to open the ‘playing field' to competitors such as Amazon.com Inc., Hulu LLC and others. (Netflix, 2011) Another major problem lied in delivering content to the place where most consumers wanted it: the living room TV. As the Watch Now button was initially only available on Windows PC, Netflix found itself up against rivals that already had a path to the TV: Apple had its own Apple TV, cable companies offered OnDemand through their set-boxes, and Amazon had TiVo. (act1)
Netflix was now experiencing the first time it wasn't the fastest to make a move within the industry. However, the brilliance of its two founders not only managed to find a solution to ensure the firm's survival, but also managed to make Netflix streaming available on more devices than any competing rival service. Hastings and Randolph managed to achieve this by making its streaming technology available to hardware firms, and by developing streaming apps for almost all consumer electronics devices, including DVD players from LG and Samsung, the iOS and Android platforms, as well as gaming consoles Xbox and PlayStation. As a result, Netflix has ended up with more television access than its rivals who were first-movers in that area.(act1)
To conclude, Netflix has expanded from a network of 50 warehouses that distribute DVDs to one that can enlist millions of devices to deliver its content instantly. (act1) The most important driving force that transformed Hastings idea into a widely adopted innovation was the advancement of technology, such as the emergence of DVDs, the dot-com, recommendation engines like Cinematch, or the shift from atoms to bits. Additionally, the founders' creativity and experience in the industry enabled them to leverage this new technology at the right time, to offer Netflix the first-mover advantage that put it on the top of the industry.
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