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1. Information Systems: A Manager’s Guide to Harnessing TechnologyBy John Gallaugher 4-1

2. This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA 4-2

3. Chapter 4Netflix in Two Acts: The Making of an E-commerce Giant and the Uncertain Future of Atoms to Bits 4-3

4. Learning Objectives • Understand the basics of the two services operating under the Netflix business model • Recognize the downside the firm may have experienced from an early IPO • Appreciate why other firms found Netflix’s market attractive, and why many analysts incorrectly suspected Netflix was doomed • Understand the factors that led to customer exodus and stock market collapse, and identify mistakes Netflix made in rebranding the firm and splitting its offerings 4-4

5. Learning Objectives • Understand how many firms have confused brand and advertising, why branding is particularly important for online firms, and the factors behind Netflix’s exceptional brand strength • Understand the long tail concept, and how it relates to Netflix’s ability to offer the customer a huge (the industry’s largest) selection of movies • Know what collaborative filtering is, how Netflix uses collaborative filtering software to match movie titles with the customer’s taste, and in what ways this software helps Netflix garner a sustainable competitive advantage 4-5

6. Learning Objectives • List and discuss the several technologies Netflix uses in its operations to reduce costs and deliver customer satisfaction and enhance brand value • Understand the role that scale economies play in Netflix’s strategies, and how these scale economies pose an entry barrier to potential competitors • Understand the role that market entry timing has played in the firm’s success 4-6

7. Learning Objectives • Understand the shift from atoms to bits, and how this is impacting a wide range of industries • Recognize the various key issues holding back streaming video models • Know the methods that Netflix is using to attempt to counteract these challenges 4-7

8. Introduction • When Netflix went public, financial disclosure rules forced the firm to reveal how profitable it was • Rivals such as Blockbuster and Wal-Mart showed up • Competitors underestimated Netflix because: • It was an Internet pure play without a storefront • Its overall customer base was microscopic in comparison 4-8

9. Introduction • Netflix survived big competitors, a price war, and spending on the rise • Factors leading to customer exodus and stock market collapse: • Netflix split it’s base service charge of $10 into two $8 plans for DVD-by-mail and Internet streaming • This caused a 60 percent price hike for customers who wanted to continue with both services • Netflix announced its plans to offer the two distinct services in two separate websites 4-9

10. Introduction • Netflix lost over 800,000 customers, its stock tumbled from $304 a share to below $75 • Whether Netflix makes a successful transition from DVD-by-mail business to Internet streaming remains to be seen 2-10

11. Why Study Netflix? • It gives us a chance to examine how technology helps firms craft and reinforce a competitive advantage • It illustrates how a highly successful firm can still be challenged by technical shifts • It gives us an opportunity to examine issues that include digital goods, licensing, platform competition, and supplier power 4-11

12. How Netflix Works: A Model in Transition • Netflix settled on a DVD-by-mail service model • It charges a flat-rate monthly subscription • Customers don’t pay mailing expenses and late fees • Videos arrive in Mylar envelopes containing: • Prepaid postage • Return address • After watching the video, consumers: • Slip the DVD back into the envelope • Drop the disc in the mail 4-12

13. How Netflix Works: A Model in Transition • Users make their video choices in their “request queue” at Netflix.com • Consumers use the Web site to: • Rate videos • Specify movie preferences • Get video recommendations • Check out DVD details • Share their viewing habits and review 4-13

14. How Netflix Works: A Model in Transition • Netflix operates via a DVD subscription and video streaming model • These started as a single subscription, but are now viewed as two separate services 2-14

15. Act I: Netflix Leverages Tech and Timing to Create Killer Assets in DVD-by-Mail • Building a great brand online starts with offering exceptional value • Advertising builds awareness, but brands are built through customer experience • Subscribers expectations from Netflix: • Huge selection • Ability to find what they want • Timely arrival • Ease of use and convenience • Fair price Technology drives all of these capabilities Technology is at the center of the firm’s brand building efforts 4-15

16. Selection: The Long Tail in Action • Netflix offers its customers a selection of over 125,000 DVD titles • Traditional retailers cannot offer this because of shelf space constraints • Traditional retailers can determine their breakeven point by considering: • Number of customers that can reach a location • Store size • Store inventory • Payback from inventory • Cost to own and operate the store 4-16

17. Selection: The Long Tail in Action • Internet firms can have just a few highly automated warehouses • Long tail: A phenomenon whereby firms can make money by offering a near-limitless selection 4-17

18. Figure 4.3 - The Long Tail 4-18

19. Selection: The Long Tail in Action • The long tail works because: • Cost of production and distribution drop • It gives the firm a selection advantage that traditional stores cannot match • Geographic constraints go away and untapped markets open up 4-19

20. Selection: The Long Tail in Action • Netflix has used the long tail to create close ties with film studios • Studios earn a percentage of the subscription revenue • Netflix gets DVDs at a very low cost • Studios do not spend on additional marketing 4-20

21. Cinematch: Technology Creates a Data Asset that Delivers Profits • Netflix uses a proprietary recommendation system called Cinematch • Each time a DVD is returned, Cinematch asks the customer to rate it • Collaborative filtering: A classification of software that monitors trends among customers and uses this data to personalize an individual customer’s experience • It can be mimicked by competitors 4-21

22. Cinematch: Technology Creates a Data Asset that Delivers Profits • The data provided by Cinematch is a switching cost • To see how strong switching costs are is to examine Netflix’s churn rate • Churn rate: The rate at which customers leave a product or service • Churn rates for Netflix’s most active regions were below 4 percent • Netflix’s marketing costs benefit from satisfied customers, as referrals are a better choice than advertisements • Netflix launched a crowdsourcing effort known as The Netflix Prize 4-22

23. A Look at Operations • Technology lies at the heart of Netflix’s warehouse operations • Netflix has a network of fifty-eight ultra high-tech distribution centers • Distribution centers are all located close to U.S.P.S. facilities • Trucks collect DVD shipments from these U.S.P.S. hubs and return the DVDs to the nearest Netflix center • Scanners pick out incoming titles • Netflix presorts outgoing mail before dropping it off at U.S.P.S. facilities • All DVDs are hand-inspected for cracks and smudges • Warehouse processes are linked to Cinematch 4-23

24. A Look at Operations • Staff members are expected to focus on improving the firm’s processes • Quality management features are built into systems • Netflix can monitor and record the circumstances surrounding any failures 4-24

25. Killer Asset Recap: Understanding Scale • Netflix’s size gives it a huge scale advantage • Scale economies allow firms to: • Lower prices • Spend more on customer acquisition, new features, or other efforts • Smaller rivals have an uphill fight • Established firms end up straddling markets 4-25

26. Killer Asset Recap: Understanding Scale • By moving first, Netflix gained scale advantages • Largest network of distribution centers • Largest customer base • The firm’s industry-leading strength in brand and data assets 4-26

27. Act II: Netflix and the Shift from Mailing Atoms to Streaming Bits • Many media products are created as bits (digital files) • When we buy a CD, DVD, book or newspaper, we’re buying physical atoms that are a container for the bits • The shift from DVD-by-mail to the streaming business poses new challenges for the firm • When the DVD dies, Netflix’s high-tech shipping and handling infrastructure will be rendered worthless 4-27

28. Access to Content • When Netflix launched its streaming video option, only 17% of the DVD catalog was available • Legal issues involved in securing the digital distribution rights • Windowing restricts the number of titles available • Wal-Mart uses its bargaining power to encourage studios to: • Hold content from competing windows • Limit offering titles at competitive pricing during the new release period 4-28

29. But How Does It Get to the TV? • Netflix initially developed a prototype set-top box • It then developed a software platform that allowed firms to build Netflix access into their devices • Advantages of the atoms to bits model • Netflix will eliminate a huge chunk of its shipping and handling costs • Bandwidth costs are minimal 4-29

30. But How Does It Get to the TV? • Disadvantages of the atoms to bits model • Wrangling licensing costs is a challenge • The switch to Blu-ray DVDs means that Netflix will be forced to carry two sets of video inventory • Standard • High-definition • Bandwidth caps: Places a ceiling on a customer’s total monthly consumption 4-30

31. No Turning Back • Streaming on-demand content with targeted ads could be a goldmine combination • It may radically undercut the one-commercial-for-all model of current broadcast television • The streaming business also offers Netflix opportunities to explore new revenue models • It allows for rapid expansion into international markets 2-31