Chapter 4: Netflix: The Making of an E-commerce Giant and the Uncertain Future of Atoms to Bits

Why Study Netflix?

Studying Netflix gives us a chance to examine how technology helps firms craft and reinforce a competitive advantage. We’ll pick apart the components of the firm’s strategy and learn how technology played a starring role in placing the firm atop its industry. We also realize that while Netflix emerged the victorious underdog at the end of the first show, there will be at least one sequel, with the final scene yet to be determined. We’ll finish the case with a look at the very significant challenges the firm faces as new technology continues to shift the competitive landscape.

Selection: The Long Tail in Action

Customers have flocked to Netflix in part because of the firm’s staggering selection. A traditional video store (and Blockbuster had some 7,800 of them) stocks roughly three thousand DVD titles on its shelves. For comparison, Netflix is able to offer its customers a selection of over one hundred thousand DVD titles, and rising! At traditional brick-and-mortar retailers, shelf space is the biggest constraint limiting a firm’s ability to offer customers what they want when they want it. Just which films, documentaries, concerts, cartoons, TV shows, and other fare make it inside the four walls of a Blockbuster store is dictated by what the average consumer is most likely to be interested in. To put it simply, Blockbuster stocks blockbusters.

Finding the right product mix and store size can be tricky. Offer too many titles in a bigger storefront and there may not be enough paying customers to justify stocking less popular titles (remember, it’s not just the cost of the DVD—firms also pay for the real estate of a larger store, the workers, the energy to power the facility, etc.). You get the picture—there’s a breakeven point that is arrived at by considering the geographic constraint of the number of customers that can reach a location, factored in with store size, store inventory, the payback from that inventory, and the cost to own and operate the store. Anyone who has visited a video store only to find a title out of stock has run up against the limits of the physical store model.

But many online businesses are able to run around these limits of geography and shelf space. Internet firms that ship products can get away with having just a few highly automated warehouses, each stocking just about all the products in a particular category. And for firms that distribute products digitally (think songs on iTunes), the efficiencies are even greater because there’s no warehouse or physical product at all (more on that later).

Offer a nearly limitless selection and something interesting happens: there’s actually more money to be made selling the obscure stuff than the hits. Music service Rhapsody makes more from songs outside of the top ten thousand than it does from songs ranked above ten thousand. At Amazon.com, roughly 60 percent of books sold are titles that aren’t available in even the biggest Borders or Barnes & Noble Superstores.C. Anderson, “The Long Tail,” Wired 12, no. 10 (October 2004), http://www.wired.com/wired/archive/12.10/tail.html. And at Netflix, roughly 75 percent of DVD titles shipped are from back-catalog titles, not new releases (at Blockbuster outlets the equation is nearly flipped, with some 70 percent of business coming from new releases).B. McCarthy, “Netflix, Inc.” (remarks, J. P. Morgan Global Technology, Media, and Telecom Conference, Boston, May 18, 2009). Consider that Netflix sends out forty-five thousand different titles each day. That’s fifteen times the selection available at your average video store! Each quarter, roughly 95 percent of titles are viewed—that means that every few weeks Netflix is able to find a customer for nearly every DVD title that has ever been commercially released.

This phenomenon whereby firms can make money by selling a near-limitless selection of less-popular products is known as the long tailIn this context, refers to an extremely large selection of content or products. The long tail is a phenomenon whereby firms can make money by offering a near-limitless selection.. The term was coined by Chris Anderson, an editor at Wired magazine, who also wrote a best-selling business book by the same name. The “tail” (see Figure 4.2 “The Long Tail”) refers to the demand for less popular items that aren’t offered by traditional brick-and-mortar shops. While most stores make money from the area under the curve from the vertical axis to the dotted line, long tail firms can also sell the less popular stuff. Each item under the right part of the curve may experience less demand than the most popular products, but someone somewhere likely wants it. And as demonstrated from the examples above, the total demand for the obscure stuff is often much larger than what can be profitably sold through traditional stores alone. While some debate the size of the tail (e.g., whether obscure titles collectively are more profitable for most firms), two facts are critical to keep above this debate: (1) selection attracts customers, and (2) the Internet allows large-selection inventory efficiencies that offline firms can’t match.

The long tail works because the cost of production and distribution drop to a point where it becomes economically viable to offer a huge selection. For Netflix, the cost to stock and ship an obscure foreign film is the same as sending out the latest Will Smith blockbuster. The long tail gives the firm a selection advantage (or one based on scale) that traditional stores simply cannot match.

For more evidence that there is demand for the obscure stuff, consider Bollywood cinema—a term referring to films produced in India. When ranked by the number of movies produced each year, Bollywood is actually bigger than Hollywood, but in terms of U.S. demand, even the top-grossing Hindi film might open in only one or two American theaters, and few video stores carry many Bollywood DVDs. Again, we see the limits that geography and shelf space impose on traditional stores. As Anderson puts it, when it comes to traditional methods of distribution, “an audience too thinly spread is the same as no audience at all.”C. Anderson, “The Long Tail,” Wired 12, no. 10 (October 2004), http://www.wired.com/wired/archive/12.10/tail.html. While there are roughly 1.7 million South Asians living in the United States, Bollywood fans are geographically disbursed, making it difficult to offer content at a physical storefront. Fans of foreign films would often find the biggest selection at an ethnic grocery store, but even then, that wouldn’t be much. Enter Netflix. The firm has found the U.S. fans of South Asian cinema, sending out roughly one hundred thousand Bollywood DVDs a month. As geographic constraints go away, untapped markets open up!

The power of Netflix can revive even well-regarded work by some of Hollywood’s biggest names. In between The Godfather and The Godfather Part II, director Francis Ford Coppola made The Conversation, a film starring Gene Hackman that, in 1975, was nominated for a Best Picture Academy Award. Coppola has called The Conversation the finest film he has ever made,D. Leonhardt, “What Netflix Could Teach Hollywood,” New York Times, June 7, 2006. but it was headed for obscurity as the ever-growing pipeline of new releases pushed the film off of video store shelves. Netflix was happy to pick up The Conversation and put it in the long tail. Since then, the number of customers viewing the film has tripled, and on Netflix, this once underappreciated gem became the thirteenth most watched film from its time period.

For evidence on Netflix’s power to make lucrative markets from nonblockbusters, visit the firm’s “Top 100 page.”http://www.netflix.com/Top100. You’ll see a list loaded with films that were notable for their lack of box office success. As of this writing the number one rank had been held for over five years in a row, not by a first-run mega-hit, but by the independent film Crash (an Oscar winner, but box office weakling).R. Elder, “‘Crash’ Remains Top DVD Rental,” Chicago Tribune, April 14, 2009.

Netflix has used the long tail to its advantage, crafting a business model that creates close ties with film studios. In most cases, studios earn a percentage of the subscription revenue for every disk sent out to a Netflix customer. In exchange, Netflix gets DVDs at a very low cost. The movie business is characterized by large fixed costs up front. Studio marketing budgets are concentrated on films when they first appear in theaters, and when they’re first offered on DVD. After that, studios are done promoting a film, focusing instead on their most current titles. But Netflix is able to find an audience for a film without the studios spending a dime on additional marketing. Since so many of the titles viewed on Netflix are in the long tail, revenue sharing is all gravy for the studios—additional income they would otherwise be unlikely to get. It’s a win-win for both ends of the supply chain. These supplier partnerships grant Netflix a sort of soft bargaining power that’s distinctly opposite the strong-arm price bullying that giants like Wal-Mart are often accused of.

Cinematch: Technology Creates a Data Asset That Delivers Profits

Netflix proves there’s both demand and money to be made from the vast back catalog of film and TV show content. But for the model to work best, the firm needed to address the biggest inefficiency in the movie industry—“audience finding,” that is, matching content with customers. To do this, Netflix leverages some of the industry’s most sophisticated technology, a proprietary recommendation system that the firm calls Cinematch.

Each time a customer visits Netflix after sending back a DVD, the service essentially asks “So, how did you like the movie?” With a single click, each film can be rated on a scale of one to five stars. If you’re new to Netflix, the service can prompt you with a list of movies (or you can search out and rate titles on your own). Love Rushmore but hate The Life Aquatic? Netflix wants to know.

The magic of Cinematch happens not by offering a gross average user rating—user tastes are too varied and that data’s too coarse to be of significant value. Instead, Cinematch develops a map of user ratings and steers you toward titles preferred by people with tastes that are most like yours. Techies and marketers call this trick collaborative filteringA classification of software that monitors trends among customers and uses this data to personalize an individual customer’s experience.. The term refers to a classification of software that monitors trends among customers and uses this data to personalize an individual customer’s experience. Input from collaborative filtering software can be used to customize the display of a Web page for each user so that an individual is greeted only with those items the software predicts they’ll most likely be interested in. The kind of data mining done by collaborative filtering isn’t just used by Netflix; other sites use similar systems to recommend music, books, even news stories. While other firms also employ collaborative filtering, Netflix has been at this game for years, and is constantly tweaking its efforts. The results are considered the industry gold standard.

Collaborative filtering software is powerful stuff, but is it a source of competitive advantage? Ultimately it’s just math. Difficult math, to be sure, but nothing prevents other firms from working hard in the lab, running and refining tests, and coming up with software that’s as good, or perhaps one day even better than Netflix’s offering. But what the software has created for the early-moving Netflix is an enormous data advantage that is valuable, results yielding, and impossible for rivals to match. Even if Netflix gave Cinematch to its competitors, they’d be without the over 3 billion ratings that the firm has amassed (according to the firm, users add about a million new ratings to the system each day). More ratings make the system seem smarter, and with more info to go on, Cinematch can make more accurate recommendations than rivals.

Evidence suggests that users trust and value Cinematch. Recommended titles make up over 60 percent of the content users place in their queues—an astonishing penetration rate. Compare that to how often you’ve received a great recommendation from the sullen teen behind the video store counter. While data and algorithms improve the service and further strengthen the firm’s brand, this data is also a switching cost. Drop Netflix for Blockbuster and the average user abandons the two hundred or more films they’ve rated. Even if one is willing to invest the time in recreating their ratings on Blockbuster’s site, the rival will still make less accurate recommendations because there are fewer users and less data to narrow in on similarities across customers.

One way to see how strong these switching costs are is to examine the Netflix churn rateThe rate at which customers leave a product or service.. Churn is a marketing term referring to the rate at which customers leave a product or service. A low churn is usually key to profitability because it costs more to acquire a customer than to keep one. And the longer a customer stays with the firm, the more profitable they become and the less likely they are to leave. If customers weren’t completely satisfied with the Netflix experience, many would be willing to churn out and experiment with rivals offering cheaper service. However, the year after Blockbuster and Wal-Mart launched with copycat efforts, the rate at which customers left Netflix actually fell below 4 percent, an all-time low. And the firm’s churn rates have continued to fall over time. By the middle of 2008, rates for customers in Netflix most active regions of the country were below 3 percent, meaning fewer than three in one hundred Netflix customers canceled their subscriptions each year.Netflix Investor Day presentation, May 2008, accessed via http://ir.netflix.com/events.cfm. To get an idea of how enviable the Netflix churn rates are, consider that a year earlier the mobile phone industry had a churn rate of 38.6 percent, while roughly one in four U.S. banking customers defected that year.“Industry Customer Churn Rate Increases 15%,” GeoConnexion, January 8, 2008. The article contains a summary of the Pittney Bowes G1 finding.

All of this impacts marketing costs, too. Happy customers refer friends (free marketing from a source consumers trust more than a TV commercial). Ninety-four percent of Netflix subscribers say they have recommended the service to someone else, and 71 percent of new subscribers say an existing subscriber has encouraged them to sign up. It’s no wonder subscriber acquisition costs have been steadily falling, further contributing to the firm’s overall profitability.

A Look at Operations

Tech also lies at the heart of the warehouse operations that deliver customer satisfaction and enhance brand value. As mentioned earlier, brand is built through customer experience, and a critical component of customer experience is for subscribers to get their DVDs as quickly as possible. In order to do this, Netflix has blanketed the country with a network of fifty-eight ultrahigh-tech distribution centers that collectively handle in excess of 1.8 million DVDs a day. These distribution centers are purposely located within driving distance of 119 U.S. Postal Service (USPS) processing and distribution facilities.

By 4:00 a.m. each weekday, Netflix trucks collect the day’s DVD shipments from these USPS hubs and returns the DVDs to the nearest Netflix center. DVDs are fed into custom-built sorters that handle disc volume on the way in and the way out. That same machine fires off an e-mail as soon as it detects your DVD was safely returned (now rate it via Cinematch). Most DVDs never hit the restocking shelves. Scanners pick out incoming titles that are destined for other users and place these titles into a sorted outbound pile with a new, appropriately addressed red envelope. Netflix not only helps out the postal service by picking up and dropping off the DVDs at its hubs, it presorts all outgoing mail for faster delivery. This extra effort has a payoff—Netflix gets the lowest possible postal rates for first-class mail delivery. And despite the high level of automation, 100 percent of all discs are inspected by hand so that cracked ones can be replaced, and dirty ones can be given a wipe down.B. McCarthy, “Netflix, Inc.” (remarks, J. P. Morgan Global Technology, Media, and Telecom Conference, Boston, May 18, 2009). Total in and out turnaround time for a typical Netflix DVD is just eight hours!N. Kenny, “Special Report: Inside Netflix,” WMC TV, July 7, 2009.

First-class mail takes only one day to be delivered within a fifty-mile radius, so the warehouse network allows Netflix to service over 97 percent of its customer base within a two-day window—one day is allotted for receipt; early the next morning the next item in their queue is processed; and the new title arrives at the customer’s address by that afternoon. And in 2009, the firm added Saturday processing. All this means a customer with the firm’s most popular “three disc at a time” plan could watch a movie a day and never be without a fresh title.

Warehouse processes don’t exist in a vacuum; they are linked to Cinematch to offer the firm additional operational advantages. The software recommends movies that are likely to be in stock so users aren’t frustrated by a wait.

Everyone on staff is expected to have an eye on improving the firm’s processes. Every warehouse worker gets a free DVD player and Netflix subscription so that they understand the service from the customer’s perspective and can provide suggestions for improvement. Quality management features are built into systems supporting nearly every process at the firm, allowing Netflix to monitor and record the circumstances surrounding any failures. When an error occurs, a tiger team of quality improvement personnel swoops in to figure out how to prevent any problems from recurring. Each phone call is a cost, not a revenue enhancement, and each error increases the chance that a dissatisfied customer will bolt for a rival.

By paying attention to process improvements and designing technology to smooth operations, Netflix has slashed the number of customer representatives even as subscriptions ballooned. In the early days, when the firm had one hundred and fifteen thousand customers, Netflix had one-hundred phone support reps. By the time the customer base had grown thirtyfold, errors had been reduced to the point where only forty-three reps were needed.J. McGregor, “High Tech Achiever,” Fast Company, October 2005. Even more impressive, because of the firm’s effective use of technology to drive the firm’s operations, fulfillment costs as a percentage of revenue have actually dropped even though postal rates have increased and Netflix has cut prices.

Killer Asset Recap: Understanding Scale

Netflix executives are quite frank that the technology and procedures that make up their model can be copied, but they also realize the challenges that any copycat rival faces. Says the firm’s VP of Operations Andy Rendich, “Anyone can replicate the Netflix operations if they wish. It’s not going to be easy. It’s going to take a lot of time and a lot of money.”Netflix Investor Day presentation, 2008, accessed via http://ir.netflix.com/events.cfm.

While we referred to Netflix as David to the Goliaths of Wal-Mart and Blockbuster, within the DVD-by-mail segment Netflix is now the biggest player by far, and this size gives the firm significant scale advantages. The yearly cost to run a Netflix-comparable nationwide delivery infrastructure is about $300 million.S. Reda and D. Schulz, “Concepts that Clicked,” Stores, May 2008. Think about how this relates to economies of scale. In Chapter 2 “Strategy and Technology: Concepts and Frameworks for Understanding What Separates Winners from Losers”, we said that firms enjoy scale economies when they are able to leverage the cost of an investment across increasing units of production. Even if rivals have identical infrastructures, the more profitable firm will be the one with more customers (see Figure 4.7). And the firm with better scale economies is in a position to lower prices, as well as to spend more on customer acquisition, new features, or other efforts. Smaller rivals have an uphill fight, while established firms that try to challenge Netflix with a copycat effort are in a position where they’re straddling markets, unable to gain full efficiencies from their efforts.

For Blockbuster, the arrival of Netflix plays out like a horror film where it is the victim. For several years now, the in-store rental business has been a money loser. Things got worse in 2005 when Netflix pressure forced Blockbuster to drop late fees, costing it about $400 million.T. Mullaney, “Netflix: The Mail-Order House That Clobbered Blockbuster,” BusinessWeek, May 25, 2006. The Blockbuster store network once had the advantage of scale, but eventually its many locations were seen as an inefficient and bloated liability. Between 2006 and 2007, the firm shuttered over 570 stores.A. Farrell, “Blockbuster’s CEO Ousted,” Forbes, July 2, 2007. By 2008, Blockbuster had been in the red for ten of the prior eleven years. During a three-year period that included the launch of its Total Access DVD-by-mail effort, Blockbuster lost over $4 billion.N. MacDonald, “Blockbuster Proves It’s Not Dead Yet,” Maclean’s, March 12, 2008. The firm tried to outspend Netflix on advertising, even running Super Bowl ads for Total Access in 2007, but a money loser can’t outspend its more profitable rival for long, and it has since significantly cut back on promotion. Blockbuster also couldn’t sustain subscription rates below Netflix’s, so it has given up its price advantage. In early 2008, Blockbuster even briefly pursued a merger with another struggling giant, Circuit City, a strategy that has left industry experts scratching their heads. A Viacom executive said about the firm, “Blockbuster will certainly not survive and it will not be missed.”E. Epstein, “Hollywood’s New Zombie: The Last Days of Blockbuster,” Slate, January 9, 2006, http://www.slate.com/id/2133995. This assessment has to sting, given that Viacom was once Blockbuster’s parent (the firm was spun off in 2004).

For Netflix, what delivered the triple scale advantage of the largest selection; the largest network of distribution centers; the largest customer base; and the firm’s industry-leading strength in brand and data assets? Moving first. Timing and technology don’t always yield sustainable competitive advantage, but in this case, Netflix leveraged both to craft what seems to be an extraordinarily valuable pool of assets that continue to grow and strengthen over time. To be certain, competing against a wounded giant like Blockbuster will remain difficult. The latter firm has few options and may spend itself into oblivion, harming Netflix in its collapsing gasp. And as we’ll see in the next section, while technology shifts helped Netflix attack Blockbuster’s once-dominant position, even newer technology shifts may threaten Netflix. As they like to say in the mutual fund industry “Past results aren’t a guarantee of future returns.”

Access to Content

First the content. Three years after the launch of Netflix streaming option (enabled via a “Watch Now” button next to movies that can be viewed online), only 17,000 videos were offered, just 17 percent of the firm’s long tail. And not the best 17 percent. Why so few titles? It’s not just studio reluctance or fear of piracy. There are often complicated legal issues involved in securing the digital distribution rights for all of the content that makes up a movie. Music, archival footage, and performer rights may all hold up a title from being available under “Watch Now.” The 2007 Writers Guild strike occurred largely due to negotiations over digital distribution, showing just how troublesome these issues can be.

Add to that the exclusivity contracts negotiated by key channels, in particular the so-called premium television networks. Film studios release their work in a system called windowingIndustry practice whereby content (usually a motion picture) is available to a given distribution channel for a specified time period or “window,” usually under a different revenue model (e.g., ticket sale, purchase, license fee).. Content is available to a given distribution channel (in theaters, through hospitality channels like hotels and airlines, on DVD, via pay-per-view, via pay cable, then broadcast commercial TV) for a specified time window, usually under a different revenue model (ticket sales, disc sales, license fees for broadcast). Pay television channels in particular have negotiated exclusive access to content as they strive to differentiate themselves from one another. This exclusivity means that even when a title becomes available for streaming by Netflix, it may disappear when a pay TV window opens up. If HBO or Showtime has an exclusive for a film, it’s pulled from the Netflix streaming service until the exclusive pay TV time window closes. A 2008 partnership with the Starz network helped provide access to some content locked up inside pay television windows, and deals with Disney and CBS allow for streaming of current-season shows.S. Portnoy, “Netflix News: Starz Catalog Added to Online Service, Streaming to PS3, Xbox 360 through PlayOn Beta Software,” ZDNet, October 2, 2008, http://blogs.zdnet.com/home-theater/?p=120. But the firm still has a long way to go before the streaming tail seems comparably long when compared against its disc inventory.

While studios embrace the audience-finding and revenue-sharing advantages of Netflix, they also don’t want to undercut higher-revenue early windows. Fox, Universal, and Warner have all demanded that Netflix delay sending DVDs to customers until twenty-eight days after titles go on sale. In exchange, Netflix has received guarantees that these studios will offer more content for digital streaming.

There’s also the influence of the king of DVD sales: Wal-Mart. The firm accounts for about 40 percent of DVD sales—a scale that delivers a lot of the bargaining power it has used to “encourage” studios to hold content from competing windows or to limit offering digital titles at competitive pricing during the peak new release period.R. Grover, “Wal-Mart and Apple Battle for Turf,” BusinessWeek, August 31, 2006. Apparently, Wal-Mart isn’t ready to yield ground in the shifts from atoms to bits, either. In February 2010, the retail giant spent an estimated $100 million to buy the little-known video streaming outfit VUDU.B. Stone, “Wal-Mart Adds Clout to Streaming,” New York Times, February 22, 2010. Wal-Mart’s negotiating power with studios may help it gain special treatment for VUDU. As an example, VUDU was granted exclusive high-definition streaming rights for the hit movie Avatar, offering the title online the same day the DVD appeared for sale.J. Jacobson, “VUDU/Wal-Mart Gets Avatar HD Streaming Exclusive,” Electronic House, April 22, 2010.

Studios may also be wary of the increasing power Netflix has over product distribution, and as such, they may be motivated to keep rivals around. Studios have granted Blockbuster more favorable distribution terms than Netflix. In many cases, Blockbuster can now distribute DVDs the day of release instead of waiting nearly a month, as Netflix does.J. Birchall, “Blockbuster Strikes Deal to Ensure DVD Supply,” Financial Times, April 8, 2010. Studios are likely concerned that Netflix may be getting so big that it will one day have Wal-Mart-like negotiating leverage.

Taken together, all these factors make it clear that shifting the long tail from atoms to bits will be significantly more difficult than buying DVDs and stacking them in a remote warehouse.

But How Does It Get to the TV?

The other major problem lies in getting content to the place where most consumers want to watch it: the living room TV. Netflix’s “Watch Now” button first worked only on Windows PCs. Although the service was introduced in January 2007, the months before were fueled with speculation that the firm would partner with TiVo. Just one month later, TiVo announced its partner—Amazon.com. At that point Netflix found itself up against a host of rivals that all had a path to the television: Apple had its own hardware solution in Apple TV (not to mention the iPod and iPhone for portable viewing), the cable companies delivered OnDemand through their set-top boxes, and now Amazon had TiVo.

An internal team at Netflix developed a prototype set top box that Hastings himself supported offering. But most customers aren’t enthusiastic about purchasing yet another box for their set top, the consumer electronics business is brutally competitive, and selling hardware would introduce an entirely new set of inventory, engineering, marketing, distribution, and competitive complexities.

The solution Netflix eventually settled on was to think beyond one hardware alternative and instead recruit others to provide a wealth of choice. The firm developed a software platform and makes this available to firms seeking to build Netflix access into their devices. Today, Netflix streaming is baked into televisions and DVD players from LG, Panasonic, Samsung, Sony, Toshiba, and Vizio, among others. It’s also available on all major video game consoles. A Netflix app for Apple’s iPad was available the day the device shipped. Even TiVo now streams Netflix. And that internally developed Netflix set-top box? The group was spun out to form Roku, an independent firm that launched their own $99 Netflix streamer.

The switch to Blu-ray movies may offer the most promise. Blu-ray players are on the fast track to commoditization. If consumer electronics firms incorporate Netflix access into their players as a way to attract more customers with an additional, differentiating feature, Hastings’s firm could end up with more living room access than either Amazon or Apple. There are 73 million households in the United States that have a DVD player and an Internet connection. Should a large portion of these homes end up with a Netflix-ready Blu-ray player, Hastings will have built himself an enviable base through which to grow the video streaming business.

Who’s going to win the race for delivering bits to the television is still very much an uncertain bet. The models all vary significantly. Apple’s early efforts were limited, with the firm offering only video purchases for Apple TV, but eventually moving to online “rentals” that can also play on the firm’s entire line of devices. Movie studios are now all in Apple’s camp, although the firm did temporarily lose NBC’s television content in a dispute over pricing. Amazon and Microsoft also have online rentals and purchase services, and can get their content to the television via TiVo and Xbox, respectively (yes, this makes Microsoft both a partner and a sort of competitor, a phenomenon often referred to as coopetitionWhen firms find themselves in situations where they are both competitors and collaborators, or “frenemies.” Technology is increasingly redefining products, pushing the boundaries of delivery channels, and creating situations where firms often find themselves in these collaborative/rival relationships., or frenemiesA. Brandenberger and B. Nalebuff, Co-opetition: A Revolution Mindset that Combines Competition and Cooperation: The Game Theory Strategy That’s Changing the Game of Business (New York: Broadway Business, 1997); and S. Johnson, “The Frenemy Business Relationship,” Fast Company, November 25, 2008.). Hulu, a joint venture backed by NBC, Fox, and other networks, is free, earning money from ads that run like TV commercials. While Hulu has also received glowing reviews, the venture has lagged in offering a method to get streaming content to the television. Netflix pioneered “all-you-can-eat” subscription streaming. Anyone who has at least the $8.99 subscription plan can view an unlimited number of video streams. And Blockbuster isn’t dead yet. It also streams over TiVo and has other offerings in the works.

There’s a clear upside to the model when it shifts to streaming: it will eliminate a huge chunk of costs associated with shipping and handling. Postage represents one-third of the firm’s expenses. A round-trip DVD mailing, even at the deep discounts Netflix receives from the U.S. Postal Service, runs about eighty cents. The bandwidth and handling costs to send bits to a TV set are around a nickel.B. McCarthy, “Netflix, Inc.” (remarks, J. P. Morgan Global Technology, Media, and Telecom Conference, Boston, May 18, 2009). At some point, if postage goes away, Netflix may be in a position to offer even greater profits to its studio suppliers, and to make more money itself, too.

Wrangling licensing costs presents a further challenge. Estimates peg Netflix 2009 streaming costs at about $100 million, up 250 percent in three years. But these expenses still deliver just a fraction of the long tail. Streaming licensing deals are tricky because they’re so inconsistent even when titles are available. Rates vary, with some offered via a flat rate for unlimited streams, a per-stream rate, a rate for a given number of streams, and various permutations in between. Some vendors have been asking as much as four dollars per stream for more valuable contentD. Rayburn, “Netflix Streaming Costs,” Streaming Media, June/July 2009.—a fee that would quickly erase subscriber profits, making any such titles too costly to add to the firm’s library. Remember, Netflix doesn’t charge more for streaming—it’s built into the price of its flat-rate subscriptions.

Any extra spending doesn’t come at the best time. The switch to Blu-ray movies means that Netflix will be forced into the costly proposition of carrying two sets of video inventory: standard and high-def. Direct profits may not be the driver. Rather, the service may be a feature that attracts new customers to the firm and helps prevent subscriber flight to rival video-on-demand efforts. The stealth arrival of a Netflix set-top box, in the form of upgraded Blu-ray players, might open even more customer acquisition opportunities to the firm. Bought a Blu-ray player? For just nine dollars per month you can get a ticket to the all-you-can-eat Netflix buffet. And more customers ready to watch content streamed by Netflix may prime the pump for studios to become more aggressive in licensing more of their content. Many TV networks and movie studios are leery of losing bargaining power to a dominant firm, having witnessed how Apple now dictates pricing terms to music labels. The goodwill Netflix has earned over the years may pay off if it can become the studios’ partner of first choice.

While one day the firm will lose the investment in its warehouse infrastructure, nearly all assets have a limited lifespan. That’s why corporations depreciate assets, writing their value down over time. The reality is that the shift from atoms to bits won’t flick on like a light switch; it will be a hybrid transition that takes place over several years. If the firm can grab long-tail content, grow its customer base, and lock them in with the switching costs created by Cinematch (all big “ifs”), it just might emerge as a key player in a bits-only world.

Is the hybrid strategy a dangerous straddling gambit or a clever ploy to remain dominant? Netflix really doesn’t have a choice but to try. Hastings already has a long history as one of the savviest strategic thinkers in tech. As the networks say, stay tuned!