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Professor Willy Shih, Senior Lecturer Stephen Kaufman, and David Spinola (MBA 2007) prepared the original version of this case, “Netflix,” HBS
No. 607-138, which was reviewed and approved by a company designate. This version was prepared by Professor Willy Shih and Senior Lec turer
Stephen Kaufman. This case was developed from published sources. Funding for the development of this case was provided by Harvard
Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not inten ded to serve as
endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 2014 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business School Publishing, Boston, MA 02163, or go to This publication may not be digitized,
photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.



Netflix in 2011

Netflix used to be a perfectly good horror movie. Company management swings a chainsaw; investors
scream and are cut to bits; audience is titillated. Now it has become one of those avant-garde films your pseudo-
intellectual friend recommends: no fun to watch, surreal and confusing . . . . The no-fun-to-watch part is the
damage that Netflix’s abrupt price increase has had on subscriber numbers. Subscriber growth ground to a halt
in the third quarter, after the increase was announced in July. In the current quarter, as the price increase is put
into effect, the company expects its physical DVD service to lose 3m—about a fifth—of its subscribers.
Streaming video subscribers are expected to be flat to down. Given that Netflix’s strategy is designed to
encourage growth in streaming, this is far worse news than the hit to DVDs.

— LEX Column: Netflix, Financial Times, October 25, 20111

Reed Hastings, founder and CEO of Netflix, was having a rough September. Only a few months

earlier, he was on top of the world. Named Fortune magazine’s businessperson of the year in 2010,2
Hastings had built the DVD-by-mail company into an enormously popular consumer service. (See
Exhibit 1 for a Netflix income statement.) In July 2011 Netflix announced that it would start charging
separately for its streaming video service and its DVD service—and that each service would cost
$7.99 a month. The streaming service was formerly a $2 add-on to the basic DVD monthly charge of
$7.99 for its entry-level one-DVD-at-a-time plan. Customers who wanted both would now have to
pay $15.98 a month. Although most new consumers who wanted only the streaming service would
actually see a price reduction, the public outcry over the 60% price increase for the combination
drowned out that fact.3

Things got worse when Hastings announced that the company would split the DVD-by-mail into
a separate business named Qwikster, and that the online streaming business would retain the Netflix
name. On September 18, 2011, he announced on his blog:

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.

615-007 Netflix in 2011


For the past five years, my greatest fear at Netflix 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 fights desperately and hopelessly to recover. Companies rarely
die from moving too fast, and they frequently die from moving too slowly.4

Hastings went on to explain that streaming and DVD-by mail were becoming two quite different
businesses, with different cost structures and benefits that needed to be marketed differently. In
addition, each business needed to be able to grow and operate independently.

Thousands of consumers criticized the plan on Netflix’s website, and Netflix stock continued its

slide, from $300 earlier in the year to $77 in October.5 By mid-October, the company reversed course
again, abandoning the breakup plan. Asked in a television interview about how it felt to apologize
for business mistakes, Hastings was humble:

Going through marriage counseling 20 years ago was really how I moved to become

a better manager and leader . . . This marriage counselor was able to get me to see that I
was often lying to myself and my wife . . . and that the value of honesty is that people

can take honesty, even if it’s not necessarily what they want to hear, if it’s really sincere.6

The bigger challenge facing Hastings and his team was how to cope with the very different
business model for streaming in a company built on the higher margins of DVD-by-mail. How would
they manage that transition within a single business, and more importantly, with the company’s 20
million customer relationships? That was the question he now had to be honest about.

The U.S. Home Video Rental Market

In the 1990s, the U.S. home video market was a fragmented industry largely populated with
“mom-and-pop” retail outlets. Customers rented movies, primarily on VHS cassette, from a retail
location for a specified time period, usually between two days and one week, and paid a fee of $3 to
$4 for each movie rented.

Blockbuster Inc. became the market leader with the insight that movie rentals were largely
impulse decisions. To customers deciding at the last minute that a given night was “movie night,” the
ability to quickly obtain the newest release was a priority. Statistics showed that new releases
represented over 70% of total rentals. Blockbuster’s growth strategy revolved around opening new
locations, both to expand geographic coverage and to increase penetration and share in existing
markets. By 2006, Blockbuster had 5,194 U.S. locations, of which 4,255 were company owned and the
balance franchised. Locations were chosen based on customer concentration and proximity to
competition, focusing on high-visibility stores in heavily trafficked retail areas. Management often

proclaimed that “70% of the U.S. population lives within a 10-minute drive of a Blockbuster.”7 Stores
were staffed primarily with part-time employees, averaging 10 staff members per store plus one
manager. Occupancy and payroll represented a significant percentage of total costs.

Blockbuster outlets carried about 2,500 different titles per store. A substantial portion of the shelf
space in a store was dedicated to hit movies, with the newest releases receiving the most prominent
display. Locations typically acquired 100 copies of a new release, and they made up an estimated
75%–80% of demand compared to 20%–25% for catalog releases.8 Consumers liked to rent new

Netflix in 2011 615-007


releases during the first three weeks of the studio distribution window.a After that, demand fell
sharply. The studios protected this window because of the increasing share of revenues that they
received from sales (see Exhibit 2). As rental demand for a particular title dropped, the stores
remarketed used copies to reduce their inventory and generate additional income.

Blockbuster’s business model depended on maximizing the days that a movie was out for rent.
Stores were reluctant to stock large numbers of lesser-known and independent films, since the
demand for these titles was inconsistent. With a relatively narrow selection of mostly familiar movies,
customers could generally select a title with a limited amount of advice from the sales staff. Movies
not returned to the renting location by the end of the specified rental period were subject to extended
viewing fees, or “late fees.” In 2004, these fees represented about 10% of revenues. Late fees also
improved asset utilization by encouraging a timely return of each rented film, allowing it to be rented
by another customer. Late returns led to increased levels of stockouts, costing Blockbuster
incremental rental opportunities as well as reduced customer satisfaction.

The unit economics of retail video rental were straightforward. Blockbuster acquired
approximately half of its rental inventory under a purchase model in which it would pay the studios
$15–$18, rent it 9–10 times for $4 per rental, and then resell the DVD for an average of $8 per unit.b
The other half was acquired under a revenue share model in which Blockbuster paid the studio about
$5 per copy, rented it 9 times, and resold it for an average of $8, sharing 30% of the revenue with the

studios.9 The mix shifted to 81.8% revenue share by 2006.10 One analyst estimated that Blockbuster
spent $837 million on rental library purchases in 2003. Retail stores cost approximately $300K to set

up, and it was estimated that they produced $900K sales per year with an operating profit of $162K.11

In 2002 Blockbuster enjoyed record levels of revenue and profitability, riding a wave of consumer
DVD-player adoption, which increased from 24% to 37% of U.S. households in just one year. (Exhibit
3 shows Blockbuster’s income statement through 2006.) As consumers sought content for their new
players, spending for in-home movie viewing reached $22.3 billion.12 2002 represented Blockbuster’s
fifth consecutive year of same-store sales growth, and the Blockbuster brand achieved nearly 100%
recognition with active movie renters. That same year Netflix went public, and some would say that
is when Blockbuster’s troubles really started to get serious.

Netflix History

Hastings conceived of Netflix in 1997 after he discovered an overdue rental copy of Apollo 13 in
his closet. After paying the $40 late fee, Hastings, a successful entrepreneur who had already founded
and sold a software business, began to consider alternative ways to provide a better home movie
service. At the time, most movie rentals were VHS videocassettes, but Hastings had heard from a
friend about the new DVD technology. DVDs were small and light, enabling inexpensive postal
delivery. “I went out, bought a whole bunch of CDs and started mailing them to myself to see how
quickly they would come back and what condition they would be in,” he explained. “I waited for two

days—and they all arrived in perfect condition. All the pieces started to fall into place after that.”13,14

a Motion picture studios made movies available for exhibition at different times depending on the distribution channel.
Specific times were known as “release windows.” The first distribution channel after theatrical release was home video on
DVD and VHS. This window lasted 45 days, and excluded most other forms of non-theatrical movie distribution, such as pay-
per-view, video-on-demand, premium television, basic cable, and network and syndicated television. Thereafter, movies were
made available sequentially to television distribution channels.

b The company amortized the cost of its in-store rental library over periods ranging from 3 to 12 months, to an estimated
residual value ranging from $2 to $5 per unit, depending on the product category.

615-007 Netflix in 2011


Netflix’s Early Days

Hastings founded Netflix in 1997, and launched the company’s first website in early 1998. Netflix
targeted early technology adopters who had recently purchased DVD players, offering cross-
promotional programs with the manufacturers and sellers of DVD players, thus providing a source of
content for customers. Hastings elaborated, “We were targeting people who just bought DVD
players. At the time our goal was just to get our coupon in the box. We didn’t have too much
competition. The market was underserved, and stores didn’t carry a wide selection of DVDs at the

Netflix’s website included a search engine that allowed its customers to sort through its selections
by title, actor, director, and genre. Using this search engine, customers built a list, called a “queue,” of
movies to be received from Netflix. Netflix sent movies to its subscribers based on the order of titles
in the queue, with subscribers receiving a new movie as soon as the previous one was returned. The
company initially used a pricing model similar to that offered by traditional video stores. Customers
chose their films using the company’s website, were charged $4 per movie rented plus a $2 shipping
and handling charge, and were expected to return films by a specific due date or be charged extended
rental fees.

Netflix’s early strategy went beyond DVD rentals. While marketing a 2000 IPO, management
described the company as the ultimate online destination for movie enthusiasts. Along with the
DVD-by-mail service, Netflix was offering its recommendation system to everyone, including
nonsubscribers, creating a Web portal rather than simply a subscription service. Hastings described
this early strategy: “Our 2000 prospectus was spun towards things that were hot . . . it reflected a
tension in our strategy. We would offer price comparisons, theater tickets. That strategic tension
didn’t resolve itself until the bubble crashed. That summer we realized we weren’t going to make it
unless we did it on rentals. . . . It was a cash-induced strategic focusing.”

This focus was pushed along by the rapid adoption rate of DVD players among U.S. households,
which followed the fastest technology adoption curve in history. U.S. household penetration, at 5% in
1999, leapt to 13% by 2000, 37% by 2002, and 65% by 2004, a pace that attracted the attention of
channels like Best Buy and Wal-Mart, which discounted them extensively to drive store traffic. DVDs
also began replacing VHS cassettes on the shelves of traditional video rental outlets. As DVDs
became more widely available both for purchase and for rental, Netflix’s value proposition to new
DVD-player owners diminished. The company shelved its plans for an IPO and struggled through a
large layoff as it began to adjust its business model in an effort to reach profitability. Chief among
Hastings’s concerns were the general customer dissatisfaction with Netflix’s value proposition and
the high cost of building a DVD library to support its growing subscriber base.

Feedback from early customers revealed a frustration with Netflix charging rental prices similar to
competing retail locations, while providing slower delivery. Neil Hunt, the company’s chief product
officer, described Netflix’s motivation for shifting to its popular no-late-fee subscription model in

Pricing had been a discussion point for a long time. Our original model didn’t
work—we needed to overcome the shipping delay. It just wasn’t a high-enough-value
product to overcome the delivery waiting time. We spent a lot of money to market to
and attract new customers, and they wouldn’t be repeat renters. We were spending $100
to $200 to bring in a customer, and they would make one $4 rental. There was no
residual value.

Netflix in 2011 615-007


Moving to a Prepaid Subscription Service

Hastings believed that moving to a prepaid subscription service could provide better value to
Netflix’s customers and also turn its longer delivery times into an advantage. The first iteration of the
subscription model allowed customers to have four movies in their possession at once and receive up
to four new films each month. Hunt explained the effectiveness of the new pricing model: “We
turned the disadvantage of delivery time into having a movie at home all the time. The value to
Netflix of having our movies in the customers’ homes at all times was our key insight.”

Netflix soon changed its pricing system again, offering unlimited rentals for the first time.
Subscribers could now keep three movies at a time and exchange them as frequently as they liked.
Hunt explained the reasons behind this quick change:

We made the observation that this change would dramatically simplify the program
and make it easier to explain the service. It also allowed us to market a more compelling
value proposition. The term “unlimited” is great marketing. . . . We had some vigorous
debates about this, but in the end it was a leap of faith. The dot-com boom was still in
full growth mode, and everyone around us was growing fast. It wasn’t the time to do
months of testing and analysis. We had to make some bets and not worry about getting
it wrong. At that time, the ones who got it right would succeed, and the ones who got it
wrong wouldn’t be around.

With this change the company added a new group of fans for whom movie rentals were a regular
part of their daily entertainment. Many of these customers were turned off by the high cost of paying
for each movie rented, yet they still chose to rent from video stores because of limited alternatives.
Others were dissatisfied with high late fees, which inhibited their ability to view movies at the times
most convenient to them. If “movie night” was not an event but an ordinary form of entertainment,
the option to hold movies beyond a two-day rental period was important. For these frequent viewers,
Netflix’s “all you can eat” model was an attractive alternative to the traditional per-day fee structure.

Subscription costs—the expense of acquiring movies for rent—were still a major burden. Hunt
explained the impact that customer demand had on managing the cost of building their film library:

We began struggling with a new problem. Half of the DVDs we were shipping out
were brand new. We realized that we had to fix that. Top new releases received a lot of
external marketing support and as a result had strong customer awareness and demand.
Of course, those movies were the most expensive to acquire. . . . We couldn’t just blindly
promote movies that already had external demand generation. We needed to stimulate
demand on the older and less-known movies and things already in our catalog. By
marketing from the rest of the “tail” we could drive the average price down of building
our catalog.

Developing The Proprietary Recommendation System

Netflix initially relied on traditional merchandising to complement its search engine and connect
subscribers to the company’s library of titles. A small number of employees highlighted different
films on the website’s home page each week, effectively providing the same recommendations to all
subscribers. Hunt explained the consequence of this marketing technique:

We started with a system that relied heavily on editorial content, but we realized that
an editor could only write so many web pages. Five movies would be highlighted on the

615-007 Netflix in 2011


website, then everything that was promoted was instantly rented out. That changed to a
different five movies each day of the week, and they were all still instantly rented out.
We tried to improve the system to ensure that subscribers weren’t referred to movies
they had already rented. Eventually, we realized that the promotional value of writing
the editorial blurbs was zero.

Realizing the inadequacy of the traditional merchandising system, Netflix engineers developed a
proprietary recommendation system to better balance customer demand. Upon establishing a new
account for the first time, customers took a short survey to identify their favorite movie genres and
rate specific movie titles from one to five. Netflix’s proprietary algorithm then used these survey
results and the respective ratings of millions of similar customers to recommend films to its
subscribers. The recommendations page not only included a list of titles with a ranking of how
closely they matched the customer’s preferences but also a synopsis of the film, a description of why
the film was being recommended, and a collection of reviews from other subscribers. As customers
rated each movie they saw, Netflix’s software refined its understanding of customers’ preferences

and more accurately recommended movies that would appeal to each customer.c

Key to the success of Netflix’s inventory management was a filter placed between the output of
the recommendation system and the results shown to the subscriber, screening for those movies that
were out of stock. The intent was to avoid frustrating a customer by recommending a title that was
not immediately available, but a side benefit was that new releases were rarely on recommendation
lists, as they were the most likely films to be in short supply. The system increased the utilization of
Netflix’s library of films by satisfying customers with movies already acquired and in stock, rather
than requiring the purchase of more copies of newer films. Compared to traditional video rental
outlets, where new releases would make up over 70% of total rentals, new releases represented less
than 30% of Netflix’s total rentals in 2006. Hunt explained the power of Netflix’s recommendations:

The recommendation system will pick the best movie for a customer, period. But it
has to be something that can ship overnight. High-demand new releases are less visible
because they are less frequently in stock. However, the customer benefits from this
system. We have recognized improved customer satisfaction by eliminating the “bait
and switch” perception. Most revealing about the value of the recommendations is that
ratings are three-fourths of a star higher on recommended movies compared to new

While the investment in software engineering was modest, this shift marked a cultural battle
within the company with those who remained loyal to the traditional merchandising system.
Hastings described his insistence on this change by highlighting another benefit: “A personalized
experience is the benefit of the Internet. If you can otherwise do it offline, people won’t pay for it
online. If our Internet offering was going to be better than stores, we had to find something stores
couldn’t do well.”

Movies were a taste-based product, for which many titles were consumed only once. As such,
consumers needed to make a series of purchases without knowing for sure whether they would like
the product. Netflix’s website resonated with subscribers because they so frequently enjoyed the
lesser-known films recommended to them that they might not have otherwise seen. The recommend-

c In 2006 Netflix initiated a competition, the Netflix Prize, which offered $1 million for the best collaborative filtering algorithm
to improve its recommendation system. Contestants had to predict viewer preferences in films based on previous ratings but
no other consumer information. Netflix provided contestants with a training data set with over 100 million ratings from
480,189 viewers.

Netflix in 2011 615-007


ation software established a relationship with customers that was not matched by part-time
employees at a retail video store, nor easily replaceable if a customer switched to a competitor’s
service. Netflix’s size and growth rate also enhanced the value of its collaborative filtering system,
with its rapid growth in customer-generated ratings. Because it had the largest collection of movie
ratings in the world, customers recognized that they were more likely to have their tastes and
preferences accurately reflected in recommendations from Netflix’s site than any other offered by a

Building the Movie Library

Even with the increased customer awareness of lower-profile films that Netflix’s recommendation
system generated, building the company’s movie library still represented a major use of cash. As a
small player in the video rental market, Netflix had no direct relationships with the major studios. It
filled its film library through relationships with a small number of movie distributors, at prices that
reflected minimal discounts. Up-front costs forced Netflix to choose carefully when stocking new
films and often resulted in fewer than the desired number of copies of a title being acquired. As a
result, one of the major sources of customer dissatisfaction was the inability to rent new releases in a
timely manner. Netflix took steps to address this by hiring Ted Sarandos as chief content officer to
manage content acquisition. Sarandos, who had been with Video City, a major U.S. video rental
chain, joined Netflix in May 2000 and led the company’s transition to revenue-sharing agreements
with the major studios. He recalled:

We were handicapped with vendors when I first arrived because other Internet
vendors at the time had not been successful. As a pure rental business that was 100%
subscription-based and 100% Internet-based, we were reinventing the wheel on three
dimensions for the studios. However, it is very much a relationship business, working
with the studios, and I had worked with those people all of my career, so I managed to
bring my relationships with me from my prior company. Within a year, Netflix had
negotiated direct revenue-sharing agreements with nearly all the major studios.

Rather than pay an up-front price of $18–$20 per DVD, the studios would reduce their unit up-
front price in return for a fee based on the title’s total number of rentals for a given period of time.
Hastings described this transition with the company’s suppliers: “We spent more money, not less,
with the studios but got bigger customer satisfaction. It was like paying 20% more and getting two
times the number of copies.”

The benefit of the new relationships with the studios extended beyond lowering the acquisition
costs for new releases. Early on Hastings had recognized the number of customers who were
frustrated with the poor selection offered at many video stores, where shelf space was focused on hit
movies and new releases. Customers interested in exploring a broader range of movie titles were left
unsatisfied by their options. Sarandos explained: “The thing that Reed and I connected on before I
even joined Netflix was the promise of a business model that promoted lesser-known movies. Films
outside of the top 20 are not distributed widely. If you didn’t see a movie within six months of when
it was in the theaters, it often disappeared forever.”

The use of a national inventory allowed Netflix to satisfy the diverse demands of movie watchers,
serving the same number of customers as a local network of Blockbuster retail locations with far
fewer copies of a given movie title. Sarandos explained the difference in economics:

Half the equation of packaged media is allocation—getting the right amount of
product in the right locations. This was more of a challenge for products that did not

615-007 Netflix in 2011


enjoy broad promotion. The trade radius of a single video store was so small that even a
single copy of a lesser-known film had lousy economics. By using a national inventory,
we avoid that issue. We never have overstocks on one side of town with understocks on
the other side. Using the subscribers’ queues provides a great deal of data. By looking
into the demand in the near future, we can replicate near-perfect inventory. Overall, we
can satisfy demand in an area with about one-third to one-fifth of the inventory needed
by a retail chain.

Distribution and Delivery

In the summer of 2001, Netflix operated out of a single distribution center in Sunnyvale,
California. While several years of operations had allowed for improvements in this center, the
majority of the country was still not able to enjoy next-day delivery of their rented movies. These
extended delivery times were a barrier for Netflix in attracting and retaining customers in those
regions. Hastings explained: “Post office variability was long on cross-country mail. . . . It essentially
meant one-week delivery times. So in the summer of 2001, we realized that regions with overnight
delivery were being disproportionately successful. We tested the theory by upgrading Sacramento.
The numbers popped quickly.”

Netflix’s Sunnyvale distribution center could serve the San Francisco Bay Area with overnight
delivery. But while outbound mail from Sunnyvale could reach Sacramento overnight, returns often
took several days. Netflix tested Sacramento by arranging with the U.S. Postal Service (USPS) to
intercept returns at a Sacramento mail-sort center and then truck them to Sunnyvale. This would
shorten the turnaround dramatically. “As we added centers in Boston, New York, and D.C., they
started performing like the Bay …

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