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

Netflix employs a subscription-based business model and subscribers can chose from a variety of subscription plans. The business model consists of two parts; the DVD-by-Mail option, and the streaming option, which launched in January 2007. Both options were bundled together until July 2011 when Reed Hastings announced the separation of the two services. Before the announcement Netflix recorded tremendous financial results, which increased significantly during 2010 and the first half of 2011. The number of domestic subscribers surged as well. However, the announcement of new pricing plans created negative consumer and investor reactions. As a result, large numbers of subscribers canceled their subscriptions, and the company’s stock price tumbled. Subscribers continued to use only one account for the DVD by mail and streaming service.

Netflix next strategic move was to expand internationally with the streaming segment. After successful expansion into Canada, Netflix decided to enter the United Kingdom and Ireland. At the same time, they continued the expansion into Latin America and the Caribbean. Domestic subscribers were decreasing, and the company had been using any generated net income to fuel the international expansion. Also, Netflix faced licensing issues with major motion picture and TV companies. Netflix was experiencing contribution losses from expansion in new geographical markets, and stock price continued to drop.

After careful analysis of the problems described above, Group D has examined several options that can potentially fix the strategy issues the company is facing, and offer solutions to turn around Netflix’s financial results. Group D recommends Netflix pursues rational international growth, product differentiation, and strengthened supplier relationships in order to maximize all aspects of the Netflix competitive advantage. This option allows Netflix to be the first mover and beat competitors to the international market. The contribution loss in the first two years in new markets could be offset by the increased revenue and profit in the long term.

1. Identification

1.1 Background
Reed Hasting, founder and CEO of Netflix, has been a strong believer in moving early and fast to initiate strategic changes that would help Netflix outcompete rivals and strengthen its brand image and reputation. Guided by this mentality, Hasting’s initiated a new pricing plan in July 2011 that effectively raised monthly subscriptions by 60 percent. This caused customers to react negatively and resulted in a 30% drop in the company’s stock price within 8 weeks of the announcement. Further declines in share price resulted from DVD providers/distributers increasing their asking price for licensed content (i.e. – Starz, a premium movie provider demanded ten times more compensation during contract renewal negotiations during late 2011/early2012; negotiations failed and the Starz contact expired).

Further to these changes, Netflix embarked on a strategy to split the DVDs by mail business from the internet streaming business, creating a separate entity named Quikster. The new business model required customers to use two different websites, depending on which type of content they desired creating confusion and frustration among subscribers. Three weeks after making this change, Netflix abandoned the Quikster strategy; realizing that having a second website would not result in improving its customer base. Overall the number of Netflix domestic subscribers dropped by a net of 810,000 during the third quarter of 2011, resulting in an operating profit, net income and earnings per share well below Wall Street estimates, and investors’ expectations.

Despite the financial losses and the loss in number of subscribers in the last quarter of 2011, Netflix announced international expansion to United Kingdom and New Zealand. The expansion to Europe seemed rushed, but again was a strategy aimed at ensuring Netflix was the first mover into the market. Other expansion strategies, such as the entry into the Caribbean market in 2011,have yet to result in recovery of high start-up expenses or reversal of contribution losses (though Netflix does estimate a two year time frame from initial launch in a new market before attaining a large enough customer base required to generate a profit). 1.2 Current Strategy

Netflix is using best-cost provider strategy by giving buyers more value for their money. Netflix is targeting customers that are looking for an alternative to paying for expensive pay-per-view movies, while providing customers with a wide selection of movies to rent. Netflix customers are able to rent movies while they are at home without the need to visit the store. Netflix offers several plans ranging from a $4.99 limited plan (maximum of 2 DVD rentals per month), to unlimited plans costing anywhere from $23.98 to $51.98 (unlimited streaming with up to 8 DVDs a month). These plans meet the needs of three types of customers; those who prefer the convenience of home delivery and/or instant streaming, bargain hunters, and movie buffs who wanted the ability to choose from a very wide of films and TV shows. Generally, Netflix developed competitive advantages over rivals by offering convenience, easy to use movie software, and a comprehensive library of movies and TV episodes that contains the most recently released movie titles. 1.3 Problem Statement

Netflix is expanding very fast and entering multiple international markets. Impressed by the strong response to the launch of the company in the UK, Netflix decided to enter another European country in the same year. Due to the two year lag from launch to profitability in new markets, Netflix must use the profits from the company’s domestic business to fuel its international expansion. The aggressive expansion plan coupled with new pricing policies has the potential to harm the company’s financial performance. Investor reaction to the company’s poor financial performance was decidedly negative and left the company’s stock price floating at a low of $72.49 per share in April 2012; a drop of 75% from its high in July of 2011.

The purpose of this report is to assess the company’s overall situation and provide Reed Hastings with a thorough analysis of the company’s internal and external environment. The report examines the different strategy alternatives that are available to the company with detailed analysis of the pros and cons of each alternative. The report offers a sound recommendation and detailed action plan aimed at turning Netflix’s struggling financial performance around.

2. Analysis and evaluation

2.1- Evaluation of the External Environment
The external environment of the TV/Movie rental industry has been examined using the PESTEL analysis, the five forces model of competition, a strategic group map, and evaluation of key success factors. Below are the results of this analysis and a summary of the overall prospects of industry profitability.

2.1.1- PESTEL Analysis:
Economic Factors:
Rising disposable incomes in many markets, along with less expensive technology has resulted in more consumers having the ability to afford broadband internet connections, and the technology needed to stream its content. Sociocultural Factors:

Increasing amount of internet piracy (streamed content obtained illegally for free), as more and more people disassociate this behavior with being illegal; reducing industry profitability. Cultural factors influence the type of content certain countries/geographic regions prefer to watch (and in which language); increases the amount of regional tailoring a company must do with respect to the products it offers, increasing operating costs. Change in consumer preference from content delivered in physical form (mail delivery) to online delivery; saves consumers time by eliminating the hassles associated with traditional movie renting.

Technological Factors:
Since 2000, rapid growth in new technologies and electronics products has multiplied consumer opportunities to view movies (i.e. – increased in ease/ability to connect televisions to the internet). Future trend is to view movies via streamed content.

Increase in access/use of broadband internet connectivity for consumers. Availability of devices able to stream internet content (smart phones, tablets, laptops, smart TV’s, Blu-ray players, gaming consoles, etc.).

Legal Factors:
Content must be licensed before it can be made available to the public adding barriers and costs into the industry. Online content can be obtained illegally by consumers via internet piracy reducing overall industry profitability. Consumer privacy – industry software tends to collect browsing habits to help pre-select content for consumers; consumer skeptics about privacy may be hesitant to switch to online content vs. traditional mail delivered content.

2.1.2- Five Forces Model of Competition:

Rivalry among competing sellers – this force is ranked strong for the following reasons: Buyer demand is growing slowly; the industry is mature and overall growth is small. There is however, a change in consumer preference away from mail delivery or brick and mortar type operations. Buyer costs to switch brands are low; most contacts with content providers can be cancelled without penalty. Rivals in the industry have diverse objectives/strategies (use of online delivery, mail order, brick and mortar rental shops, variety of technologies employed, etc.). Exit barriers are high due to investments made to acquire content, R&D to support product differentiation, investments in various types of infrastructure (whether it is network related or retail locations, etc.). Products overall tend to be weakly differentiated; most companies have access to similar catalogues of content to offer to consumers.

Potential new entrants – this force is ranked moderate for the following reasons: Industry growth is not strong which discourages new entrants. Capital requirements are high; new entrants would need to invest in technologies to allow them to compete in online delivery, as well as to acquire movie and television content. Existing industry members are looking to expand their market reach, entering into the online/streaming segment. The fast paced growth in this aspect of the market is a major factor here.

Firms in other industries offering substitute products – this force is ranked weak for the following reasons: The substitutes in the market tend to be not very good (free television has limited selection and is preprogrammed which limits viewing flexibility) Substitutes tend to be expensive (a night out to the movies can cost as much as two months’ worth of unlimited streaming service).

Bargaining power of suppliers – this force is ranked as strong for the following reasons: Industry members are less likely to be able to integrate backwards and self-supply. There are no good substitutes for what the suppliers provide. Industry members incur high costs switching to alternate suppliers; many of the contractual arrangements with movie studios involve a commitment for a defined period of time to share revenues or pay fees based on content utilization. Suppliers had increasingly greater leverage in setting prices as number of subscribers for online content grew (industry members would need to offer more content to retain customers, and the suppliers were well aware of this).

Bargaining power of buyers – this force is ranked as moderate for the following reasons: Buyers are small and numerous relative to sellers, and they cannot integrate backward. Sellers’ products are differentiated; in terms of how the content is offered (streaming, VOD rentals, online purchase, mail delivery rental, in store purchases/rental) and in total content available (the library of movie/TV show titles offered by the industry member). Buyer switching costs are low (no contractual obligations to remain with a certain provider). Buyers tend to be well informed about their purchasing options.

Overall the competitive forces in the TV and movie rental market are ranked as strong. Rivalry among competing sellers and bargaining power of suppliers dominate the industry for the following reasons: The overall market is mature and is only growing at a moderate pace, but the online market segment is experiencing tremendous growth as consumers’ preferences have switched from acquiring content from a physical source to that delivered via the internet. Competitors are competing fiercely to capture market share over the past few years as this shift has taken place. Industry players must differentiate their product offering to become competitive in the online market segment; one way to do this is to offer a broad library of TV and movie content to consumers. Movie studios, aware of this, have leveraged their bargaining power to charge more for the content they sell to the market players.

2.1.3- Strategic Map: TV and Movie Rental Industry
The strategic group map below plots industry players based on 2 criteria: The selection quality of the TV/Movies titles available through the content provider (rated both in terms of number of titles available, and how current/up to date the selection is).

Price/Perceived quality of the service: meant to reflect the value associated with the cost of the service and how well the content is delivered (i.e. – is the experience convenient? Is it appealing enough to use the service again at a similar price point?).

2.1.4- Industry Key Success Factors:

Customers in this industry will make purchasing decisions based on convenience (in terms of time required to locate desired content, rent it, and begin watching it), affordability, and content availability/selection. To fulfill these needs industry players must have resources and capabilities that enable them to acquire content (build their libraries), and develop technology that provides customers with a superior platform to enjoy viewing content. Companies are likely to be at a significant disadvantage if they are unable to move quickly into the online environment (either offering streaming or VOD content), if they are unable to afford the higher prices being charged by studios to license content, and if the technology rolled out to consumers offers an experience that is slow/cumbersome, and makes it difficult for users to locate TV/movie titles that appeal to them. Based on this the industry key success factors are: Offer consumers a product that is differentiated from the competition: a broad library of titles, an online system that is easy to use and makes recommendations that helps the user find titles they would enjoy viewing. Invest in R&D to ensure technological advances keep pace with the fast changing streaming/VOD market segment. Build relationships with suppliers/studios to ensure access to new content is attainable as quickly as possible, and at the best pricing available.

2.1.5- Overall Industry Outlook: Is it conducive to profitability? The industry should be viewed as having unattractive profitability to companies that are: Unable to differentiate their products (provide a broad content library and a unique and easy system to access online content). Unable to compete technologically (have the capital resources necessary to invest in R&D to develop an online method of content delivery). Those that do not have the necessary capital to enter into licensing agreements in order to offer consumers a sufficiently large library of content. This is somewhat balanced with growth in global disposable incomes, especially within emerging markets where technologies mentioned above are becoming more widely available and at lower costs to consumers. Netflix is positioned well, in terms of meeting the industry key success factors; however, rivalry among competing sellers is quite strong. Future profitability will be highly dependent on an industry players’ ability to develop and maintain strategic advantages.

2.2 Internal analysis:

2.2.1 SWOT analysis:
Strengths:
Enter foreign markets ahead of other streaming rivals to build a profitable subscriber base. The convenience of being provided a postage-paid return envelope for customers and the policy of no late fees and due dates on DVD rentals attract large customers. Providing subscribers with a comprehensive selection of DVD titles and library of movies and episodes. Having strong ties and relationship with various video providers that help to acquire new contents. Entrenched as the biggest and best-known Internet subscription service for watching TV shows and movies. Large amount of resources.

All new subscribers received a free one-month trial.

Weaknesses:
Poor public relation and communication ruins the customer relationship and results in significant devaluation of the stock prices. Poor financial performance in 2011 and early 2012 and negative contribution margin in international segment. The breakdown with Starz resulted in paying higher prices to renew its rights to distribute its content to Netflix subscribers. The wrong decision result in bad consequence as 600k member cancelled and stock price dropped. Reputation was damaged after attempting to increase the subscription fee and separate DVD & streaming video.

Opportunities:
Increasing numbers of devices had recently appeared in electronic stores that enabled TVs to be connected to the internet and receive streamed content from online providers. Movie viewers saw unlimited Internet streaming from subscription services as a better value than movie rental, which provide growth opportunity for Netflix. As more and more households began to have high-speed Internet connections, Netflix intend to convert its DVD-by-mail subscribers into instant stream movie subscribers. As more and more people use smartphone, Netflix can anticipate an increasing number of mobile device model to become available. As internet becomes accessible easily for more countries, international expansion is a feasible strategy for Netflix.

Threats:
The competition is intense; Hulu plus and Amazon are large instant streaming rivals. Competitors are offering streaming video and bidding more original series for exclusive rights. Customer’s reactions in new markets may lead the company not to acquire enough number of subscribers within the forecasted two years, which will worsen the company’s financial situation. Piracy can be a contributing factor to declining sales of movie DVDS. Much of Netflix’s streaming library was rumored to be available through online piracy. Customer may be unwilling to provide sensitive payment information due to the increase in online fraud. Some under developed countries lack the necessary infrastructure to support Netflix products.

Based upon the above SWOT analysis, Netflix is positioned well to pursue the opportunities and defend against any threats. The significant amount of resources will allow Netflix to pursue the international growth and establish new subscribers, revenues, and profit.

Profitability, from 2000 to 2011, revenues increased rapidly and cost of revenues also increased. Gross margin ratio increased from 2.23% in 2000 to 37.23% in 2010; however it dropped to 36.36% in 2011. Net income ratio increased to 7.44% in 2010 and slightly fell to 7.05% in 2011. The profitability ratios are in good standing and are relatively stable over the 11year period 2000-2011. The decrease in gross margin is due to the increasing cost of international expansions and rising costs from suppliers. Although there is uncertainty with the supplier bargaining power, the streaming market segment is expecting to grow due to the popularity of the smart phone and smart TV. ROA increased to 17.05% in 2009 but dropped to 7.37% in 2011, ROE increased to 58.21% in 2009 but dropped to 35.17% in 2011, ROE increased more than ROA, which indicates that Netflix utilized debt leverage wisely. To illustrate this in 2011 the cash provided by financing activities reached 261.6M. 3. Alternatives Analysis

Based upon the external and internal analysis of Netflix there are several strategic alternatives that Netflix can pursue in creating a competitive advantage and ultimately ensure its long term success. The alternatives are:

Option one: Aggressively pursue international growth

This alternative includes aggressively pursuing international growth into regions in which Netflix is currently being developed or does not exist.

Pros:
Large potential for long term growth in revenues and profits; Beat competitors to the international market, thereby strengthening brand recognition amongst subscribers and ensuring long term subscription; Can lead to global economy of scale and reduce costs in the long term; Cons:

Temporarily depress overall company profitability;
Takes approximately two years to build a sufficiently large subscriber base to cover costs; Current losses in international segment of $103.1 million; Some international regions are unfamiliar with video-streaming; Some international regions have underdeveloped internet infrastructures.

Option two: Focus on product differentiation and regress from international expansion: This alternative includes regressing from the international market to mitigate any future losses from this segment, and to focus on R&D for technology and expanding the library subscribers have to choose from

Pros:
Immediately mitigates losses from the international segments; Allows superior technology to be developed to improve the ease of use of the product, thereby increasing subscribers and revenues; Allows an increase in library items, which is attractive to subscribers and a strong competitive advantage. Cons:

Losses out on the potential for large future growth, revenues, and profit from international expansion; Potential to lose out on global economies of scale; Will allow competitors to grow their market share globally giving them more resources to compete locally; Will limit brand recognition internationally, which will largely affect any future plans of growth globally.

Option three: Focus on supplier relationships, increase licensing, and decreasing DVD’s by mail This alternative focuses on improving supplier relationships and increasing licensing to grow subscriber base and reduce cost of library items.

Pros:
Will have the ability to offer more shows if supplier relationships are improved, thereby potentially growing subscriber base and instilling a
competitive advantage; Potential to reduce costs with increased relationship with suppliers; Has the ability to retain more subscribers for the long term and reduce the “churn rate”; Has the ability to reduce costs by reducing DVD’s by mail as the cost is $1 per DVD as opposed to $0.05 for streaming; Decreasing trend in DVD by mail will allow for Netflix to eliminate inventory storage costs and warehouse labour costs. Cons:

Supplier bargaining power is currently moderate to strong. This gives Netflix limited power over pricing; With little focus internationally, Netflix losses out on the potential for large international growth, revenues, and profit; With increased library base and no international growth the cost of licensing may become more expensive as global economies of scale are not being reached; With little R&D and an increasing library the ease of streaming may become more difficult, which may negatively affect subscriber retention; May lose subscribers only interested in DVD by mail to competitors such as Redbox.

Option four: Pursue international growth, product differentiation, and supplier relationships This alternative includes pursuing international growth, product differentiation, and supplier relationships to maximize all aspects of the Netflix competitive advantage.

Pros:
Large potential for long term growth in revenues and profits; Beat competitors to the international market, thereby strengthening brand recognition amongst subscribers and ensuring long term subscription; Can lead to global economy of scale and reduce costs in the long term; Allows superior technology to be developed to improve the ease of use of the product, thereby increasing subscribers and revenues; Allows an increase in library items; attractive to subscribers and a strong competitive advantage Will have the ability to offer more shows if supplier relationships are improved, thereby potentially growing subscriber base and instilling a competitive advantage; Potential to reduce costs with increased relationship with suppliers; Has the ability to retain more subscribers for the long term and reduce the “churn rate”; Has the ability to reduce costs by reducing DVD’s by mail as the cost is $1 per DVD as opposed to $0.05 for streaming; Decreasing trend in DVD by mail will allow for Netflix to eliminate inventory storage costs and warehouse labour costs. The combination of these strategies has the potential for a sustained competitive advantage that will be difficult to imitate by competitors. Cons:

Temporarily depress overall company profitability;
Takes approximately two years to build a sufficiently large subscriber base to cover costs; Current losses in international segment of $103.1 million; Some international regions are unfamiliar with video-streaming; Some international regions have underdeveloped internet infrastructures. Marketing costs and brand recognition costs will be substantial in entering the new markets; Increased costs for developing new technologies, and decreasing DVD’s by mail; May lose subscribers only interested in DVD by mail to competitors such as Redbox.

5. Recommendation

Netflix is faced with several decisions in order to repair investor relations and increase share price, which has been steadily declining. A series of unpopular strategic changes and initiatives was driving down share price and harming the overall reputation of Netflix. As a result, it was necessary for Netflix to conduct an analysis into potential alternatives.

Four alternatives were considered in detail and the pros and cons of each determined. Through the use of a decision matrix, Netflix identified several key business objectives and considered the overall ranking of each alternative in each area. The criteria were ranked on a scale of 1-5. Overall, alternative 4 was weighted most in alignment with the overall company objectives. This alternative includes pursuing international growth, product differentiation, and supplier relationships to order to maximize all aspects of the Netflix competitive advantage. Brand recognition is ranked very important to Netflix and this alternative allows the brand to continue to strengthen worldwide. Additionally, this alternative was ranked high for international presence, revenues and profitability and supplier relationships.

The key advantages of pursuing this alternative include the large potential for growth in revenues and profits. In the first quarter of 2012, the number of streaming subscribers in the United States rose 7.8% indicating likely continued growth in the domestic market. Contribution profit in the domestic streaming market also increased in the first quarter of 2012. The international market saw increased revenues in the same period; however contribution profit was down due to the increased costs incurred from obtaining licenses from movie studios and the owners of TV shows.

It is recognized that it takes approximately two years to build a large enough subscriber base in new international markets to obtain enough revenues to cover these additional costs. There are also additional costs related to marketing and advertising expenses required to attract new customers during this estimated two year international growth period. It is believed that the long-term benefits of this alternative will provide Netflix with the global presence and brand recognition that will allow it to reduce overall costs and increase profitability. This can be achieved through economies of scale that will strengthen relationships with suppliers and ultimately reduce costs.

The first alternative, aggressively pursuing international growth, was the second highest ranked alternative. However the chosen alternative combines the benefits of this first alternative and adds product differentiation and supplier relationships into the plan in order to achieve maximum benefit with a comprehensive overall strategy. 6. Action plan

In order for Netflix to succeed in crafting and executing its strategy, the firm should consider the five factors that make strategic action plan successful: Achievement of an important objectives

Build, sustain and/or enhance a core competencies or competitive advantage Block competitive threats by offering services/products other than competitors Expand new market opportunities
Mitigate business risks
The below action plan identifies objectives, tasks, timelines and goals that are required to implement Netflix strategy. Objective

Increase number of International subscribers in International Markets by advertising Advertise with affiliate partner companies which are trusted and known in the geographic areas to increase international markets Educate
international users on Netflix services

1 year
Increase number of Global Netflix users

Control operating expenses while expanding international market Create strategic alliances and affiliates internationally
1 -2 years
Aim to decrease marketing expenses by at least 30-40 %, through viral marketing and affiliate marketing internationally. Affiliate marketing would decrease expenses in the international markets

Exclusive strategic relationships
Build exclusive strategic relationship with program producers internationally 1 year
Exclusive rights to original shows and movie series to our beat competitors

KPI – Feedback and monitoring
Feedback on new products and services.
Evaluation of new programs in terms of:
Market expansion (%)
value analysis for promos
service and product quality monitoring
Minimize subscriptions cancellations
Immediate
Continuous monitoring for quality of new and existing services Better understanding of users “wants and needs”
Understand the reasons behind subscriptions cancellations

Build loyalty
Follow-up calls and business development calls
Newsletters and communication
Immediate
To improve communication and reduce number of cancelations

Invest in R&D – streaming technology
Invest in R&D to advance in the streaming market, and invent new more efficient ways of streaming 1-2 years
To ensure technological advances and keep pace with the fast changing streaming and VOD technology. Or implement new streaming technology.

Invest in R&D to address illegal usage

Invest in R&D to prevent sharing of accounts by multiple IP addresses and users 6 months
To prevent loss of revenue due to account sharing by friends and families in various geographical

Invest in R&D – International Mobile App development
Develop mobile app for different platforms (phone, tablets) for instant access to movies and programs in different languages 6-9 months
Increase number of mobile users Internationally

Netflix should continue its strategic and marketing efforts to develop international brand precedence. Continuous efforts in identifying new opportunities, development of international presence, capturing of new markets, strategic alliances and winning customers from competitors will ensure that company stays profitable. Contingency plan

If the above recommendation does not generate results as we have forecasted then, Netflix can focus on option three – improving supplier relationships and increasing licensing to grow subscriber base and reduce cost of library items. Netflix will have the ability to offer more shows if supplier relationships are improved, thereby potentially growing their subscriber base and instilling a competitive advantage. Also this option helps reduce costs by reducing DVD’s by mail as the cost is $1 per DVD as opposed to $0.05 for streaming.