A few years ago, a friend of mine made a statement that I found hard to believe at the time, but have come to appreciate greatly. He mentioned that while the hard disciplines of business (accounting, finance, and marketing) were important, companies lived and died by the soft disciplines, especially strategy. In the age of the “quants” I was skeptical of his statement. However, a quick review shows that the fortunes of companies are controlled by strategic decisions. Netflix is a perfect example of a company whose fortunes rose, and will fall, by strategy rather than by the getting the numbers right.
The Rise of Netflix
The rise of Netflix is a text-book example of the power of proper strategic planning. They came into a “Red-Ocean” full of cut-throat competitors. Brick and mortar movie rental companies competed on number and location of outlets, selection, availability of new releases and cross-selling to improve margins. The competition was not limited to video rental stores like Blockbuster and Hollywood video, grocery stores, cable companies, and satellite service providers competed in the same market.
In such environment, Netflix offering disrupted the market in a way that let them create a new “Blue Ocean” in which they played alone. Their DVD-by-mail subscription model was so attractive to consumer that they grew by leaps and bounds, and ended up putting many video rental companies out of business. Companies like Blockbuster and Hollywood Video just couldn’t compete. Netflix had no brick and mortar locations, so their cost structure was much lower. They mailed DVDs from large regional warehouses, and were able to carry a large selection of films because they weren’t limited by a store size. Moreover, because they were readily able to collect data on rentals, it was easy for them to customize their service based on the subscriber’s preferences.
The Netflix subscription model was a game changer: customer could keep movies as long as they wanted without incurring late fees, could rent and send back as many movies as they could watch, and had access to a library of films unrivaled by any of Netflix’s competitor.
In 2009 a colleague of mine and I analyzed Netflix strategy. We looked at the company’s “Value Canvass” in comparison to direct competitors like Blockbuster, and indirect competitors like HBO, and scored the companies on 11 dimensions as shown in the chart below:
While the competition competed on convenience and spontaneity, Netflix business model allowed to not only compete in areas where the competition was week; such as selection, flexibility and availability of new releases; it also allowed the company to add two dimensions that weren’t available for the competition.
Netflix showed its prowess in the “hard” business disciplines by crowd sourcing an algorithm that recommended movies to subscribers based on their review of the movies they had watched. This was a strong differentiator because the competition didn’t even have the option of adding such offering. In addition, a connection to Facebook allowed subscribers to leverage social media in recommending movies to their friends directly from Netflix.com.
Netflix strategy worked beautifully. The charts below show that the number of subscribers was increasing almost at a logarithmic rate, and that the operating margin was trending up.
Not only was the company adding subscribers like it was going out of style, it was making more money per subscriber. Netflix became a Wall Street darling. From July 2009 to July 2011, the stock price went from around $39 to about $297.
Our study concluded that Netflix faced two main risks:
- Lack of Spontaneity: Netflix customers had to plan ahead of time to watch a movie. They had to put DVDs in their “queue” and wait for them to be mailed. If they didn’t feel like watching the movie(s) they had at home at that time, they had to wait at least 3 days to get a different one(s).
- Cost of content: Other forms of content delivery (mainly streaming) removed the control over the cost of content afforded by the “First-Sale Doctrine.” This was bound to put pressure on operating margins.
In the past two months the above risks materialized and Netflix stock price went from $297 to $117.
In the next installment we will discuss how the “Blue Ocean” Netflix dominated turned red.