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~ t r a t e ~ i ~ M a n a ~ e m e nConcepts & Cases

Cotnpe t i t ive e s s and Gl ~ b a H z a t i o n8th Edition

Michael A. HittTexas A&M University

R. Duane IrelandTexas A&M University

Robert E. HoskissonArizona State University

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Strategic Management: Competitivenessand Globalization (Concepts and Cases)8th EditionMichael A. Hitt, R. Duane Ireland, andRobert E. HoskissonVP/Editorial Director: jack W. CalhounVP/Editor-in-Chief: Melissa AcunaSenior Acquisitions Editor:Michele RhoadesDevelopmental Editor:Rebecca Von Gillern-Bookworm EditorialServicesExecutive Marketing Manager:Kimberly KanakesMarketing Manager: Clint KernenMarketing Coordinator: Sara RoseSenior Cont ent Project Manager:Colleen A. FarmerTechnology Project Editor: Kristen MeereManufactur ing Coordinator: Doug WilkeProduction Service: LEAP PublishingServices, Inc.Compositor: ICC Macmillan, inc.Senior Art Director: Tippy McintoshPhoto Manager: Sheri I. BlaneyPhoto Researcher: Marcy LunettaPrinter: TranscontinentalInternal & Cover Designer: Craig Ramsdell,Ramsdell DesignCover Image: Don Hammond/DesignPics/Corbis

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Amy Falter, Scott ThompsonArizona State University

Netflix is one of the most recognizable online movierental services in the world. Since the company's launchin 1998, its business model has revolutionized themovie rental business and the wayU.S. viewers rent andwatch movies. Netflix's service has captured approximately 6.7 million subscribers and offers a video libraryof more than 90,000 movies, television, and other entertainment videos on DVD. 1 The majority of Netflixsubscribers pay about $18 per month and are allowedto keep up to three movies at a time. 2 Although Netflixwas the first company to tap this new market of onlinemovie rental, they would not be the last trying to capitalize on its potential.In August 2004, Blockbuster countered Netflix'sentry into the movie rental business with a strategicresponse by introducing Blockbuster Online, its ownonline rental service. 3 Blockbuster Online offered thesame services as Netflix, putting the two companies indirect competition with each other for the first time. Inlate 2006, Blockbuster revamped the online rental serviceand renamed it "Blockbuster Online Total Access:'4 Thisnew Blockbuster service gives the customer the optionof either returning the video through the mail or dropping it off at a local Blockbuster store. 5 It does however,encourage customers to return videos rented online tothe store by offering a voucher for a new in-store rental.6As Blockbuster boasts, "With this kind of access, you'llnever have to wait to have a new movie to watch!"7 Theonly caveat with the new in-store rental is that normaldue dates and late fees typical ofbrick-and-mortar videorental stores are enforced. 8 Without any physical stores,Netflix executives now face the difficult challenge offinding a legitimate and value-adding way to competewith Blockbuster.i:i:, Netflix also faces the development of video stream-ing and downloads on PCs as well as mobile devices.-gg "Computers, portable MP3 video players, and telephones

are now options for watching downloaded TV showsand movies, especially among younger audiences:' 9Companies such as Amazon, Apple, and YouTube haveall been looking at ventures in this market. 10 To stay atopthe online rental market, Netflix must decide how toadjust its current business model in order to grow andadapt to the market's dynamic environment.To better understand these salient strategic challenges, the following topics will be touched upon:Netflix's history, current strategic leaders, the competitive environment, supplier relationships, Netflix's currentstrategies and functional operations, and recent financialoutcomes.

Brief HistoryReed Hastings founded and incorporated Netflix inAugust 1997 as a more conventional rental service,with online offerings. 11 It was not until April 1998 thatNetflix opened its Internet store for DVD rentals andthen offered a subscription service in September 1999YNetflix's rapid growth can be attributed to its early strategic relationships with leading DVD hardware and hometheater equipment manufacturers (Sony, Toshiba, RCA/Thomson Consumer Electronics, Pioneer, and Panasonic)and marketing tactics (promotional techniques) to buildbrand recognition and acceptance among the growingDVD-rental consumer base.13 In December 1999, Netflixannounced the elimination of due dates and late fees,helping it to quickly become a popular rental service,as it also did not charge shipping and handling fees andper-title rental fees. 14 On May 22,2002, Netflix made aninitial public offering (IPO) of5.5 million shares of common stock at $15 per share.15Due to the overwhelming acceptance of and demandfor Netflix services, it became necessary for Netflix to

The authors would like to thank Professor Robert E. Hoskisson for his support under whose direction the case was developed. The authors do not intend to8 illustrate either effective or ineffective handling of a managerial situation. The case solely provides material for class discussion. This case was developed with contributions from: Garret Lumley, Evan Mallonee, & Terri Phillips.

275

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~ ~ ~ Exhibit1 Monthly Plansz;::;Q)(f)rou

Movie Rentals Cost1 at-a-time (2 per month} $ 4.99 per month1 at-a-time (unlimited) $ 9.99 per month2 at-a-time (unlimited) $14.99 per month3 at-a-time (unlimited) $17 .99 per month4 at-a-time (unlimited) $23.99 per month5 at-a-time (unlimited) $29.99 per month6 at-a-time (unlimited) $35 99 per month7 at-a-time (unlimited) $41.99 per month8 at-a-time (unlimited) $47.99 per monthSource http //www netflrx.com/MedraCenter

build new distribution and shipping centers every year.In the 2003 fiscal year, Netflix recorded its first profitable year with record revenues of $272.2 million, up78 percent from the 2002 fiscal year with earnings of$152.8 million. 16 As Netflix grew, it developed tailoredservice packages based on consumers' desired numberof rentals per month (see Exhibit 1). In 2005, the number of subscribers grew to a record high of 4.2 million,60 percent over the previous year. 17 Both 2005 and 2006were also solid growth years, leaving CEO Reed Hastingsoptimistic about future growth and earnings potential:"Our accomplishments during the year [2006]-strongsubscriber growth, continued improvement in the customer experience, and increased profitabi lity-togetherwith the recent launch of the first generation of our online video option, leave us better positioned than ever toachieve our long-term objective of being the movie rentalleader:'18 In February 2007, Netflix celebrated the delivery of its one-billionth DVD by giving the recipient a freelifetime Netflix membership. 19Netflix recently offered new features to its subscribers. In January 2007, Netflix launched "Watch Now:' 20This feature allows subscribers not only to rent onlineand continue to receive DVDs through mail, but alsowatch more than 1,000 movies and television shows viatheir PCs.21 Netflix hopes to eventually bring this typeof technology to any device with access to the Internet,22Another new endeavor Netflix has launched is RedEnvelope Entertainment; this new division "looks toleverage its proprietary technology to offer subscribersunique and original content to which they wouldn't otherwise have access:'23 The unique and original contentincludes independent films such as those found at theSundance and Toronto Film festivals. 24At year end 2006 Netflix employed 1,300 full-timeand 646 temporary employees at the corporate headquarters in Los Gatos, California, and in its shipping centersacross the nation. 25 Many ofNetflix's senior officers have

been with the company for a majority of the company'slifespan. The current strategic decision makers ofNetflixare six key individuals from the C-suite.

Netflix Strategic LeadersFounder, CEO, and Chairperson. Reed Hastingshas served as chairman since the company's inception.26 Hastings studied mathematics at BowdoinCollege in Brunswick, Maine, and was awarded theSmyth Prize in 1981 by the math department and received his BA in 1983.27 To round out his education,Hastings went to Stanford University and received amaster's degree in computer science.28 A former Netflixdirector, Bob Pisano, said of Hastings "[he is] an engineer, is analytical and very charismatic . . . that's a rarecombination:'29

Hastings created the vision for Netflix and is in perpetual motion to evolve and sustain his business basedon critical factors developed by other members of hismanagement team.Neil Hunt, Chief Product Officer. Neil Hunt created and manages the Netflix site. He has served in thiscapacity since 1999.30 His job and decisions are of criticalimportance, because his output is the portal customersultimately interact with via the company. Hunt's focus is"Customization and personalization [ensuring] everyNetflix member [receives] a unique experience everytime they visit the site. This includes the movies theysee on each page, the recommendations they receive onmovies, and the critical account management tools theyuse, such as their dynamic queue to order movies:'31 Mr.Hunt is a noteworthy scientist who has the leadershipskills to inspire teams to be innovative, and create powerful software that is user-friendly.Ted Sarandos, Chief Content Officer. Since 2000,Mr. Sarandos's role is to manage and cultivate relationships with studios, networks, film makers, and producers to gain access to films and distribution channels. 32His most critical role is making sure customers' needsare satisfied through the current video selection and bystaying abreast of new trends within the entertainmentindustry.Leslie Kilgore, Chief M arketing Officer. BecauseNetflix is an online entity, Ms. Kilgore's responsibility isto find the most effective and cost-efficient methods toacquire new subscribers through various marketing approaches.33 Her success is demonstrated in that "morethan 90 percent of trial members convert to paying subscribers and more than 90 percent of those tell familyand friends about the service:'34

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Barry McCarthy, Chief Financial Officer. Since1999 Mr. McCarthy has overseen the financial and legalaffairs for Netflix. Barry has vast experience in his field,including work with Credit Suisse First Boston. He hashelped Netflix become a billion dollar revenue companywithin 7 years.35Patty McCord, Chief Talent Officer. Ms. McCordhas been with Netflix since 1998 and helps the companyattract and retain high-talent employees. Having 16 yearsof human resources experience with high-tech companies, she plays a large role in establishing a culture inwhich employees are devoted to superior customer service. "She is adamant about keeping a lean organizationin which openness, approachability, and honesty are valued above all else:'36

The strategic leaders have directed Netflix to targetthree distinct customer segments: those who like the convenience of free home delivery, the movie buffs who wantaccess to the widest selection of, say, French New Waveor Bollywood fllms, and the bargain hunters who want towatch 10 or more movies for 18 dollars a month. The challenge is to keep all segments happy at the same time. 37Netflix hopes that catering to the needs and desiresof its different customer segments will help it remain akey player in this rapidly developing and competitiveindustry.

Competitive EnvironmentUntil recently, Blockbuster Inc. dominated the movierental industry, with few threatening competitors anddrawing annual revenues of more than $3 billion.38Netflix challenged the traditional brick-and-mortar videorental chains. With the continual advent of new technology and widespread Internet adoption and usage, theNetflix business model appealed to many consumers,especially those who were frustrated with Blockbuster'slate fees. With Netflix's entire business model focused onproviding unique online rental, free delivery to households, no due dates or late fees, and movie recommendations to all its subscribers, Netflix appeared to have founda niche market.39As a result of the short product life cycles in the technological sector, continual improvements in products,and lower costs in technology, it has become morecommon for consumers around the globe to own theirown movie viewing devices and access the Internetfrom home. Thus, the online movie rental market baseis expected to grow continuously. In 2005, the onlinemovie rental industry had more than 6 million subscribers in the United States and Europe, and by theend of 2006 that number rose to more than 8 millionsubscribers. 40

Em e rging Compet i to r sProgress in technology is changing the competitive dy-namics. The main impetus challenging movie rental companies is video on demand (VOD). Video on demand isgaining more attention and popularity, especially amongcable/satellite companies, television networks, and dotcom companies. In contrast to buying or renting a video,VOD allows the user to download the entire movie to acomputer or stream the video, where the movie is viewedin realtimeYDownloadable movies are in an embryonic stage,with early adopters experimenting with the service,but are not yet widely utilized among Internet users. 42A potential current pitfall of this product is that neither downloaded nor streaming videos come in highdefinit ion yet, and this could be a deal buster for manyconsumers who have recently bought into the highdefinition crazeY However, most of the key onlinerental industry players have sought relationships withvideo on demand providers to maintain a competitiveadvantage.New entrants are crafting technology devices specifically designed to support these new services. One majorplayer will be Apple; movies and television shows canbe viewed on Apple TV, iPods, and Macs. Smartphoneswill also begin to offer the downloadable movie andtelevision show service, acting as portable TV . 44 Thedownloadable Amazon Unbox allows consumers to access DVD-quality movies and television shows for rentor purchase.45 Wal-Mart joined the fight for marketshare by creating its own downloading movie businessin February 2007.46 Wal-Mart has gained the interest ofstudios such as 20th Century Fox, Lions Gate, Disney,MGM, MTV Networks, Paramount Pictures, UniversalStudios, Sony Pictures Entertainment, and WarnerBros.47 Wal-Mart currently offers approximately 3,000titles for download purchase ranging in price from$14.88 to $19.88.48Netflix is in its infancy stage of introducing streaming videos and television shows offered to current subscribers.49 This new addition of streaming service wasbuilt upon the Microsoft infrastructure.5 Over time, thecompany hopes to make Netflix's service available onother software combinations, portable devices, and televisions screens.51 Netflix has also partnered with videorecorder maker TiVo to allow TiVo customers access toDVDs on Netflix's Web site.52 CEO Reed Hastings hasstated, "We want to be ready when video on demandhappens. That's why the company is [called] Netflix andnot DVD-by-mail:'53Even though Blockbuster has been Netflix's strongest competitor, other companies are strengthening theircompetitive position to challenge these two giants andgain market share. These competitors seem to believe

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Also, Blockbuster recently acquired Movielink LLC,an online movie downloading company owned by majorHollywood studios, such as MGM, Paramount Pictures,Sony Pictures Entertainment, Universal Studios, andWarner Brothers.76 In this agreement, Blockbuster willhave long-term deals for content with the major filmstudios, which will significantly enlarge its current videolibrary used by both the brick-and-mortar stores andonline subscribers.77 Blockbuster has also sought out avideo download partner so its customers will have threeways to attain movies-in-store, mail order, or download. "While Blockbuster trailed behind in the onlineDVD rental business after entering it in 2004-five yearsafter Netflix-it's not taking a wait-and-see attitude toward movie downloads:'78Mov ie G a l l e ry , In c .Movie Gallery is the second-largest North Americanvideo rental retail chain, with more than 4,700 storeslocated in all 50 states, Canada, and Mexico.79 Its growthstrategy is internal growth and pursuing selective complementary acquisitions. "By focusing on rural and secondarymarkets, [Movie Gallery] is able to compete very effectively against the independently owned stores and smallregional chains in these areas:'80 Movie Gallery's acquisition of Hollywood Entertainment in 2005 made the company stronger and more competitive with Blockbuster bychallenging Blockbuster on its strength-owning storesin prime locations.By acquiring Hollywood Entertainment, MovieGallery inherited 74 automated movie vending machinekiosks similar to ATMs, which "provide around the clockavailability of movies" for rent. 81 Because of the minimal overhead and fixed costs associated with the kiosksMovie Gallery intends to expand its fleet with a rollout ofan additional200 units through 2007.82

Joe Malugen, chairperson, president, and CEO ofMovie Gallery, stated "While we firmly believe that ourretail brick-and-mortar stores will remain the foundation of our business, over the past three years we havebeen diligently pursuing alternative delivery platformsto further complement our base business:'83 As such,in March 2007 Movie Gallery purchased MovieBeam,a movies-on-demand service, which was created andfunded by Walt Disney Co., Cisco Systems, and IntelCapital. 84 Movies are "beamed" into consumer homes using MovieBeam's patented over-the-air data-casting technology to the set-top box. 85 Currently, this technology islimited to television set use only, but Movie Gallery plansto expand these services to video on demand capabilityover the Internet.86Hastings Entertainment. Hastings Entertainmentoperates in approximately 20 midwestern and western

tates, focusing on small to medium-sized towns with 0underserved markets (towns with populations of 33,000 ffito 105,000).87 This multimedia retailer "combines the sale ':::::of new and used CDs, books, videos, and video games, as zwell as boutique merchandise, with the rental of videosand video games in a superstore format:' 88 Sales and rent-als of videos and games account for the primary revenuestream (35 percent) with music sales pulling in the sec-ond highest amount (25 percent). 9 According to Hoover'sInc., "As is the case throughout most of the rental indus-try, Hastings video rental sales continue to drop in theface of mail-order rental houses like Netflix and videoon demand services from cable companies:' 90 AlthoughBlockbuster, Movie Gallery, and Hastings Entertainmentare the "Big Three" competitors for Netflix, other moviedelivery methods exist and capture some of the marketshare.Oth e r C o mp e t i to tsWhile movie rentals are the most common method forviewing newly released films or older pictures, otherchannels are available. These channels include movie retail stores (e.g., Best Buy, Wal-Mart, and Amazon.com);subscription entertainment services (e.g., Showtime andHBO); Internet movie providers (e.g., iTunes, Amazon.com, Movielink, CinemaNow.com, and Vongo); Internetcompanies (e.g., Yahoo! and Google); and cable and direct broadcast satellite providers.91

To remain a key player in the industry it is just asimportant for Netflix to consider the movie content providers as it is the competitors.

Content ProvidersNetflix has exercised great effort in establishing strongrelationships with a number of entertainment film providers. They have sought to ensure that the relationshipsare mutually beneficial. Netflix obtains content from thestudios through either revenue sharing agreements ordirect purchase. The revenue sharing program providesNetflix with a tremendous cost savings, and in returnprovides the studios a percentage of Netflix's subscription revenues for a defined period of time. This agreement also allows the studios an additional distributionoutlet for new releases, television shows, and so on. Oncethe defmed period for the revenue sharing has ended fora particular movie title, Netflix will destroy the title, purchase the title, or return it to the studio.

Netflix contracts movies offered through its instantviewing feature with studios and other content providerson a fixed fee or per-view basis. The general arrangementis the same, but the specific terms are often unique toeach provider.92

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I I Netflix orders movies in two different formats: HDDVD and Blu-Ray9 3 through content providers such asHollywood Film studios, 20th Century Fox, Walt DisneyStudios, Columbia Pictures, Lions Gate Films, New LineCinema, Paramount Pictures, Universal Pictures, WarnerBros. Pictures, and other independent film studios.94

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The online rental industry has enjoyed large growthand success up to this point largely due to the distribution rules established by studios. Currently, DVDs areavailable for movie rental and retail sales three to sixmonths before the movies are available on pay-per-viewand VOD, nine months before satellite and cable, andtwo to three years before basic cable and syndicated networks. The studios have discussed either eliminating thedistribution windows or shortening them, which wouldadversely affect Netflix. 95Netflix has been able to establish a relationship withcontent providers and differentiate itself among competitors through its strategic approach.

Netflix'sStrategies and FunctionalOperationsNetflix is focused on continuous improvement and metrics to add value to the business and the customers' experience.96 All these goals culminate into one overlyingcompany strategic goal-to maintain a low-cost structure. Dillon states,The Company's fulfillment costs are about half whatBlockbuster's are, which enables profitability at a lowerprice. Every penny counts in a high-volume business. Aswe keep lowering our cost, we're able to lower our price. It'sa very elastic market; so, the lower the price, the more ourmarket grows. 97

As mentioned previously, the company developedstrategic alliances with sources in the film and televisionsectors.98 These arrangements provided a significant costsavings, which freed up funds to use for other projectsand investments, such as the continued investment anddevelopment of its proprietary software for inventorymanagement, logistics, and shipping. 99

Netflix has also carefully managed its payroll expenses to keep in line with the low-cost structure. "Whenthe company first started in 1999, Netflix had 75,000customers and was using 100 employees to package software for customer support:' 100 Netflix cut that numberroughly in half with just 45 current employees servingmore than 6 million subscribers. 101 This dramatic cutin staffing is driven by an essentially self-service Website and home-grown support software that enables representatives to handle higher volumes. 102 Tom Dillon,COO explains,

We firmly believe in building IT rom scratch; this is a cus-tom business. . . . If you want to get it done exactly theway you want, build it yourself. . . . IT is not a strategicweapon in most companies. But in our company, IT is thebusiness. We live and breathe [the idea] that the way youget more competitive, lower your costs, and provide betterservice is through continuous improvementof he information technology. 103

Netflix transcended the norms for IT use and willcontinue to rely on its information technology capabilities and resources. It has built a strong, reliable Webplatform that is compatible with all kinds of portals andbrowsers in order to sustain a large number of users andmaintain a positive "brand experience:' 104

Netflix is a company that competes on its strongfoundation of mathematical, statistical, and data management expertise and uses these strengths to furtherdistinguish itself from other competitors.105 It uses analytics in two different ways. Internally created, algorithmically driven software makes movie recommendationsfor customers through a system called Cinematch. 106 Thiscapability essentially led to the creation of personalizedWeb sites for each customer who visits Netflix and givesa customized interaction with every individual. 107 Netflixalso uses a process called throttling. With this process,the company balances the frequent-use and infrequentuse distribution shipping requests of its customers. 108Infrequent-use customers are given higher priority inshipping than frequent-use customers. 109 Some customers became disgruntled when they learned that Netflixuses the throttling process. Netflix's senior leaders didnot seemed concerned about the complaints as shown ina statement by CEO Reed Hastings, "Few customers havecomplained about this 'fairness algorithm: We have unbelievably high customer satisfaction ratings:' In January,1995 Netflix changed its "terms of use" to read "In determining priority for shipping and inventory allocation,we give priority to those members who receive the fewestDVDs through our service:'110

Netflix's services provide value for its large customerbase. The value provided has led Netflix to be almost fourtimes larger than Blockbuster's in regard to subscribers forthe online service, and to maintain this position, Netflixis continually reinvesting its money into marketing. 111

Marketing ApproachesMarketing has been a key advantage for Netflix. Earlyon it established an agreement with Best Buy in thatBest Buy set up a co branded version of the online DVDrental service on its five online Web sites and instituteda joint-market ing program in the 1,800-plus retailstores. In return, Netflix directs its customers interested in buying DVDs to Best Buy's Web sites.112 It has a

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Exhibit 2 Advertising ExpendituresAs of Blockbuster NetflixDecember 2006December 2005December 2004December 2003

$154,300,000252.700,000257.400,000179.400,000

$225,524,000144,562,000100,534,00049,949,000

Sources http / lwww.rnarketwatch com, Netfl1x SEC1 0-K 2003, NetfllxSEC10-K 2004, Netfl1x SEC10-K 2005, and Netfl1x SEC10-K 2006

similar agreement with Wal-Mart; both companies havepromoted one another since 2005 when Wal-Mart exitedthe online movie market. 113Other marketing efforts include online advertisementssuch as banner ads, paid search listings, pop-up advertisements, and text on popular Web portals-Yahoo!, MSN,and AOL. 114 Netflix was ranked as being the number twocompany to spend the most money on online advertisements.115 Most online retailers face budget restrictions onadvertising expenditures, as did Netflix in the beginning,and therefore are selective in the channels of advertising, 116but as Netflix's subscriber base has grown, so has its advertising budget and expenditures (see Exhibit 2).Netflix also targets a broad demographic in its advertising plan by running ads on the mainstream networksABC, NBC, FOX, and CBS, as well as radio advertisements.117 Direct mail, print advertising, and promotions incertain consumer package goods are used as well in theirmarketing strategy. 118For online video rental, Netflix pioneered the use ofdatabase marketing to develop a personalized relationship with consumers. The database, possible because ofNetflix's strengths in IT, allowed Netflix to understandindividual customers, aggregate and predict behaviors,and then send customized e-mails informing customers of what new movies are available. Netflix has a strongculture of analytics and a test-and-learn approach to itsbusiness. 119 Metrics tracked include Web site users, advertising testing, data mining, subscriber satisfaction, segment research, and marketing material effectiveness. 120Often, the effectiveness of its marketing endeavors canbe assessed by reviewing the company's financials.

Financial ResultsS toc l< R e lated Issu esNetflix's stock price has been highly volatile since itsIPO on May 22, 2002. After adjusting for the eventual2-for-1 stock split on February 12, 2004, its first yearstock was valued anywhere between $2.42 and $9.10.l2lIn the following three years, the stock price fluctuatedeven more until it started showing signs of stabilizationin 2006 (see Exhibit 3). The earnings per share (EPS) for

Exhibit 3 Historic Stock Price and P/E Ratios 006 2005 2004 2003 2002High Price 33 .12 30 .25 39 .77 30 .50 9.10Low Pnce 1812 8.91 9.25 5.93 2.42Year-End 25.86 27.06 12 .33 27.35 5.51PnceH1gh P/E 46 .61 47.16 119 .18 294.52 -12 .25Low P/E 25 .50 13 .89 27.72 57.21 -3 .26Year-End P/E 36 .39 42.19 36 .95 26405 -7.41Source http //stocks us reuters com/stocks/performance asp?symbol=NFLX O&WTmodLOC=L2-LeftNav-18-Performace

Netflix has been constantly on the rise (see Exhibit 4).Estimates for 2007 and 2008 suggest that this trend willcontinue at a reasonable rate, which can also be seen inExhibit 4.Also important to note is Netflix's PIE ratios. Netflix's2006 PIE ratio of 32.88 (2007) is showing a trend towardbecoming more in line with the rest of he industry, whichhas a current PIE ratio of29.17. 122 This high PIE ratio indicates that the market views Netflix as having a higher potential for future earning compared to others in the videorental industry. Netflix's PIE ratio has moved from an ex-tremely high number in 2003 to its more stable currentPIE ratio. Historic PIE ratios can be found in Exhibit 3.123

C ompany Liqu id it yThe current ratios for 2002-2006 can be found in Exhibit 6.Netflix has consistently had a high current ratio, alwaysabove 1.75. 124 As of December 2006, its current ratio was2.20, while the rest of the industry had a less favorable ratio of .59. 125 At 2006 year end, the cash ratio was 2.09 andthe debt ratio was .319. With all these ratios considered,Netflix seems to be in a favorable position. (See Exhibit 5for balance sheet information.)Comp a ny Pro f ita bilit yNetflix has continued to increase revenues since itsIPO at a significant rate. 126 The net profit margin hasremained in the 4 to 6 range for the past three yearsand appears to be the most stable profitability ratio.This value is significantly lower than the industry'snet profit margin at 14.80. 127 Return on assets, returnon stockholders' equity, operating profit margin, andnet profit margin have all been computed and listed inExhibit 7.Comp e t i tor and Ind u st ryFinancia l R a t iosSee Exhibit 8 for a list comparing Netflix to its maincompetitors-Blockbuster, Hastings Entertainment, andMovie Gallery-and to o ther indust ry averages.

0[J)(f)CD'::;

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Exhibit 4 Income StatementN Income Statement(in US$ thousands, except per share data)2002 2003 2004 2005 2006 2007 (est.) 2008E

Revenues $150,818 $270,410 $500,611 $682,213 $996,660 $1,295,5 50 $1,595,890Cost of revenuesSubscnpt1on 77,044 147,736 273,401 393,788 532,621Fulfillment expenses 20,421 32,623 58,311 71,987 94,364Total cost of revenues $ 97,465 $180,359 $331,712 $465,775 $626,985Gross prof1t 53,353 90,051 168,899 216,438 369,675Operatmg expensesTechnology and develop ment $ 17,632 $ 21,863 $ 29,467 $ 35,388 $ 48,379Marketmg 37,423 51,535 100,534 144,562 225,524 wGeneral and admm1strat1ve 9,867 13,390 22,104 35,4 86 36,155Gam on disposal of DVDs (896) (1,209) (2,560) (1,987) (4,797)Total operatmg expenses $ 64,026 $ 85,579 $149,545 213,449 $305,261Operatmg 1ncome (loss) $(10,673) $ 4,472 $ 19,354 $ 2,989 $ 64,414Other 1ncome (expense)Interest and other 1ncome 1,697 $ 2,457 $ 2,592 $ 5,753 $ 15,904Interest and other expense (11,972) (417) (170) (407)Income (loss) before mcome taxes $(20,948) $ 6,512 $ 21,776 $ 8,335 $ 80,318ProviSions for (benefit from) mcome taxes - - 181 (33,692) 31,236Net 1ncome (loss) $(20,948) $ 6,512 $ 21,595 $ 42,027 $ 49,082Net 1ncome (loss) per share:Bas1c $ (0 .74) $ 014 $ 0.42 $ 0.79 $ 0 78 $ 0.79 $ 104Diluted $ (0 .74) $ 0.10 $ 033 $ 0.64 $ 0.71Weighted average shares outstandingBas1c $ 28,204 $ 47,786 $ 51,988 $ 53,528 $ 62,577Diluted $ 28,204 $ 62,884 $ 64,713 $ 65,518 $ 69,075

Year-end pnce per share $ 5.51 $ 2735 $ 12 .33 $ 2706 $ 25.86Pnce/earnmgs rat1os (745) 273 .50 3736 42 .28 36.42 29.83 $ 21.79

Sources Netfllx SECl 0-K 2002, Netfl1x SEC I0-K 20m, Nettllx SEC 1O-K 2004, Nettl1x SEC1 0-1

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Exhibit 5 Balance SheetBalance Sheet(in US$ thousands, except share and per share data)2002 2003 2004 2005 2006

AssetsCurrent assetsCash and cash equivalents $59,814 $89,894 $174,461 $212,256 $400,430Short-term investments 43,796 45,297 7,848 4,742Prepaid expenses 2,753 2,231 2,741 5,252 9,456Prepaid revenue shanng expenses 303 905 4,695 13,666 3,155Other current asses 409 619 5,449 4,669 10,635Total current assets 107,075 138,946 187,346 243,691 428,418DVD library, net 9,972 22,238 42,158 57,032 104,908Intangible assets 6,094 2,948 961 457 969Prope1ty and equipment, net 5,620 9,772 18.728 40,213 55,503Depos1ts 1,690 1,272 1,600 1,249 1,316Deferred tax assets 21,239 15,600Other assets 79 836 1,000 800 2,065Total assets $130,530 $176,012 $251,793 $364,681 $608,779Liabilities and Stockholders' EquityCurrent liabilit iesAccounts payable $20,350 $32,654 $49,775 $ 63,491 $93,864Accrued expenses 9,102 11,625 13,131 25,563 29,905Deferred revenue 9,743 18,324 31,936 48,533 69,678Current portion of capital lease obligations 1,231 416 68Total current liabilities 40,426 63,019 94,910 137,587 193,447Deferred rent 288 241 600 842 1 121Capital lease obligations, less current portion 460 44 68Total liabilities $41 ,174 $63,019 $95,510 $138,429 194,568Commitments and contingenciesStockholders' equity 45 51 53 55 69Additional pa1d-1n capital 260,044 270,836 292,843 315,868 454,731Deferred stock-based compensation (11,702) (5,482) (4,693)Accumulated other comprehensive 1ncome (loss) 774 596 (222)Accumula ted defic it (159,805) (153,293) (131 ,698) (89,671) (40,589)Total stockholders' equity $89,356 $112,708 $156,283 $226,252 $414,211Total liabilities and stockholders' equ1ty $130,530 $176,012 $251,793 $364,681 $608,779Sources Netfhx SEC10-K 2002, Netfl1x SEC10-K 2003, Netfhx SEC10-K 2004, Netfhx SEC10-K 2005, and NPtfhx SEC10-K 200 6

Netflix experienced some financial setbacks in thefirst quarter of 2007, most of which can be attributed toits key strategic challenges.

Key Strategic ChallengesNetflix faces a rapidly developing competitive environment with new technological innovations affectingproduct and service offerings among the various movierental businesses, whether it be a brick-and-mortar store,

click-and-mortar store, or online business. However, perhaps the main challenge Netflix will encounter is tryingto figure out how to adjust its business model to the newtechnological pressures while staying true to the company'sstrengths and providingvalue to its subscribers.ChurnChurn is the cancellation ofa subscription service. Churncan be triggered by a number of factors: insufficient useof the service does not justify the expense; delivery is

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Exhibit 6 Liquidity Ratio

Current ratio2002 2003 2004 2005 20062.65 2.20 1.97 1.77 2.20

Sources: Netfhx SEC10-K 2002, Netflrx SEC10-K 2003, Netfhx SEC10-K 2004, Netfhx SEC10-K 2005, and Netfhx SEC10-K 2006u

Exhibit 7 Profitability Ratios2002 2003 2004 2005 2006

Return on assets(%) -19.56 3.70 11.53 11.52 8.06Return on stockholders' equ ity -23.44 5.78 13 .93 18 .58 11.85Operating profit -13 .89 2.41 4.35 1.22 8.06Net profit margin -13 .89 2.41 4.31 6.16 4.92Sources: Netfhx SEC10-K 2002, ~ J e t f l r x SEC10-K 2003, Netfhx SEC10-K 2004, Netflrx SEC10-K 2005, and Netflrx SEC"IO-K 2006

Exhibit 8 Comparative Performance of Netflix and Key CompetitorsBlockbuster Hastings Movie Gallery Netflix IndustryBBI Entertainment HAST MOVI.O NFLX Median

ProfitabilityGross profit marg in 54.68% 6762% 60.19% 37.09% 48.94%Pre-tax profit margin -0 .15% 1.51% -095% 8.06% 16.47%Net profit margin 1.23% 0.59% -1.01% 4.93% 14 .82%Return on equ1ty 10 .54% 5.22% 15 .33% 11.84%Return on assets 2.15% 1.26% -203% 10 .08% 6.37%ValuationPrice/Sales rat1o 0.22 0.12 0.06 1.60 2 82Price/Earnrngs ratio 21.43 13 .99 32 92 18 .97Pr ice/Book ratio 2.06 0.69 3 84 3.80OperationsInventory turnover 757 3 28 7.30 27.08Asset turnover 1.75 2.13 2.00 2 05 0.52FinancialCurrent ratio 1.12 163 0 89 2.22 0.63Quick rat1o 0.88 0.16 0.37 2.22 0.48Total debt/Equi ty ratio 1.33 0.42 0.00 0.68Sources. http //stoc'r's us reuters com/stockslratros asp 7symboi=NFLX O&WTmodLOC=LZ-LeftNav-16-Ratros, http //stocks us reuters com/stocks/ratros asp?symboi=BBI N, http //stocks us reuters com/stocks/ratros asp7symboi=MOVI 00 , http /lv:ww rnvestor reuters wallst com/stocks/Ratrosasp7rpc=66&trcker=HAST0

too long; poor service; or competitive services providebetter added value and/or experience to the consumer.These factors are critical to any online movie rental busi-ness, but especially for Netflix because its entire businessmodel is based on attracting and mainta ining subscribers(see Exhibits 9 and 10).

Some of the company's key competitors have morebrand name recognition, experience, and financial

resources to provide value to the customer. This makes itdifficult for Netflix to compete at its existing price level orat lower price level structures in the future. Netflix needsto offer services that compete effectively.M anaging GrovvthFinally, Netflix must have the ability and foresight tomanage extensive growth to maintain its current service

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Exhibi t 9 Potential Growth for NetflixITotal Online Subscribers! (in thousands)

The overall market fo r online subscription rentalsis still early in its growth cycle, according toestimates from Adams Media Research andinternal Netflix estimates.

Exhibi t 10 Subscriber ChurnNetflix Subscriber Churn*

Better service means higher retention- In the fourthquarter of 2006, churn declined to a record lowof 3.9 percent.

level. Since the company's launch in 1998, Netflix has seenphenomenal growth and profitability (see Exhibit 11).As the company grows, it must add additional distribu-tion centers to its already existing infrastructure (seeExhibit 12). However, if the company does not properlyprepare for a continual increase in clientele Netflix's man-agerial operations and financial resources could be spreadtoo thin, which translates into orders not being met andcustomer satisfaction levels decreasing.

The Central QuestionReed Hastings started Netflix on the premonition thatusers would buy into his business concept ofonline movierental without the hassle oflate fees and due dates while

Exhibit 11 Subscriber GrowthNetflix Subscriber Growth(in thousands)

Netflix has enjoyed rapid subscriber growthsince it invented online DVD rentals.

Exhibit 12 Netflix Distribution NetworkNetflix Distribution Network

Rapid expansion of our distribution network- weadded 29 distribution centers in the past four years-has enabled us to provide quick delivery to ourdramatically growing subscriber base.

choosing a movie from the confines of their home. WithHastings's vision and charisma, along with his strongsupporting cast of IT, marketing, and entertainment in-dustry experts, Netflix set in motion a new wave of howconsumers viewed the movie rental business. Netflix wasthe primary proponent of change in the movie rentalbusiness. Now, the key concern is how to cope with in-dustry and technological trends that are evolving. ShouldNetflix transition from an online movie rental businessto solely VOD or streaming services? Or can Netflixmaintain its stronghold position with its current busi-ness model while making slight improvements to keepcurrent with VOD and other new technologies? ShouldNetflix's strategic leaders and decision makers consider amerger or a joint venture with another company in order

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I I to offer a unique basket of services to consumers? Netflixmust weigh its options carefully. It has established brand

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1. 2006, Netflix Inc. Annual Report.2. M. Helft, 2007, Netflix to deliver movies to the PC, New York

Times, http://www. nyti mes.com/2007 01 /16/technology/16netflix.html ?ex= 1326603600&en=71618d2092f5b372&ei=5088&partner=rssnyt&emc=rss, January.

3. 2007, Hoover's Company Reports-Full Overview, Netflix, February 8.4. 2007, Hoover's Company Reports-Full Overview, Blockbuster Inc .,

February 10.5. 2007, Blockbuster Total Access-How It Works, http://www

.blockbuster.com.6. Ibid.7. Ibid.8. Ibid.9. 2007, Netflix, Blockbuster competes for supremacy with new DVD

services, Pittsburgh Post Gazette, January 30.10. Hoover's company reports.11. 2007, About Us, http://www.netflix.com, March.12. 2007, First online DVD rental stores open, http://www.netflix.com/

mediacenter, March.13 . 2007, Netflix's aggressive growth plan, http://www.netflix.com/

mediacenter, March.14 . 2007, Netflix.com transforms DVD business eliminating late fees and

due dates from movie rentals, h ttp: //www.netflix.com/mediacenter,March.

15 . 2007, Netflix announces IPO, http://www.netflix.com/mediacenter,March.16 . 2004. Netflix announces 04 revenue growth of 80% year over yearand a 2-for-1 stock split, Netflix financial release, http://www.netflix.com, January 21.

17. 2006, Netflix announces 04 2005 financial results, Netflix pressrelease, http://www.netflix.com, January 24.

18. 2007, Netflix announces 04 2006 financial results, Netflix pressrelease, http:// www.netflix.com, January 24.

19. 2007, One billion and counting, http://www.netflix.com/mediacenter,March.

20. 2007, Netflix offers subscribers option of instantly watching movieson their PCs, http://www.netflix.com/mediacenter, March.

21. Ibid.22 . 2007, Netflix press release, http://www.netflix.com/MediaCenter,

March 27.23. 2007, http://www.netflix.com/mediacenter.24. 2007, Netflix Hoover's Full Overview, http://premium.hoovers.com.25. 2006 Netflix Inc. Annual Report.26. 2007, Netflix board of director's committee composition, ht tp://

ir.netflix.com/committees.cfm.27. J. Hopkins, 2006, Charismatic founder keeps Netflix adapting,

USA Today, http://www.usatoday.com/money/companies/management/2006-04-23-exec-ceo-profile-netflix_x.htm, April 23.

28. Ibid.29. Ibid.30. 2007, Management, http://www.netflix.com/mediacenter.31. Ibid.32. Ibid.33. Ibid.34. Ibid.35. Ibid.36. Ibid.37. P. Sauer, 2005, How I did it: Reed Hastings, Netflix, http://www.inc

.com/magazine, December.

short history. Now Netflix must realize how it can sustainits business livelihood in a cutthroat, highly competitiveindustry.

38. T. H. Davenport & J. G. Harris, 2007, Competing on analytics: Thenew science of winning, The Nature of Analytical Competition, http://harvardbusinessonline, 3.

39. Ibid., 4.40 . M. Kirdahy, 2007, Blockbuster takes on Netflix, Forbes, http://www

.forbes.com, January 3.41. 2007, Video on Demand (VODJ: About Broadband Movies, Downloads

and More, Broadbandinfo.com, http://www.broadbandinfo.com/gothigh-speed/video-cn-

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78. Ibid.79. 2007. About Movie Gallery, Moviegallery.com, http://www

.moviegallery.com, March 18.80. Ibid.81. 2007, Movie Gallery to introduce online video rental service

and extend automated video vending machine program,Movie Gallery press release, http://phx.corporate-ir.net/phoenix.zhtml?c=85959&p=irol-newsArticle&ID=975465&highlight=,March 25.

82. 2007. Movie Gallery to launch online service, htt p://w ww.businessweek.com, March 19; R.C. Lim, 2007. Movie Gallerymayhem, Motley Fool Stock Advisor, www.fool.com/investing,July 24.

83. Ibid.84. P. Sweeting & C. Spielvogel, 2007. Movie Gallery acquires

MovieBeam, www.videobusiness.com, March 7; 2007, Movie GalleryNews Release, http://www.moviegallery.com, March 7.

85. Ibid.86. Ibid.87. 2007. Hastings Entertainment, Hoovers.com, http://premium.hoovers

.com/subscribe/co/overview.xhtmi?ID=ffffctthjfcxryycrk, February 10.88. 2007. About Hastings, Gohastings.com,http://www.gohastings.com/lnvestor/AboutHastings.stm, February 10.89. 2007. Netflix Full Overview, http://premium.hoovers.com, February 10.90. Ibid.91. 2006, Netflix Inc. Annual Report.92. Ibid.93. Ibid.94. 2007. Motion Picture access, major film studios in the U.S ., http://

ncam.wgbh.org/mopix/studios.html.95. 2006, Netflix Inc. Annual Report.96. Ibid.97. Ibid.98. Ibid.99. Ibid.100. Ibid.101. Ibid.102 . Ibid.

103. Ibid.104. M. Levy, 2002, Net flix analyzed via the value framework, ht tp://www

.valueframeworkinstitute.org/May2002/feature.article.htm, May105. T H. Davenport & J. G. Harris, 2007, Competing on analytics.106. Ibid.107. Ibid.108. Ibid.109 . Ibid.110. 2006, Frequent Netflix renters sent to the back of the line,

Associated Press, http://www.msnbc.msn.com/id/11262292/,February 10 .111. P. Sauer, 2005, How I did it: Reed Hastings, Netflix.112 . 2001, Best Buy and Netflix offer co-branded online DVD movie rental

service, Retailer Merchandiser. http://www.allbusiness.com/retail,September 11.

113. P. Sauer, How I did it: Reed Hastings, Netflix.114. 2006, Netflix Inc. Annual Report.115. L. Punch, 2007. Advertising to the masses, htt p://ww w

.internetretailer.com, January.116. Ibid.117. Ibid118. 2006 Netflix Inc. Annual Report.119. Ibid .120. Ibid.121. 2007. Historical prices for Netflix Inc., Yahoo! Finance, http://finance

.yahoo.com/q/hp? s=NFLX&a =OO&b= 5&c=2002&d=03&e= 17&f=2007&g=m.122. 2007. Summary for Netflix Inc., Yahoo! Finance,http://finance.yahoo

.com/q ?s=nflx&x=O&y=O.123. 2007. Netflix Inc. performance, http://stocks.us.reuters.com/stocks/

performance.asp?symboi=NFLX.O&WTmodLOC=L2-LeftNav-18-Performace.

124. 2006, Netflix Inc. Annual Report.125. 2007. Netflix Inc. ratios, http://stocks.us.reuters .com/stocks/ratios

.asp?symboi=NFLX.O&WTmodLOC=L2-LeftNav-16-Ratios.126. 2006, Netflix Inc. Annual Report.127. Ibid.

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