2010

Santa Clara University

MGMT 162- Capstone

Professor Schneider

Winter Quarter:2010

NETFLIX:
A COMPANY ANALYSIS
Prepared By Group 5: Alex Krengel, Annie Dudek, Rick Momboisse, Trish Paik, & Tyler Martin
 Table of Contents
I. Wall Street Journal Article and Executive Summary ..4
I A. Wall Street Journal Article 4
I B. Executive Summary ..5
II. External Analysis ..7
II A. Industry Definition ..7
II B. Six Industry Force Analysis ..8
II C. Macro Environmental Forces Analysis, Economic Trends, and Ethical Concerns ..15
II D. Competitor Analysis ..17
II D. Netfli ’s Co petito s ..17
II D. Netfli ’s P i a Co petito s ..17
II D. P i a Co petito s’ Busi ess Le el a d Co po ate Le el “t ateg ..18
II D. 4 How Competitors Achieve Their Strategic Position ..18
II D. 5 Willingness to Pay ..21
II D. 6 Comparative Financial Analysis ..22
II D. 7 Implications of Competitor Analysis ..23
II E. Intra-Industry Analysis ..24
III. Internal Analysis ..24
III A. Business Definition/Mission ..24
III B. Management Style ..24
III C. Organizational Structure, Controls and Values ..25
III C. 1 Organizational Structure ..25
III C. 2 Organizational Controls ..25
III C. 3 Organizational Values ..25
III D. Strategic Position Definition ..26
III D. 1 Corporate Level ..26
III D. 2 Business Level ..27
III D. 3 Resource & Capability Level ..28
Value Minus Cost Profile ..28
Value Chain ..28
VRIO Analysis ..28
Consumer Retention Analysis ..29
4Ps Analysis ..29
Product Life Cycle ..30
III E. Financial Analysis ..31
III E. 1 Netflix Financial Performance Analysis ..31
III E. 2 Valuation of Netflix ..32
III E. 3 Scenario Analysis ..33
IV. Analysis of the Effectiveness of the Strategy ..34
V. Recommendations ..35
V A. Short-Term and Long-Term Recommendations ..35
V A. 1 Short-Term Recommendations ..35
V A. 2 Long-Term Recommendations ..36
V B. Strategy Implementation ..38
V B. 1 Short-Term Strategy Implementation: Video Game Industry ..38
V B. 2 Long-Term Strategy Implementation: Streaming ..38
V C. Corporate Social Responsibility and Ethical Decision-Making Practices ..39
VI. Conclusions ..39
VII. Bibliography ..40

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VIII. Main Appendix ..43
Exhibit 1: Video Entertainment Industry Diagram ..43
Exhibit 2: Average Weekly Hours of Consumption by Age ..43
Exhibit 3: Average Weekly Hours of Consumption by Age Chart ..44
Exhibit 4: Leisure Activities at Home, by Age ..45
Exhibit 5: Hours Available for Leisure per Week ..46
Exhibit 6: Industry Six Forces Analysis ..47
Complements .. 47
Threat of Entry ..48
Supplier Power ..50
Buyer Power ..53
Rivalry ..55
Substitutes ..56
Exhibit 7: Market Share (Retail and Rental) ..57
Exhibit 8: Market Share (Rental) ..57
Exhibit 9: Average Annual Sales Growth ..58
Exhibit 10: Average Gross Profit Margin ..58
Exhibit 11: Average Return on Assets ..59
Exhibit 12: Average Debt-to-Equity ..60
Exhibit 13: Current Ratio ..60
Exhibit 14: Average Collection Period ..61
Exhibit 15: Average Asset Turnover ..61
Exhibit 16: Average Inventory Holding Period ..62
Exhibit 17: Industry Financial Ratios ..63
Exhibit 18: Netflix, Inc. Organizational Chart ..69
Exhibit 19: BCG Matrix ..69
Exhibit 20: VRIO Framework ..70
Exhibit 21: Value Chain ..71
Exhibit 22: Netflix, Inc. 2008 Income Statement ..71
Exhibit 23: Cost of Debt/Cost of Equity ..72
Exhibit 24: WACC Weights ..73
Exhibit 25: Netflix, Inc. Income Statement Plus Warner Bros. Agreement Changes ..74
Exhibit 26: Cost of Debt/Cost of Equity ..75
Exhibit 27: WACC Weights ..76
Exhibit 28: WACC Calculation ..78
Exhibit 29: Capital Expenditure ..79
Exhibit 30: Net Working Capital ..79
IX. Financial Background Appendix ..79
IX A. Netflix Current Value 2008 ..79
IX A. 1 Justification of Approaches ..79
IX A. 2 FCF Analysis ..80
IX A. 3 Growth Metrics ..82
IX A. 4 Free Cash Flows ..83
IX B. Netflix Valuation Incorporating the Warner Bros. Deal ..84
IX B. 1 FCF Analysis ..84
IX B. 2 Growth Metrics ..86
IX B. 3 Free Cash Flows ..88

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I. Wall Street Journal & Executive Summary
I A. Wall Street Journal Article
UPDATE: Netflix, Warner Bros. Reach New Deal
By David B. Wilkerson
January 6, 2010
Online DVD rental pioneer Netflix Inc. (NFLX) has reached a new deal with Warner Bros. Home
Entertainment that will make new Warner Bros. DVD and Blu-ray titles available for rental 28
days after their release, the companies said Wednesday.

The new agreement addresses the shifting preferences of consumers who appear more
reluctant to buy DVDs in a shaky U.S. economy and a wider array of entertainment options.

Terms of the latest deal also cover Warner Bros. titles made available for streaming to Netflix
customers. Streaming is an increasingly important part of the company's strategy in the digital
age; the number of subscribers who streamed a movie or television episode from Netflix jumped
by 20% over the third quarter of last year.

Warner Bros. Home Entertainment, owned by Time Warner Inc. (TWX), announced its intention
several months ago to renegotiate terms with Netflix. Time Warner Chief Executive Jeff Bewkes
told investors in September that the previous deal's economics didn't "make sense" for the
studio.

Most DVD sales come in the first weeks of a title's release. In October, Netflix CEO Reed Hastings
said his company would not be opposed to a "sales-only" window of about a month at any
studio, as long as Netflix could reach favorable terms.

"We've been discussing new approaches with Warner Bros. for some time now and believe
we've come up with a creative solution that is a 'win-win' all around," said Ted Sarandos, chief
content officer for Netflix, in a statement.

Ron Sanders, president of Warner Bros. Home Entertainment, said "The 28-day window allows
us to continue making our most popular films available to Netflix subscribers while supporting
our sell-through product."

The weakened economy and the advent of $1 rentals, most notably from kiosks operated by
Coinstar Inc.'s (CSTR) Redbox, have contributed to this trend towards fewer sales and more
rentals.

But because the majority of Netflix's shipments to customers are catalog titles, it is less
dependent on new releases than its DVD-based competitors. For that reason, the company is
perhaps better positioned to adapt to a delayed-rental strategy faster than its rivals - most
pointedly, Redbox.

Still, Netflix said Wednesday that its new agreement with Warner Bros. gives it better access to
new releases, which currently account for about 30% of its total shipments.

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Netflix shares were up 3.2%, at $53.15 in late-afternoon trading Wednesday. Time
Warner stock was down marginally, at $29.04.

I B. Executive Summary
Netflix Inc. is in the home video entertainment market, within the larger video entertainment
industry. Horizontal markets include Airline, Hotel and Theater video entertainment markets.
All four markets together make up the industry. Video rental and retail combined made
Netfli ’s a ket o th $ . illio i . BBI The market is segmented into a number of
strategic groups, which include brick and mortar rental and sales, DVD vending kiosks, online
rentals and sales, mail-delivery services, and video-on-demand services accessible through the
television.

Due to rapid technology convergence, which characterizes the quality of the disruptive
technologies, the rental portion of the market is changing from physical rentals to digital rentals,
provided via streaming channels through broadband-connected set-top boxes, game consoles,
and computers. All o k to i g st ea i g o te t st aight to the o su e ’s tele isio ,
making viewing interactive, easier, and available whenever the consumer wants it.

Consumers may be broken into two segments, needy consumers and convenience consumers.
Needy consumers are typically older, and less prone to using new technologies and are
committed to watching specific programming, while convenience consumers are younger,
watching video when they can, often utilizing technologies to access titles on their schedule.

Netfli ’s p i a o petito s a e Blo k uste a d Co ast. Blo k uste has the ajo it of the
market share (52 percent), Netflix has 13 percent, and Comcast has 3 percent. Netflix adds most
value to consumers through low capital and input costs, and through convenience of streaming
video.
For our comparative financial analysis, we took five years of data (from 2004 to 2008) and
compared competitors based on growth, profitability, leverage, liquidity, and efficiency. Netflix
saw the most growth on average (40.3 percent/year), whereas Blockbuster saw negative
average growth (- 2.16 percent/year). Blockbuster, Netflix, and Comcast all saw good positive
profit margins, but in terms of efficiency Blockbuster and Comcast had return on assets below
the industry average. Netflix is the most efficient out of these three companies, with an ROA of
10.39 percent. Netflix also does not leverage its business with debt, whereas Blockbuster does.
Blockbuster has an average debt-to-equity of 4.42, suggesting that it has a high credit default
risk if it continues to see negative growth.
Our competitor analysis showed that the traditional Home Video Entertainment industry is
reaching stasis. Netflix should continue its reach into streaming video, as consumer demand is
moving towards streaming.
Netflix Inc. and Warner Bros. reached an agreement in January of 2010 regarding movie title
acquisitions. Within the agreement, Netflix Inc. (NFLX) has agreed to accept new titles 28 days
after being released to the public. In return, Warner Bros. have agreed to provide Netflix with
o e titles eleased late tha fi e ea s ago a d st aight-to- ideo DVD, Blu-ray discs, and
streaming video that are currently not offered. Warner Bros. has agreed to continue ongoing
negotiatio s ega di g p i e ha ges that ill fa o Netfli ’s title a uisitio p i es.

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The recent agreement between Netflix and Warner Bros. has many implications on
each company and the industry as a whole. By agreeing to receive new release titles 28
days after being released, Netflix is surrendering access to newly released movies. New releases,
according to Netflix comprise 25% of their current business. Warner Bros. hopes to see disc
sales increase as they have significantly decreased in a similar manner to iTunes versus CD sales.
Netflix will also lose out on having access to new titles, potentially giving their competitors an
advantage on sales. Netflix, however, has received access to new titles that were released more
tha fi e ea s ago as ell as straight-to- ideo titles. B gai i g a ess to o e titles, Netfli
hopes to expand business into new movies and become more competitive with large name
video rental stores such as Blockbuster. Netflix is also in negotiations with receiving a price
decrease from all Warner Bros. titles that is intended to lower their current operating margin by
roughly 1.3% to match their target of 10%. Analysts feel that there is strong potential that this
deal will lower customer satisfaction and hurt profitability. Netflix feels that achieving their
target operating margin will increase profitability of the company in years to come.

Netfli ’s usi ess le el st ateg is o the ph si al dist i utio of o ies a d tele isio titles to
the consumer, whereas on a corporate scale Netflix hopes to make a push into the streaming
market by introducing more titles for the consumer to have access to. When looking through
Netflix VRIO we realized that Netflix has a sustainable advantage when it comes to their ability
to physically distribute their titles in a new and innovative way that creates added customer
service. They also have the upper hand when it comes to online streaming of content because
they are the first movie distribution means that can stream directly onto your game console,
computer and television. Netflix is currently positioned to make long and short-term moves in
the streaming market once they gain access to more titles. This will add to consumer retention
as well as bring in more consumers who will now have move access to movies than just the
previous means of physical distribution.

Examining the strategic shift using a discounted cash flow and net present value technique
shows that the deal with Warner Bros. will make Netflix more profitable. Using a moderate
growth forecast, as Netflix will begin to reach maturity in the business cycle, Netflix has an
enterprise value of $2.16 billion USD before the Warner Bros. agreement. This leaves Netflix
with a fair market value of $35.48 per share. Implementing the deal with Warner Bros. has
se e al i pli atio s o the fi a ials. As e o ed a ess to Ne Release titles ill hu t so e
business, revenue is forecasted to drop by 5% this upcoming year. The strategic move does yield
cost saving techniques. The valuation incorporates a 10% decrease in technology and
development expenses as Netflix will not have to spend money and resources converting new
titles to st ea i g. A lo g te % de ease i the disposal of DVD’s as used as Netfli shifts
toward more streaming content, removing the physical inventory. With the changes that will
occur from the Warner Bros. deal, Netflix is estimated to have a value of $3.22 billion USD and a
fair market value of $52.97. Netflix will see significant value added by adding more titles,
especially to their streaming catalogue.

After analyzing Netflix internally and relative to the industry, Netflix appears to be in a good
position regarding its deal with Warner Bros. The 28-day waiting period for new releases should
not harm their revenues as they move toward continuously increasing the size and popularity of
their non-new release library. By making other strategic moves such as shifting power in the
online streaming industry, potentially internationally as well, and teaming with firms in the
video game and smart phone industries, Netflix will greatly expand its sources of revenues. The
more Netflix grows, the less emphasis is placed on new release rentals. Therefore, the best way

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to handle this new position is to expand in other industries and reach new markets as
much as is wise and possible.

II. External Analysis

I A. Industry Definition
Netflix Inc. is considered to be in the video entertainment industry, which distributes to
consumers through movie theaters, airlines, hotels, and in-home (Netflix, Inc; 2009). Netflix and
its competitors serve in-home consumers specifically through a number of alternative channels,
making up the different strategic groups or segments of their portion of the entire industry
which includes brick and mortar (Blockbuster) and DVD vending machine rentals (Redbox), mail-
delivery (Netflix and Blockbuster), and online rental (Netflix, Amazon, and iTunes), pay-per-view
video (available from specialty suppliers such as HBO and Showtime through your cable
provider), and on-demand services (VOD; those offered through digital cable providers), as well
as brick and mortar (Walmart and Best Buy) and online purchasing (Amazon and iTunes).

Historically speaking, this industry began as stand-alone brick and mortar rental stores such as
Blockbuster and the later entrant Hollywood Video/Movie Gallery (which for the most part were
all corporately-owned, with small portions of franchised locations) and local rental businesses.
They started in VHS and progressed to DVDs along with technology and household adoption.
They would typically carry about 2,500 titles and performed better when copies were rented
and out of the store—the longer period the better. (Spinola) This would influence customers to
make a different rental and come back again to find the title they wanted. Furthermore, with
renters holding titles for longer periods of times, rental stores would enforce late penalties
when titles were not returned within their allotted rental window.

Because of the inconvenience of going to the store to find your desired title stocked out, and fed
up with late fees, Reed Hastings started a new business in 1997 called Netflix, which made DVDs
available through the mail, eventually operating on a monthly subscription, and without late
fees. This model quickly displaced brick and mortar stores. As technology has continued to
progress, the consumer has seemingly become even more a target of the industry, with online
or streaming video becoming available directly from the Internet—the same place consumers
were renting online—to their televisions.

Netflix defines their main competitors to be Blockbuster, Time Warner, Comcast, DirecTV, Best
Buy, Wal-Mart, Amazon, Apple, Echostar, AT&T and RedBox. These competitors exist across the
array of different segments of the home video entertainment industry, with Netflix in both the
mail-delivery and online rental segments. Nonetheless, they compete against all of these firms,
which capture some share of the market through their respective channels. A discussion of
industry trends follows the competitive forces analysis, but it is important to recognize that due
to a movement towards immediate viewing segments (online, pay-per-view, on-demand, and to
some extent vendors because of their ease of use and low price), industry members that have
the capability to offer such services will ultimately be the most competitive. Wal-Mart and Best
Buy will continue to command online and brick and mortar purchasing, which eats into the
e tal seg e ts’ sales, a d i e e sa. Blo k uste stated that the e tal a ket as o th
$10.2 billion (physical rentals making up for 81%) while retail was worth $16.5 billion in 2008.
(BBI)

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Suppliers
Suppliers are somewhat concentrated and offer perfect product differentiation. These are
movie studios; the main 6 studios together command more than half of theatrical release sales.
Mass marketed and popular titles are mostly offered by these main studios: Buena Vista,
Warner Bros., Sony Pictures, 20th Century Fox, Paramount Pictures and Universal. Smaller,
independent studios are also suppliers to industry competitors, but have less new releases and
less archived titles as well. Traditionally, brick and mortar stores have done a poor job at
stocking independent films because their demand is much less consistent (Spinola). With the
move towards large distribution centers controlling all of the inventory, there has been
increased access for consumers to independent films, with Netflix claiming that they make up
from 60- % of i depe de t studio’s post-theatrical release revenues. (Spinola)

Consumers
Industry consumers are divided into two sections: needy and convenience consumers. Needy
consumers are particular and choosy; they have a specific title or genre they are looking for,
(often making up niche market consumers), and they desire a rich viewing experience. This
means they want to sit in comfort, watch on a television screen (the bigger the better) with full
surround-sound audio, which currently makes them more likely to consume hardcopy media.
They are willing to wait a few days to acquire their title, as long as it meets their expectations.
These consumers also have a low propensity to substitute, because they are committed to video
entertainment, and possibly a higher propensity to purchase video. They are also more likely to
be older, and because they view and access rentals through more traditional channels, they
invest more time and energy in their choices. They will subscribe to mail-delivery services such
as Blockbuster Online or Netflix and find new releases at brick and mortar locations nearby.

Convenience consumers, on the other hand, are becoming more common. They watch videos
when they can. They value easy and immediate access, portability and transferability of the
product, and are more than willing to watch video on their computers. Many of these
consumers will watch illegally posted or otherwise free programming on the web, and
participate more frequently in online rentals. While they do not require devoted equipment
such as a television or full home theater, they are not opposed to watching in that format. This
consumer has a higher propensity to substitute than the needy consumer and will play video
games, watch live programming, listen to music, or enjoy other, non-media based forms of
recreation and entertainment. Convenience consumers are also typically younger, and more
Internet-savvy.

See Exhibits 2 and 3 for video consumption through specific distribution channels by age.

I B. Six Industry Force Analysis

The following written section details the Level 2 and Level 3 Industry Forces Analysis, by rank of
importance of each force in the industry.
Level 1 Analysis
Please refer to Exhibit 6 for the Six Forces Framework
Level 2 Analysis
Effect of Complements: Extremely Favorable

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Complements to the entertainment video industry come in many forms: television
hardware produced by large consumer hardware electronics companies such as Sony,
Samsung, Sharp, Panasonic, Toshiba, and others such as LG, Vizio, and Pioneer and many
generics; video players for DVD as well as Blu-ray playback produced by many of the same
companies; computers made by HP, Dell, Sony, Apple, Lenovo and generics; and Internet service
provided by MSOs. This had more than 70% penetration and broadband access to an estimated
63 million in the U.S. alone in 2007, allowing for greater content transfer at higher bandwidths,
and offered by satellite, cable, fiber optics or DSL. (Horrigan: 2006; Mintel; Oct. 2008)

Twenty-first century game consoles which connect to the I te et su h as Mi osoft’s X o ,

“o ’s Pla statio , a d Ni te do’s Wii all se e as o e ge e platfo s i the e te tai e t
video marketplace. They are essentially computers with more dedicated usefulness in
entertainment mediums. Their key purpose is to play videogames, a substitute for many video
watchers, but because of their functionality and ease of bundling with television sets, game
consoles have evolved to take media straight off the Internet and play it in full resolution on
o e’s television, leading to further bundling of online rentals and other media content streamed
directly to the television. Game consoles can also play music. Despite bundling with what may
be traditionally classified as a substitute, game consoles are actually increasing the total usage
of each form of entertainment because of decreased costs for separate units, and most
importantly, accessibility and ease-of-use. The online rental marketplace is undergoing a large
transition due to the technology convergence demonstrated in these consoles, as well as with
set-top boxes.

Set-top boxes have done the same thing, but without the ability to play videogames. Instead,
these boxes increase accessibility and ease-of-use for all entertainment video, from VOD
services to online rentals and sales. Following TiVo, AppleTV made a move into the set-top
marketplace in March of 2007, combining the online rentals and sales from iTunes and
connecting them directly to the television set. Other products such as Roku, a box devoted to
streaming video content from a vast array of providers including Netflix and Amazon as well as
exclusive content providers like MLB.TV, also halle ged TiVo’s pla e as a DVR-based set-top.
(Roku.com) This complements online broadcasting for streaming content from that segment of
the market.

Complements are increasingly important to the entertainment video industry. Because of major
advances in technology and a sustained trend towards media integration, disruptive
technologies have boosted innovators such as Netflix over the past few years as demonstrated
by an increase in online video content and simultaneous divestiture from brick and mortar
rental stores (BBI). Hence, all major complements, which may function with or independent of
the Internet, have the effect of increasing viewership through accessibility and ease-of-use.
These ideas also illustrate the effect complements have on pull-through. Needy consumers can
access high-resolution video straight through their game console or set-top unit, as well as
convenience users who may prefer to use their laptop, if it better serves them at the time.

Concentration in electronics production and distribution is weak, decreasing price and

increasing consumption, consoles and set-top box manufacturers are more diversified and
concentrated while game consoles, at least, are pulled-through by their entertainment media
capabilities. Internet providers are not concentrated, but command high prices for service
nonetheless, because of the high infrastructural costs associated with establishing their
networks. There is such great demand for Internet, however, that it has driven up its value.
High speed Internet access is available to a great number of Americans, and may see even

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higher per capita usage abroad, in countries like South Korea, Hong Kong, the
Netherlands, Denmark, Switzerland, and Canada (Nationmaster).

There is little threat of vertical integration from complementors, however one area of concern
may come from Internet providers. Since many Internet providers are MSOs with pre-existing
access to cable (television) media, they have a unique market position which they can utilize to
integrate into online rentals from traditional pay-per-view, and online VOD through computers.

The final factor of this industry force, which is very important to consider in industry evaluation,
is the rate of growth of the value pie. Because of the increasing accessibility and ease-of-use for
consumers—thanks to disruptive technologies—there is immense continued growth in this
industry, and in electronics, which will help increase profitability among staple industry
members. It is important to note, however, that consumers are still demanding programming
on their televisions, with an estimated 83% of film and television viewers preferring to view
their shows on television instead of their PCs (Mintel). As technology continues to converge and
the ease of accessing streaming video on television increases, the online video rental segment
will eat away at other segments of the market, but also allow for growth because of increased
accessibility for consumers.

Effect of Threat of Entry: Unfavorable

There is almost no product differentiation in the industry. The channel through which a product
is delivered to the consumer differentiates it by restricting it to specific viewing mediums
(computers vs. TVs) as well its degree of sophistication (i.e. resolution, sound quality and
encoding, special features). Competitors may also differentiate themselves by deepening their
title selection. Needy consumers, who prefer hardcopy video will avoid newer channels, while a
greater portion of consumers gravitate toward easy-to-use mediums such as online rentals and
VOD services. Hence, product differentiation is minimal and exists only across segments, or
between consumer groups. There is relatively uninhibited access to distribution channels. The
home video entertainment industry is a conglomeration of distributors and market share is
determined by distributional effectiveness, making this factor very important for the threat of
entry.

Economies of scale vary across segments; the greatest economies of scale exist in the VOD
segment because distribution is directly tied to multiservice operators (MSOs) who have high
infrastructural costs (Comcast had more than $24B in PPE in 2008) and overhead (major cable
providers in VOD segment had an un-weighted 5-year average 0.32-3.35% ROA), with lower
marginal costs (2008 financials from respective firms). The DVD vending kiosk segment also has
large economies of scale because of manufacturing equipment and supplies required to produce
kiosks. Other segments have low economies of scale and additional capacity is added as
appropriate to accommodate greater demand. Experience effects differ little across segments,
but are present, as in most industries. Learning effects come into play only in combined
manufacturing segments, such as the DVD vending kiosk segment, and otherwise do not play a
role in experiential cost reductions. Experience in the industry may also affect relationships with
suppliers, whose product is relatively intangible. Because of this, suppliers like to work with
distributors who can effectively protect their product from copyright infringement and piracy.
Members in all segments are thus affected by the length of relationship with suppliers and cost
structures can be optimized over time through more beneficial revenue sharing and content
license and leasing contracts.

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Capital requirements for online rentals are moderate, with overhead in the form of
hardware for electronic cataloguing, and investment in high-bandwidth
communications for better distribution. Streamlining of hardware functionality is key to
reducing variable costs. However, as the industry continues to move toward streaming content,
revenue sharing models become ever-more-common, reducing the need for inventory, and
lowering costs even more so that capital requirements in this growing segment are restricted
almost completely to building hardware capabilities to allow for broadband distribution. The
VOD segment, as stated above, is related to MSOs and is an individual business unit within a
la ge usi ess ith high o e head. B i k a d o ta e tals, su h Blo k uste I .’s o e
business see fair capital requirements, and face diminishing demand, which is reflected in the
divestiture from brick and mortar locations, especially abroad. (BBI) The mail delivery segment
has very low capital requirements; with relatively low overhead and primarily variable-based
cost structure, overhead grows appropriately with scale. As stated above for the kiosk segment,
there are greater respective capital requirements to market. Online sales segments may work
on the same platform as rentals but have much lower cataloguing expenditures. Since brick and
mortar sales now operate as units of larger retail operations, their capital requirements are
generally high, though some sales certainly come through brick and mortar rentals as well.

Possible entrants to the market would have to start by analyzing segments, and developing
industry growth, revenue, and cost projections. The most attractive segments for entrants,
because of its growth and disruptive technologies would be online sales and rentals. For a
minimum efficient scale (MES), an entrant would have to establish national distribution, with
servers in data centers located regionally based on the volume and density of usage in a
particular area. This most likely would mean at least one large data center on each coast,
possibly more. In 2006 set-up for a distribution center for Netflix—they ended the year with
44—cost $60,000. With the need for only 3-5 distribution centers, assets for startup could
range anywhere from right around $200,000 up to $400,000. A company would set their goal
MES at this level. With increasing broadband penetration in homes—36% of survey
respondents in 2005 and 54% in 2007 reported having broadband connections at home—
streaming video is becoming more commonplace and a more popular way to access video
entertainment, which means higher distributional bandwidths required in more places to
provide adequate streaming speeds. (Mintel) Once costs associated with technology have been
estimated, they would need to be compared to potential market share for the given operational
capacity based on title volume and variety. Because revenue sharing is the predominant model
for streaming video, this reduces inventory costs to zero for a streaming-only entrant. To
achieve true efficiency in the market, however, a firm would need to establish distribution to its
customers through innovative channels and take advantage of bundling opportunities with
broadband and television-connected hardware. Establishing partnerships should be easy
because the consumer demands greater selection and there are no exclusive contracts (as of
yet) between renters and hardware manufacturers in the industry to deter entrants from
grabbing a piece of the pie.

Because the industry is composed of a number of large competitors spanning different

segments, with different business models, and the industry is in a period of technological
disturbance, contrived deference is nonexistent. There are no government barriers to entry,
allowing for the establishment of distribution without bureaucratic tie-ups. However, MSOs
offering VOD services face anti-trust regulation, capping market share at 30% in any telecom
market. On the other hand, the government may in some cases restrict competition to reduce
infrastructural redundancies possibly created by an entrant. That is, MSO incumbents, who
maintain ownership of communication infrastructure, may be protected from entrants because

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of increased investment in redundant infrastructure which would result in inefficiencies
and waste.
Effect of Supplier Power: Moderately Unfavorable
Supplier power is a fairly unattractive force, with space nonetheless for industry incumbents to
gain and compete for power by building relationships with suppliers. The major traditional film
suppliers are Buena Vista, Warner Bros., Sony Pictures, 20th Century Fox, Paramount Pictures,
Universal as well as other big distributors and smaller studios. The most important factor in
unattractiveness is perfect product differentiation, which directly determines industry demand
fo the supplie ’s p odu t. Th eat of fo a d i teg atio is the se o d st o gest fa to , allo i g
incumbents power to establish customer base and provide distribution channels, the purpose of
their business. Despite an imminent shift in distribution channels toward media allowing for
immediate viewing, film studios are unlikely to eliminate distributors because of rental revenue,
and because communication technologies have never been a core competency. However, major
television networks have had an established presence in video distribution since the
introduction of TiVo and have continued development with demand for immediate viewing via
free, proprietary online channels.

Because the industry is dependent on studios for their specific, unique products, and studios
find greater revenues in other facets of their business such as ticket sales, merchandise, and
sales of hardcopy and electronic video, industry power is unattractive in profit-generating terms.
There are substitutes for video rentals, but substitution propensity depends on customer
characteristics and desires. A table describing non-electronic leisure activities is provided in
Exhibit 4. Convenience customers, looking for general entertainment in a relaxed atmosphere
and as an expenditure of free time may be indifferent to the form of electronic entertainment.
This segmentation between needy and convenience consumers is discussed in the next section,
but ease-of-use is critical for capturing the passive market and will decrease propensity to
substitute in the more passive portion of convenience consumers in the market for other
electronic forms of entertainment. An even smaller portion of these customers might also
substitute video watching with card-playing, exercising, and live TV-watching, among other
alternatives.

Supplier switching costs are low, but the industry maintains some power by creating greater
reach through alternative channels. This could lead to a small network/learning effect that
would derive more power from supplier and pass it along to industry powers. Overall, this
factor has a relatively small effect on the unattractiveness of this force. Finally, consolidation, as
judged by concentration ratio, is the least important factor. This is because of the importance of
the quality of delivered product, which is, for the most part, independent of the studio supplying
the title. The concentration ratio will have the effect of increasing price to distributors and
decreasing total benefit (V-C).

Effect of Rivalry: Neutral

Rivalry in the entertainment video industry is most strongly affected by its great diversity of
competitors. Diversity in the industry is very great. As discussed in the industry overview, there
are a number of different segments. Each segment is reliant on different distribution channels.
Competitors typically specialize in only one channel, allowing for greater effects of learning in
that segment. There is also a great variety of corporate and business-level strategy amongst
competitors, who may see the entertainment video industry as their main business, or a
secondary business grown out of strengths in a related industry, which was valued by

12 | P a g e
Blockbuster in 2009 to be over $26 billion industry (rental and retail combined). (BBI)
Blockbuster also reported the media entertainment industry as a whole grew 9.5% in
2008, and that it was expected to continue growth (BBI). This drives the force of rivalry towards
favorability because there is more space for competition.

Exit barriers are moderately high, keeping competitors in the industry. Long-term assets and
inventories make up just over 50% of assets for both Blockbuster and Netflix. Netflix maintains
a $3 salvage value in the depreciation of its DVDs with a life-term of only 1-3 years depending on
its release date (Netflix Inc.; 2009). This value is likely close to the resale value of those DVDs to
the company. Between 4 and 5% of revenues each year also come from the continued resale of
DVDs as physical rental segments face divestment in favor of online and pay-per-view rentals.
This illust ates that e it a ie s o i e to a e lo , as . % of Netfli I .’s total o te t
library value is resold every year from physical inventories. Properties, plant, equipment, and
other long-term assets are less liquid and account for around 40% of total assets across the
industry.

Consolidation in the industry is moderate. The industry is composed of a number of very large
firms operating in different segments. Because of the size of the competitors and the different
segments, the effect of consolidation is essentially neutral despite the number of competitors
that exist. The concentration ratio was calculated by adding Netflix Inc. and its largest three
o petito s’ sha es i ph si al a d digital ideo e tal f o the Blo k uste ’s al ulated a ket
size. The three other companies were Blockbuster Inc., Time Warner Inc., and Comcast Corp.
and the CR4 was 69.7% in 2008. Amazon could also be considered a major competitor because
of the volume of titles they offer for online rental and purchasing. All of these figures are in the
Appendix with industry financial data.

Capacity in the home video entertainment industry is added in small increments, leading to a
lower fixed cost dependency and more stable average costs, all having the effect of weakening
rivalry in the industry. Addition of capacity refers to an increase in title selection or inventory
size. Online distribution on the other hand is much more reliant on revenue-sharing models,
which means that industry members in that segment have virtually no costs to increase
selection. Additional costs from increasing capacity thus stem from increased infrastructural
and distributional costs. These ideas all relate to the final factor determining rivalry: the ratio of
fixed costs to variable costs. At the current state of the industry, this ratio relatively even.
However, as demand transitions into immediate viewing segments, variable costs will drop with
the increased use of communication technology, which at the same time will boost fixed costs,
making rivalry fierce, and less favorable.

Effect of Buyer Power: Moderately Favorable

Buyers in the industry pose little threat to industry members. There is no concentration in
either consumer group, and they pose no backward integration threat. As discussed above,
there is essentially no product differentiation, and little to no switching costs, giving consumers
full autonomy to access titles however they please. With that said, it is important to remember
that although the title being viewed does not change, the way it is viewed does. Firms in the
industry can differentiate their product to better capture consumers from either consumer
segment by providing titles available for television playback, and the easier and quicker it is to
access those titles the more successful they will be.

The product is a small cost to the convenience consumer, and an even smaller relative cost to
the needy consumer, who values it more. However, with 82% of families watching film

13 | P a g e
broadcast through network television services, and less than one third subscribing to
online rental services, home film and television viewers seem disinclined to pay for
additional rental services, because it impinges on other forms of entertainment in their budget
(Mintel: 2009).

Effect of Substitutes: Moderately Favorable

Needy consumers are less likely to substitute because they are committed to movie watching as
their primary form of entertainment. These consumers may also make up older age groups and
thus be less likely to participate in active entertainment or other forms of digital entertainment
apart from television. A survey by Mintel of adults in late 2008 showed that with age, the
frequency of engaging in electronic forms of recreation was increasing, while engaging in non-
electronic forms was decreasing. The category which saw the greatest increase was watching
movies at home, with a net increase of 34% of respondents having increased their viewership
(Mintel: 2008).

Convenience consumers, on the other hand, may opt to read a book, or listen to music. Video
game use is also increasing, and for young male consumers ages 12-24, was the preferred form
of entertainment in 2007, but was not so popular in older groups, or females (Mintel: Jul. 2008).
Nonetheless, sales in the video game industry have been high ever since 2008, when market
reached $21.8 billion, and has wavered around $20 billion since then (Terdiman, 2009).
However, due to technology convergence, the increased use of video games has actually served
to i ease o li e ideo e tals e ause of o soles’ ompatibility with Netflix’s o li e e tals
and put them straight onto the television.

Level 3 Analysis

Overall Market Attractiveness: Moderately Attractive

The video entertainment industry is moderately attractive. As a result of the level two
competitive forces analysis, and rapid technology convergence, as discussed in the next section,
the strongest force in the home video entertainment industry is complements, followed closely
by the threat of entrants. These two forces work together, with the effect of technology
convergence between the television and the Internet driving industry attractiveness. Disruptive
technologies have opened the door for entrants with superior technology or at least a better
way to harness technology to deliver video to the consumer in an easy-to-use and
comprehendible format direct to their television, PC, or other graphic interface. At the same
time, technology convergence also contributes to the attractiveness of rental complements,
e ause the a e espo si le fo eati g a o e di e t use i te fa e to eet a o su e ’s
demand for selection and immediate access.

As discussed earlier, supplier power is unfavorable, but despite differentiation, there is only
moderate concentration and pull-through from consumers is evenly spread around. Studios
want to sell their product. If not, they want to rent it, so they need renters to distribute their
titles. However, it is important to consider the forward integration threat that these large
companies pose in online rentals and sales, which is especially considerable for television
studios such as ABC, NBC, and Fox, who already provide free streaming video on their websites
to viewers. Companies such as TiVo, providing set-top boxes are already starting to coalesce live
television programming and I te et st ea s. TiVo does this usi g thei “ i el “ea h hi h
allows users to browse shows on the Internet or TV to view or record (Mascari). Competitors
ill likel follo TiVo’s lead a d soo the e ill e i dis i i ate ie i g et ee li e

14 | P a g e
television and online content on the television, when the consumer wants it. Studios
are unlikely to enter the market because it is far from their core business. They are
very large, however, and do have the resources to enter the market, but would probably face
stiff deterrence from their core customers, on the supply side of a new business arm.

Rivalry plays less of a role because the market is so segmented. With the trend toward
streaming (discussed more below), some of these segments may dissolve, and clear industry
leaders—as Blockbuster once was—will reemerge in the dominant segment, increasing rivalry in
a more discrete market. For now, rivalry has little effect on the industry, and is a weaker force
e ause of the i dust ’s u e t st u tu e.

Despite the further favorable effects within the industry from weak buyer power and
substitutes, the industry has only moderate attractiveness. This is because the threat of entry
increases with lower cost structures from revenue sharing and rapid evolution of disruptive
technologies, which play against the stronger factors contributing to increased distribution and
access to consumers.

II C. Macro Environmental Forces Analysis, Economic Trends and

Ethical Concerns
Industry Trends

Mu h of the i dust ’s t e ds ha e al ead ee dis ussed, so the follo i g ill suffice to

conclude on the aforementioned direction of the industry towards online or streaming rentals
and purchases. For reasons already mentioned, the industry is moving in this direction because
of the ease-of-use new technologies provide to consumers.

Convenience consumers demand immediate access to film and television titles. They can access
television shows and movies through VOD and pay-per-view services, which are integrated
directly into the cable box and are the easiest to use. However, newer set-top boxes like Roku
or TiVo can integrate all media types for playback through the TV, no matter its origin (cable,
Internet, or computer). Newer still, some TVs are now offering direct broadband connections
which will be able to stream content from online rental and purchasing hubs, such as Netflix,
Amazon and iTunes.

With this convergence, even needy consumers may play into the online segment because of the
growing capabilities of broadband communication, which allows for further sophistication and
full content access through the Internet, without the hassle of procuring a hard copy.
Convenience consumers are slowly beginning to dominate the market, as average weekly leisure
time falls precipitously (16 hours per week in 2008: Exhibit 5) and there is less time to search for
and wait for titles, and an increased need for relaxation. (Mintel: 2009) Also, as age groups
senesce, familiarity with broadband Internet technology spreads and the ease-of-use across
groups increases due to the experience with the technology.

Consumers in general have been affected by the current recession, with a decrease in the
propensity to go to movie theaters and an increase in home video watching. (Mintel) More
importantly, 19% of consumers claim the Internet was their primary source of leisure
entertainment, the greatest amount of any such activity. (Mintel) This marks a shift towards
immediate, when-you-want-it entertainment, the likes of which is only available from online
sources or other forms of proprietary entertainment (i.e. videos in home collection, video

15 | P a g e
games, books, card games, etc). Something that is not changing, however, is a desire
for big-screen entertainment and a continued longing for a bigger, better television.
(Mintel) And because they buy it, consumers want to use it, with more than 25% of consumers
saying that they want online video available directly on their television. (Mintel)

Technology Convergence Creates Threats and Opportunities Within the Industry

With these trends, there are some distinct opportunities in the industry, which also serve as
threats. With broadband Internet on the rise, as discussed earlier, the delivery of Internet
directly to television is becoming more and more common, and with cheaper, easier to use
technologies, more and more consumers are able to take advantage of changing technologies.
The biggest opportunity exists in services that will provide a deep selection of titles available
whenever the consumer wants. This means that partnerships with hardware providers such as
TiVo, Roku, and MSOs and other cable providers are crucial to establishing distributional
networks and greater market share. An opportunity also exists for exclusive contracts with
hardware suppliers, something that has not yet been executed, but could potentially cut off
competition for large numbers of consumers and allow for uncontested development of
customer-supplier relationships between renters and distributors.

Distributors that are not aiming to be broad differentiators will be threatened by those that are.
Possible entrants with aggressive distribution strategies in new technologies and access to
streaming video from suppliers also pose a threat to industry members. Hence, it is crucial that
the opportunities created by new technologies become a key focus of every capable industry
participant. The online segment will become the primary strategic group for successful
television and video rental firms.

VOD services also pose a threat to the livelihood of the online rental segment in that they can
offer free on demand video of network programming for discrete time periods. As the
bandwidth gap between Internet and television narrows, television providers may fear their
viewership will decrease and online services will make expensive cable packages less attractive.
Hence they may react by expanding horizontally to capture VOD customers. One thing that
MSOs will not be able to provide in VOD, however, is the interactivity available with online
video.

The trend towards streaming online content also opens up the global market on a scale which
was never before possible. With distribution centers to increase bandwidth and content quality
internationally, firms would be able to operate with extremely low variable costs as they expand
across markets worldwide. Looking back at broadband penetration in foreign markets, there are
significant opportunities many European countries as well as eastern Asian countries such as
China, Japan, and South Korea.
Further discussion of threats and opportunities is available in section II E.

16 | P a g e
II D. Competitor Analysis
II D. 1 Netflix’s Co petitors
Home Video Entertainment Industry

Netfli ’s o petito s a e Wal-Mart, Best Buy, Amazon.com, Blockbuster, Time Warner Cable,
Comcast, Dish Network, DirecTV, and Apple iTunes. Wal-Mart and Blockbuster enjoy the largest
percentages of market share, of 30 and 20 percent respectively. Netflix has a 5 percent market
share in the overall industry. This breakdown of market share for both video retail and rental is
shown in Exhibit 7. Market share for video rental only is shown in Exhibit 8.

In terms of video rentals in this industry, Netflix has 13 percent market share. Blockbuster has
the majority market share of 52 percent. Comcast has 3 percent, and Time Warner has 2 percent
market share.

We al ulated the i dust size f o Blo k uste ’s -K fiscal year 2008. Revenues for the retail
segment and fo ideo-on-de a d e e ased o u e s f o Mi tel, he eas e e ues
fo the e tal seg e t a e f o fi s’ a ual epo ts.

II D. 2 Netflix’s Pri ary Co petitors

Netfli ’s p i a o petito s a e Blo k uste a d Co ast. These t o o pa ies ha e o line
a d a le ideo-on-de a d apa ilities, aki g the th eate i g e tities i te s of ideo
rentals that can be viewed immediately. DVDs come standard, so the way that DVD rental
companies have to differentiate themselves is through unique services. Although Wal-Mart and
Best Buy have relatively large market shares, they do not operate in rental services via the
I te et, o do the ha e ideo-on-de a d se i es. Thus, e do ot i lude the as
p i a o petito s gi e Netfli ’s st ateg of o i g towards rentals through streaming video
capability. Having been founded 12 years prior to Netflix, Blockbuster has been an existing
competitor within the industry. Although Blockbuster has more of the market share than does
Netflix, it saw negative sales growth from 2005 to 2008 (see Exhibit 17). Although Blockbuster
has failed to create a sustainable strategy in which it can compete in streaming video, cable
p o ide s su h as Co ast a d Ti e Wa e a e i easi g thei ideo-on-de a d
subscribers. Netflix has to worry about this capability. Tha ks to O -De a d featu es, these
fi s ha e the pote tial to steal a ket sha e f o Netfli . With O -De a d , usto e s do
ot ha e to ait a hole usi ess da to e ei e o ies i the ail as the did ith Netfli ’s
primary business model. Now that Netflix is moving into the streaming video category, it is
becoming more of a direct competitor with such cable providers.

II D. 3 Pri ary Co petitors’ Busi ess Level a d Corporate Level Strategy

Netflix employs differentiation for its business level strategy. This means that the company tries
to exploit product uniqueness for a broad market. When Netflix was first founded, its purpose
was to offer customers an old product (rentable movies) in a new format. Instead of having to
take the time to drive to a physical location and browse through a selection of titles, customers
could browse through titles online and then receive DVDs through the mail, often in just one
business day. (According to Netflix, more than 97% of its customers receive their DVDs in about
one business day (How Does It Work: 2010). Consumers valued the uniqueness of this type of

17 | P a g e
business model. Netflix also differentiated itself by charging customers based on a
subscription fee rather than the traditional per-title basis.

Blockbuster also initiated its business level strategy through differentiation aimed at a broad
a ket. The o pa ’s o igi al pu pose as to allo o su e s to e t o ies athe tha
spend full price to purchase them. Consumers valued this type of business model, as it was
unique at the time. Consumers would have rather rented a movie for a few days rather than
purchase one and watch it maybe once or twice a year. However, Blockbuster was not able to
maintain a competitive advantage through this strategy. The Internet became increasingly
popular, both for personal use and business. Netflix recognized this opportunity and seized it,
leaving Blockbuster and its traditional physical storefront behind.

Comcast uses a cost leadership business level strategy in order to capture a higher market share.
They target a broad market and sell their products at prices below the industry average.
According to CNNMoney.com, the average cable bill in the United States is about $75/month.
Co ast’s digital a le osts $ . / o th. Co ast also offe s e usto e s dis ou ts if
they bundle its services: cable and Internet costs $79.99/month (Comcast.com: 2010)

Corporate Level Strategy

In terms of corporate level strategy, Netflix is a single business. 100% of its revenues come from
its sole business of renting out DVDs. Blockbuster is a dominant business. 83.2% of its revenues
come from its main business, rentals. 16.2% of its revenues come from merchandise sales of
movies, games, and general merchandise (Blockbuster 2008 Annual Report) Comcast is a single
business. Its main business is its cable segment, which had revenues of $32,443 million in 2008.
Its total revenues for the same year were $34,256 million. Its cable segment brought in 94.71%
of its total revenues (a specialization ratio of about .95) (Comcast 10-K Form: 2008).

II D. 4 How Competitors Achieve Their Strategic Position

Value Drivers - Netflix

Netflix increases value to customers based on four major value drivers: technology,
delivery, customization, geography, and brand/reputation.

 Technology
Netfli ’s usi ess odel depe ds o the I te et to fu tio . B utilizi g the oad ea h a d
speed of the Internet, Netflix positions its product with superior functionality relative to
Blockbuster. Because the Internet has become so widely accepted in the US, most consumers
e ui e a high le el of fu tio alit a d featu es su h as those i luded i Netfli ’s usi ess.

 Delivery
Netfli ’s deli e ti e fo DVD titles is a out o e usiness day. O e % of Netfli ’s usto e s
e ei e thei DVDs ithi o e usi ess da , o pa ed to o l % of Blo k uste ’s usto e s
receiving their DVDs in one business day (Blockbuster By Mail: 2010). With its streaming video
option, consumers can view titles instantly on their computers or on streamed onto their
tele isio s th ough a Netfli ead de i e , su h as a X o o a P“ s ste . Bei g the fi st i
the industry to offer streaming video, Netflix has been able to achieve its strategic position.
Consumers appreciate the ability to save costs in regard to time and transportation. The
p o le ith t aditio al ideo e tal as the fa t that it took ti e out of us o su e s’ li es

18 | P a g e
to go to the sto e, o se th ough the titles, a d e t the . Netfli ’s se ice allows
these consumers to save time, which is possibly what people value the most.

 Customization
Netflix also offers title suggestions to its customers based on their ratings of titles and on the
ratings of other customers who ha e si ila tastes i o ies Netfli Media Ce te : Featu es:
2010). This is a a that the o pa tailo s to its usto e s’ eeds.

 Geography
Netflix has 58 distribution centers, dispersed in such a way that the company can deliver titles to
over 97 percent of its subscribers in about one business day (Netflix Corporate Fact Sheet:2010)

 Brand/reputation
Netfli also has uilt a st o g eputatio . A o di g to the o pa , o e tha pe e t of
su s i e s ha e e a gelized Netfli a d o e tha pe e t of su s i e s had a e isting
usto e e o e d Netfli Netflix Corporate Fact Sheet)

Value Drivers - Blockbuster

Blockbuster increases value to consumers based on three major value drivers: geography,
customization, breadth of line, and brand/reputation.

 Geography
Blockbuster has 4,585 stores in the US; 3,878 of these are company-owned and the other 707
are franchised (Blockbuster 2008 Annual Report: 2008). Although the company has enough
stores to cater a large number of American consumers, the industry is moving towards
streaming video. Blockbuster will not be able to sustain a competitive position in the industry if
it does not move towards streaming video as well.

Blo k uste ’s head ua te s a e lo ated i Dallas, TX. Its dist i utio e te , hi h is lo ated i
McKinney, TX, supports all of the company-owned stores. This helps the company to lower
logistics costs and coordinate its business activities more efficiently.

 Customization
Ea h Blo k uste sto e’s ua tit a d sele tio of e ha dise a e usto ized to fit the
preferences of local customers.

 Breadth of Line
Blockbuster not only rents and sells DVDs and Blu-ray titles, but video games, video game
consoles and accessories, and snack items as well. Customers place value on this because
Blo k uste ’s ide p odu t li e eates a o e-stop shop (Blockbuster 2008 Annual
Report:2010).

 Brand/reputation
Blockbuster entered the movie rental business in 1985. Since then, it has built up its brand
name. When people think of movie rentals, they think of Blockbuster. Its brand equity is partly
what is keeping the company in business.

Value Drivers – Comcast

Comcast adds value through technology, the breadth of line of their products, and geography.

19 | P a g e
  Technology
Co ast positio s its p odu ts th ough toda ’s supe io te h olog . It offe s high
speed Internet, cable and voice services using up-to-date fiber optic network technology.

 Breadth of line
Comcast provides cable, video programming, Internet, and voice services to consumers. It offers
a variety of regular cable channels as well as programming options.

 Geography
Comcast has 116,000 optical nodes in the US. An optical node can reach anywhere from 25-2000
homes. With such dispersion, Co ast’s se i es ha e a e la ge s ope. A o di g to the
company, node health is above 90 percent (Comcast.com), which means the nodes not only
exist but actually function in a way that adds value to consumers.

Cost Drivers- Netflix

Netflix competes on cost based on low capital and input costs, as well as scale economies.

 Low capital costs

Netflix saves money from not having to build and maintain physical stores. The company
reported $124.948 million for property and equipment in 2008, whereas Blockbuster reported
$406 million in that same year. Netflix owns less property than Blockbuster does; Blockbuster
has to report depreciation on its income statement whereas Netflix does not. This also gives
Netflix the increased potential for investments using cash that it does not expend on plant,
property and equipment.

 Low input costs

In its deal with Warner Bros, Netflix will have access to 100,000 streaming titles with lower
acquisition costs. By saving on costs for acquiring new titles, Netflix can increase its profit
margins.

 Scale Economies
Netflix had a large up-front investment when first developing their content library, but the
o pa ’s a e age ost u e has de li ed steadil o e ti e as it added o e titles a d
i eased its o te t li a ’s olu e. Netflix also has relatively small fixed costs, largely in part
due to the lack of physical storefronts.

Cost Drivers – Blockbuster

Blockbuster saves on costs by lowering input costs.

 Low input costs

The company lowers its annual overhead costs by outsourcing. It also renegotiated its lease
agreements, saving a significant amount in its future store occupancy costs. The company also
stated that it eli i ated staffi g a d o e head edu da ies oth i its sto es and in its
corporate structure (Blockbuster 2008 Annual Report: 2008).

Cost Drivers – Comcast

Comcast lowers its input costs by outsourcing business processes.

 Low input costs

20 | P a g e
 Instead of processing remittance payments in-house, Comcast outsources to Unisys
Corporation. By doing so, Comcast saves on overhead and processing costs, allowing
them to expend capital in other areas of their business.

II D. 5 Willingness to Pay
Blockbuster Comcast
V V Netflix
V

Value Drivers:
Value Drivers: Value Drivers:
-Technology/uniqueness
- 4,845 stores in - Up-to-date fiber optic of business model
the US technology
- Delivery speed
- Local - Bundling cable, voice,
customization of and Internet services - Streaming video
P
- Customization 
merchandise
selection - 116,000 optical
nodes; node health suggested titles
- One-stop
- Geography  58
P above 90%
shop P
distribution centers

- Strong brand 
- Brand name
since 1985
Cost Drivers: Cost Drivers:
customer loyalty
- Outsources - Outsources
staff 
Cost Drivers:
remittance
lowers payments - No physical stores
C overhead
costs - Saves on - Little fixed costs
C overhead
C

Netfli p o ides the g eatest u e ’s su plus out of these th ee o pa ies. Its p i e is lower
tha that of Co ast’s su s iptio se i es a d its ost lo e . The efo e, it eates a igge
profit for itself. Netflix and Blockbuster have identical costs for their services. ($8.99/month for
1 DVD at a time, $13.99/month for 2 DVDs at a time, and $16.99/month for 3 DVDs at a time.)
Netflix also saves the most on its cost by not having physical storefronts. This is a significant cost
advantage compared to Blockbuster, which has to pay to maintain its stores and hire employees
for said stores.

21 | P a g e
II D. 6 Comparative Financial Analysis
To pe fo a o pa ati e fi a ial a al sis, e hose ele e atios to easu e o petito s’
g o th, p ofita ilit , le e age, li uidit , a d effi ie . All o pa ies’ data e e take f o
annual financial statements from 2004 to 2008.

Growth: Exhibit 9 shows the average annual sales growth for Netflix, Blockbuster, and Comcast.
Sales have grown at an average of 40.3 percent for Netflix and 13.42 percent for Comcast.
Blo k uste ’s sales ha e flu tuated, ut sales g o th as egati e f o to a d the
company saw average sales growth of -2.16 percent.
Profitability: All three companies have strong gross profit margins: Netflix has an average gross
profit margin of 53.56 percent, and Blockbuster and Comcast have 67.72 percent and 58.88
percent respectively. Exhibit 10 shows these profit margins. However, Blockbuster has a ROA of
-13.90, which is substantially lower than the industry average of 2.55 percent. This suggests that
Blockbuster does not effectively use its assets to produce profits. Netflix has average ROA of
10.39 percent, which is substantially higher than the industry average, suggesting that the
company does make effective use of its assets to turn profits. Comcast has average ROA of 1.73
percent. Exhibit 11 sho s ea h o pa ’s a erage ROA.
Leverage: Netflix has average debt-to-equity of 0.59. The industry average is 1.60. Compared to
other companies in the industry, Netflix does not leverage its business that much. Blockbuster,
on the other hand, has average debt-to-equity of 4.42. It leverages its business with debt more
than other companies in the industry, and therefore might have a higher credit default risk.
Comcast has average debt-to-equity of 1.66, which is about average for the industry. Exhibit 12
displays average debt-to-equity of these companies.
Liquidity: A o pa ’s u e t atio is a easu e of its li uidit . A highe li uidit ea s that a
o pa has lo edit isk. Netfli ’s a e age u e t atio is . . Ho e e , Blo k uste a d
Comcast have current ratios of 1.01 and 0.48 respectively. Comcast has a high credit risk; if it
sees lower sales in the future, it may have trouble paying back its creditors.
Efficiency: Netflix does not report receivables on its balance sheets; its collection period is not
applicable. Blo k uste ’s a e age olle tio pe iod is . da s, hi h is su sta tiall lo e tha
the industry average of 24.16 days, suggesting that the company is more efficient than others in
the industry. Comcast also has a collection period lower than the industry average: 18.52. It is
not as efficient as Blockbuster, however, in terms of collecting on its receivables. Exhibit 14
displays the average collection period (in days) for these companies.
Netfli ’s a e age asset tu o e is . , hi h is highe tha the industry average of 1.44. Netflix
is highly efficient in regards to generating revenue with its assets. Blockbuster is also efficient
here with an average asset turnover of 1.93. Comcast, however, has an average asset turnover
of 0.24, suggesting that it does not efficiently utilize its assets to generate sales.
Netflix does not report inventory on its balance sheets, so its inventory holding period is not
appli a le he e. Blo k uste ’s a e age i e to holdi g pe iod is . da s, hi h is
significantly higher than the industry average of 35.96 days. This suggests that Blockbuster is
inefficient at turning over its assets. If it is holding its inventory for almost 80 days, it might
mean that current consumer demand is significantly lower than it used to be. This is another
sign that the industry is moving towards streaming video.

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II D. 7 Implications of Competitor Analysis
The previous analysis shows that the traditional DVD, Home Video Entertainment industry in the
US in reaching stasis. The signs of our analysis point to the increasing demand for streaming
ideo i this i dust . Co e ie e a d speed a e t o ig de a ds of toda ’s o su e , a d
companies in the industry must meet these needs in order to continue to grow and make
profits.
Rivalry in this industry has always been high, and it is ever increasing. Because DVDs are widely
available, competitors have to compete on price. They must differentiate their companies to
offer a common product through an uncommon medium. Companies also might compete by
increasing the breadth of their product lines over time. Companies that can keep seeing sales
growth and that increase efficiency will be more able to sustain themselves for a longer period
of time.
Netfli should o ti ue to fo us o its st ea i g ideo apa ilities. Co su e s’ de a d fo
streaming will keep increasing in the future, and eventually renting DVDs through the mail and
in-store might become obsolete.

II E. Intra-Industry Analysis
Netflix is strategically placed well in their industry currently. They are among the four major
players in the market who competes for customers. Netflix is strategically placed well in the
market because they have a unique rental strategy compared to Blockbuster and other boutique
video rental stores. Customers can manage their rentals online, keep them for however long
they wish, and return them at their convenience. Movies can be mailed to the house or
streamed directly to a computer or television. By offering both of these technologies, renting
titles is easy and convenient for busy customers who do not want to take the time to drive and
select a movie. Netflix is the only company in the industry to provide both types of services
included under one subscription. Netflix also has strong, long lasting contracts with studios and
Starz programming that allow them to acquire titles for cheap prices. Through revenue sharing,
they are foregoing some of the high, upfront costs of acquisition that companies like
Blockbuster are hurting because of their costs. Long-term contracts of ten years ensure stable
profitability and good growth opportunity.

Netflix is disadvantaged because they are a newer company and have a smaller title selection
compared to Blockbuster. Their limited selection, especially in acquiring new release titles, is a
turn off to potential consumers who are seeking new titles. Even though Netflix executives state
that they are not interested in this part of their market, this aspect comprises a large portion of
the market. Netflix is missing out on potential profitability. Another drawback to the Netflix
system is that their business model is comprised of subscriptions. For a set monthly rate,
viewers gain access to their services. Being locked in for only a month at a time enables people
to jump in and out as they please. This makes revenue forecasting tough as there is tremendous
volatility.

With this strategic move, Netflix is pushing toward the newer industry they are seeking to fully
be in within the next couple years. The streaming market is primarily dominated by Netflix, and
is a rapidly growing market due to new technologies. Through the deal with Warner Bros.,
Netflix will expand their title selection, specifically in the streaming market. This will give them a
competitive advantage over other providers, making their subscriptions more attractive.

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III. Internal Analysis
III A. Business Definition/Mission
Netflix, Inc. is the largest online movie rental company on the planet. Based in Los Gatos,
California, it has a selection of over 100,000 titles that continues to grow. Alongside its DVD
rentals are its more than 17,000 titles available through Internet streaming, and available
i sta tl eithe th ough a use ’s TV ith the use of a e te al Netflix-friendly device, or directly
through any computer (Netflix Corporate Fact Sheet). With zero shipping fees, late fees, or due
dates, Netflix is the optimal movie rental service.
With its issio , stati g that ou appeal a d su ess a e uilt o providing the most expansive
selection of DVDs; an easy way to choose movies; and fast, free delivery (Topix.com) Netflix
continues to grow and make new goals for itself. Its growth strategies include expanding its
leadership position in online DVD rental into internet delivery of content; to make the best
product, and best consumer experience, even better; to lead the expansion of Internet delivery
of content by offering subscribers both mail delivery and a continuously improving internet
delivery option; maintaining mutually beneficial relationships with entertainment providers; and
to increase its catalogue number and decrease its new releases aspect (Netflix Corporate Fact
Sheet).

III B. Management Style

Founder and CEO Reed Hastings has created a unique management style that is most notably
si ila to that of Geo ge Cloo e ’s Da O ea ole; that is, a leade who hires the best, and
gets out of the a (Wells). Netflix thus has a laid-back structure that allows employees to
make their own decisions, but greatly encourages that smart decisions are made. Some of the
perks include allowing employees to structure their own compensation packages, no clothing
policies, and having a—hypothetical—unlimited amount of vacation days. The goal is to
emphasize that numerous detailed policies are not the most effective way to manage a firm,
and that by giving employees freedom to make their own decisions, they will be more inspired
to grow and be innovative at work. Hastings understood that valuable employees are happy
employees. However much of the importance of this style of management is in its beginning:
hiring top-notch colleagues. And finally, regarding expensing, entertainment, gifts and travel,
si pl a t i Netfli ’s est i te est (Siegler). By creating an ideal workspace to provide a highly
productive environment, excellence in work quality is expected, and crucial. In the case that
employees do not live up to this high standard, Netflix provides large severance packages for
quick termination (Kaltschnee, 2007).

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III C. Organizational Structure, Controls, and Values
III C. 1 Organizational Structure
Netflix has a functional organizational structure, which is segmented by the aims of its functions
themselves, rather than by customer segments or regions. The structure is centralized, as CEO
Reed Hastings has direct control over the six departments, each with individual managers. The
organizational flow beyond this point is not as structured. See Exhibit 18 for the organizational
chart.

III C. 2 Organizational Controls

Going along with the management style, the controls used by Netflix regarding monitoring and
appraising employees are anti- o t ols. The otto is Co te t, ot Co t ol (Siegler), implying
that very little control is given to employees, rather employees are held responsible for their
actions and are expected to work efficiently independently. This form of organizational control
makes Netflix unique in the corporate world, but it has also been extremely successful, so there
seems to be no need to make changes.
Although there is very little control from management in the organizational structure, there are
still tests and policies to make sure that employees are not abusing their freedom and are
e ai i g i o ati e a d p odu ti e. Netfli i ple e ts the Keepe Test, used a age s
to evaluate employees. The person implementing the test asks his or he self: hi h of
people, if they told me they were leaving in two months for a similar job at a peer company,
would I fight hard to keep at Netfli ? (Siegler) This shows how strict Netflix is about employees
remaining useful and acknowledging their huge amount of responsibility in an appropriate and
p odu ti e a e . We do ’t easu e people ho a e e i gs o eeke ds the a e i
their cubicle. We do try to measure people by how much, how quickly and how well they get
work done—especially under deadline (Siegler). While this could seem to be an intimidating
app oa h to o t olli g a d e aluati g e plo ees, hi i g stu i g e plo ees, thei
number one motive, any issues are resolved before they occur, and efficiency is optimized.

III C. 3 Organizational Values

The e is a huge e phasis o the alue of stu i g olleagues, a d thei i po ta e i a g eat
o kpla e. G eat o kpla e is not daycare, espresso, health benefits, sushi lunches, nice
offices, or big compensation, and [they] only do those that are efficient at attracting stunning
colleagues (Siegler). This shows that the number one priority at Netflix is accumulating a
phenomenal work team. There are also nine values within each and every stunning colleague
that Netflix looks for. These traits are judgment, impact, curiosity, innovation, courage, passion,
honesty, and selflessness. (Siegler). There is wiggle room for different styles and techniques, but
by living out these nine valued skills daily, employees at Netflix are constructing the ideal
workspace and helping their firm continue to grow.
Anothe o e aspe t of Netfli ’s culture is that values are what they value. Coupled with the
values required in employees, there are core values of the firm that all employees are expected
to abide by and withstand. The basic firm values include workplace efficiency, emphasis on
effectiveness over effort, management best practices, retention practices, and a large emphasis
on a large salary, rather than stock options and bonuses (Siegler). Together these create an

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effi ie t, p odu ti e, a d sustai a le o k at osphe e. The fi ’s la ge e phasis o
the importance of mutually understood values was made evident in the 128-page
internal document that lists the values word-for-word, along with Netflix’s e pe tatio s of
e plo ees ega di g all othe aspe ts of o kpla e effi ie . But at the e d of the da , the
real company values, as opposed to the nice-sounding values, are shown by who gets rewarded,
promoted, or let go (Siegler).

III D. Strategic Position Definition

III D. 1 Corporate Level
Business Portfolio
The main areas of focus for Netflix Inc. are online DVD rentals and rentals via online streaming.
While the tangible rentals of DVDs and Blu-ray discs are where Netflix currently earns the most
revenues, they hope to expand their selection of titles available for online streaming, and thus
continue into this Internet-focused industry. The two rental options are closely linked, and can
both be enjoyed by consumers in one payment package. That is, customers pay a flat rate
depending on how many DVDs they decide to rent monthly, and unlimited streaming is included
(Wells).
Since online streaming is the newer feature, and currently linked to the rental of DVDs, its
success is currently dependent on the success of the DVD rental feature. However, as the
number of titles available continues to grow, as well as the increased popularity of On Demand
a d o li e ie i g of o ies a d tele isio se ies’, Hasti gs is su e that his $ illio
investment in the streaming feature will become a huge asset to Netflix, Inc. (Wells:2009).
Ru elt’s Classifi atio s
According to Richard Rumelts classifications of businesses and multi-business firms, Netflix
would be considered a dominant business. While it has partnerships with other companies and
is linked to other businesses which allow it to provide titles and give numerous options as to
how they are provided to consumers, Netflix still generates more than 75% of revenues and has
not participated in acquisitions as of now.
Partnerships
Netflix has been partnered with Warner Bros. in the past, and as of late January 2010, the firms
have reached a new deal regarding new releases. As stated in the attached article, there is now
a 28-day gap between when new releases are available to the public and when the will be
available for Netflix to rent out (Wilkerson). The purpose of the deal is to hopefully bolster the
number of new releases that are bought in that 28-day period, rather than rented. It will be
helpful for Warner Bros., and whether or not it will be beneficial to Netflix was still up in the air.
In order to make the best of this deal, Netflix is working to increase its number of titles and
increase the catalogue revenues more so than new releases revenues. Currently catalogue titles
make up 73% of total revenue, while new releases make up 27 percent. Knowing this, Netflix
was able to go ahead with the deal with Warner Bros. Home Entertainment, while keeping in
mind that they should continue to make catalogue titles more popular rentals.
Netflix recently partnered with Nintendo to allow streaming of titles directly through the Wii
Co sole. Wii o e s ith a oad a d I te et o e tio ho ha e at least a $ -a-month
su s iptio to Netfli ’s DVD-by-mail service will be able to use the online service at no

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additional cost “to e . While this is a successful partnership, it will help boost
Netflix’s e e ues, ut ill ost likel e o e e efi ial to Ni te do. The Wii
o sole’s di e t o petito s, Mi osoft’s X o a d “o ’s Pla statio , al ead ha e this
feature, so this partnership was crucial in order to compete in the industry.
BCG Matrix
The Boston Consulting Group (BCG) Matrix, displayed in Exhibit 19, shows the position of three
of Netflix’s features relative to market growth and market share. Given the current information,
the fi has featu es i positio s of sta s, ash o s, a d uestio a ks.
The online streaming is viewed as a star, as this feature has a very high growth rate, and Netflix
has a high market share. Online streaming is a growing market that Netflix has jumped into.
With this large amount of cash spent will hopefully be large amounts of revenues. By bundling
the online streaming feature with their current flat rate online DVD rental packages, Netflix is
prompting its consumers to choose them over other online streaming options.
The cash cow at Netflix is its online DVD rentals. This feature is the foundation of the firm, and
is still where the majority of revenues a e ea ed. It is the o ld’s la gest o li e DVD e tal
service, obviously dominating the market share.
Netfli ’s thi d featu e is the st ea i g of titles to TVs th ough a e te al de i e, and is
categorized as a question mark. On Demand TV viewing is a high growth market, and with cable
companies providing viewing options of a multitude of titles directly through On Demand
channels, Netflix will have a difficult time competing. The external device necessary for its TV
streaming requires more effort, in a sense, than its competitors, putting it in the low growth
position.

III D. 2 Business Level

The generic business level strategy for Netflix has been in the DVD rental market. More recently
Netflix has been moving into online streaming of movies that can be watched directly on your
computer or gaming consol. Netflix has captured over ten million subscribers who currently
have access to 100,000 DVD and Blu-ray rentals, as well as another 12,000 movies which can be
directly streamed to o e’s computer.
The corporate strategy of Netflix is the distribution of movies to consumer located in the United
States. They have made little attempt as of right now to move into any foreign markets. They
hope to return to the European market in 2010 by only offering streaming videos because they
would not have the capability to manually distribute discs. Their corporate strategy fits in with
their business level strategy since Netflix deals primarily with the distribution of discs manually
and via online streaming.
The strategic move that has Netflix waiting 28 days before renting out any new releases has
major ramifications on their business model. This move will put a major hit onto the 27% of
their revenues earned exclusively from new releases, if their competitors will not have such
restrictions. This move will also lower the margins at which Netflix receives their movies by ten
percent, making them cheaper and thus more profitable.

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III D. 3 Resources and Capability Level
Value minus Cost Profile
Cost for $8.99 model 8.99-0.54= $8.45
Cost for $13.99 model 13.99-0.85= $13.14
Cost for $16.99 model 16.99-1.03= $15.96
Cost for $4.99 model 4.99-0.30= $4.69

Netfli ’s current strategic move will increase the value on the online streaming content that it
provides. The consumer will be gaining access to even more movie titles via online streaming
which will bring down the already low hassle that their customer service provides. The move will
also be bringing in new older titles at the exchange of pushing back new releases by 28 days.
This tradeoff is difficult to measure, but because they are expanding their library of movies, and
they will eventually be receiving new releases, the value change from this move is not
significant. The majority of Netflix inc. business model involves the company selling older
movies over new releases, which means that they are expanding their larger segment.
Value Chain
Please refer to Exhibit 21.
VRIO Analysis
Please refer to Exhibit 22 for the VRIO Framework.
Netflix is currently positioned in a moderately sustainable place. They have worked hard to
create a distribution model that is far beyond what any of their competitors have been able to
achieve up to this point. The two aspects that are temporary for Netflix are their hard copy
DVDs and Blu-ray discs, which other companies have also been distributing. For this reason the
majority of their business model is in their distribution of their movies. Its strategy for DVD
distribution is through mail, instead of having physical stores. This makes it easier on the
consumer as they do not have to physically drive anywhere to enjoy their DVD; instead it just
comes to them free of postage. This is a temporary and sustainable advantage because
Blockbuster has shown that they are capable of moving into that market; this makes Blockbuster
one of their biggest threats. Title variety is one of the ai poi ts of Netfli ’s current strategic
move, because they will gain license agreement to thousands of older independent movies
which will expand upon their larger market.
Customer service is important to Netflix and is evident through their website. They allow the
consumer to rank which movies they will receive in the mail, which can be updated by the
consumer at anytime. It has created an intricate system in which they organize and distribute
their movies from their many locations. Another service they provide is free and easy shipping.
Netflix has taken all of the hassle out of shipping and made it as easy as dropping o e’s DVDs off
in o e’s ailbox and obtaining the new rentals about a day later. This can be seen as a
sustainable advantage because not many companies are willing to pay that high of a price in
order to provide ease to their consumers.
The capability of online streaming is a sustainable advantage for a number of reasons. This is
the area Netflix is moving towards because it will completely cut out shipping costs. This can be
seen as a sustainable advantage because of the variety of ways Netflix has been able to get into
the virtual streaming market. They have teamed up with the big three video game consoles so

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that consumers will be able to download the ability to stream movies directly onto
their systems. Another new feature is their ability to stream directly onto o e’s PC o
Mac computer. The main threat to this advantage would be Apple’s presence in online
streaming through iTunes.
Customer Retention Analysis
Netflix has been able to retain consumers with its various means of connecting its products to its
consumers. The overlying similarity with all of their different modes of distribution is that they
are all easy for the consumer to use and operate. Netflix differentiates itself from all of its
competitors by being able to bring the movies to o e’s house, instead of having to drive
somewhere to pick them up. This is a major driving factor behind why Netflix has become so
successful, and why Blockbuster has been attempting to imitate the business model that it has
established. Netflix also has four different price packages which all give access to the same
amount of titles; the only difference is how many titles the consumer desires to watch in the
span of a month. This model gives the consumer the opportunity to determine how light or
heavy of a user of the service he or she would like to be.
4Ps Analysis
Price
Unlimited Plans
$8.99 a month
1 DVD out at-a-time
No limit to how many you can have per month.
Instantly watch online on your PC or Mac or right on your TV via an Internet connected Netflix
ready device. Instantly watch as often as you want, anytime you want.

$13.99 a month
2 DVDs out at-a-time
No limit to how many you can have per month.
Instantly watch online on your PC or Mac or right on your TV via an Internet connected Netflix
ready device. Instantly watch as often as you want, anytime you want.

$16.99 a month
3 DVDs out at-a-time
No limit to how many you can have per month.
Instantly watch online on your PC or Mac or right on your TV via an Internet connected Netflix
ready device. You can watch as often as you want, anytime you want.
Limited Plan

$4.99 a month
1 DVD out at-a-time
Limit: 2 per month
Instantly watch up to 2 hours of movies & TV episodes online on your PC or Mac.
All envelopes are prepaid by Netflix, which adds no extra hidden costs to the consumer.
Netflix spends an average of $300 million on postage per year.

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Product
Netflix has DVD and Blu-ray discs of new releases, classics from all genres and time
periods, and TV series.
Anytime streaming of a variety of new releases, classic movies, and TV series, directly to your
computer, television, or gaming consol.
Netflix is continuously working with studios to add more titles, including the deal with Warner
Bros., which will increase the number of titles Netflix has to offer.

Promotion
Netflix began with extensive advertising campaign in many different mediums. They have taken
advantage of newspaper/magazine advertising, TV commercial advertising, and online
advertising. Web banners, ads o a ious e sites, a d pop-u de ads a e thei ost
prominent form. These ads appear underneath the website one has recently visited, and have
actually had a negative response from consumers (Kaltschnee, 2009). As Netflix has experienced
significant popularity and recognition, there has been a drop in advertising campaigns. It now
relies heavily on viral marketing. In a survey conducted by Neilsen Online and ForeSee/FGI
Resea h, o e % of su e ed su s i e s sa that the ould e o e d Netfli ’s se i es
to a f ie d. Netflix Corporate Fact Sheet).

Place
Netflix is primarily a US business. Recently in 2010, Netflix has announced that they are going to
be moving into the European market as a streaming only service.
PC’s, Internet streaming, and DVD and Blu-ray discs.
Product Life Cycle
Netflix has created a product life cycle that has been thriving in the growth stage ever since it
was created. They have currently captured 10 million subscribers who pay a monthly fee for
access to a library of over a hundred thousand titles. The DVD title sales are entering the
mature phase of the product life cycle, while the Blu-ray discs are still in the growth phase.
Internet streaming as well as streaming onto the game consoles has just recently moved past
the introduction phase and has really started to grow. The ease and accessibility of online
streaming has created a market that has much less cost than their current plan of mailing out all
of their movie rentals, and it is the foreseeable future of the Netflix business model.

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 III E. Financial Analysis
III E. 1 Netflix Financial Performance Analysis
Below is a list of the financial ratios for Netflix over the past five years. The same equations were
used when evaluating our industry competitors in Exhibit 3 to remain consistent across all
companies.

Netflix, Inc.
Financial Ratio Formula Measure 2004 2005 2006 2007 2008 Average

Sales Growth (Current Sales - Prior Sales) / Prior Sales Growth 85.95% 34.76% 46.09% 20.94% 13.76% 40.30%

Gross Profit Margin (Sales - COGS) / Sales Profitability 62.81% 47.41% 52.86% 53.44% 51.28% 53.56%

Return on Assets Net Income / Average Total Assets Profitability 8.58% 11.52% 8.06% 10.35% 13.44% 10.39%

Debt to Equity Ratio

0.61 0.61 0.47 0.50 0.78
(times) Total Liabilities / Stockholders' Equity Leverage 0.59

Current Ratio (times) Current Assets / Current Liabilities Liquidity 1.97 1.77 2.21 1.96 1.67 1.92

Acid Test (times) (Current Assets - Inventory) / Current Liabilities Liquidity 1.97 1.77 2.21 1.96 1.67 1.92

Collection Period (days) 365 x Average Receivables / Sales Efficiency N/A: no receivables 0.00

Inventory Holding Period

N/A: no inventory
(days) 365 x Average Inventory / COGS Efficiency 0.00

Return on Equity Net Income / Average Stockholders' Equity Profitability 13.82% 18.58% 11.85% 15.54% 23.92% 17.00%

Asset Turnover Sales / Average Total Assets Efficiency 1.99 1.87 1.64 1.86 2.22 1.92

Times Interest Earned EBIT / Interest Expense Liquidity N/A: no interest expense 49.50 49.50

What is important to note about Netflix is the lack of inventory and production costs. As most of
their tangible titles are either rented or bought in mass quantities at a significant discount, profit
margin appears to be tremendously healthy. Their primary costs lie in the packaging and
shipping of titles, as well as servers that monitor subscriptions. Their high sales growth can be
attributed to the fact that Netflix is a relatively new company still in the high growth model of
the business cycle. The drastic decrease in sales growth from 2006-2007 and then again from
2007-2008 is a direct result of a high number of subscriptions early. As the number of people
taper off, sales growth appears to have a health decrease as the company reaches the mature
phase of the usi ess le. As Netfli ’s usi ess odel is o e depe de t o su s iptio
growth rather than managing operation expenses, sales growth, gross profit margin, and return
on equity are the key ratios to monitor to determine the health of Netflix.

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III E. 2 Valuation of Netflix
Valuation Technique

Netflix can best be valued using a Net Present Value (NPV) valuation. This technique is most
espo si e to g o th i fi s, hi h is ge e all a good i di ato of a fi ’s t ue value. The
major fallback is that the valuation relies heavily on predictions about growth in the firm. Please
refer to the Financial Index for a complete rationale for NPV Valuation.

Key Assumptions

The valuation technique is based closely on the forecasted predictions of Netflix executives. This
model follows the forecasted predictions that were stated in the earnings call in February, 2010.
The primary forecasting prediction lies in the growth of the firm. Netflix executives predict that
their transition from physical DVD and Blu-ray titles to a purely streaming system is their
number one strategic goal. As this relatively new technology takes off, high growth numbers are
forecasted for several years into the future. As the company matures and settles in to its market
niche, growth is expected to slow exponentially.

The rest of the financial information is pulled directly off of the 10-K issued in February, 2009.
The complete financial data and information can be found in Exhibits 22-30. This growth model
does assume a constant tax rate into perpetuity and that operation models do remain fairly
constant.

Netflix Value

A valuation of Netflix yields an Enterprise Value of $2,162,000,000 as of February, 2009. Using

the shares outstanding value provided in the 2008 10-K, Netfli ’s fai a ket alue is $ . pe
share. Please refer to the Financial Appendix for a complete step-by-step process of how this
value was derived.

Enterprise Value
PV of FCF $ 4,633,303,785

Enterprise Value $ 2,162,955,933

Shares Outstanding 60,961,000

Stock Price $ 35.48

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III E. 3 Scenario Analysis
Valuation Technique

To remain concurrent with the valuation technique of Netflix alone, the scenario analysis also
uses a NPV Valuation for the same purposes as stated in the previous section.

Key Assumptions

In addition to the assumptions that have already been stated above, the deal with Warner Bros.
has several significant implications. Our growth horizon is stretched slightly under the new
agreement. As Netflix acquires more titles and access to streaming video, growth can be
expected to remain high for an extra year as Netflix emerges as a niche giant. As other
competitors begin to implement similar strategies, growth rates are expected to come down
and settle slightly higher than if this agreement would have not been made due to the strategic
benefits.

On the financial statements, several major impacts are forecasted to occur as a direct result of
the deal. Although customers will gain access to more titles and in streaming capabilities,
revenue is expected to drop slightly, as consumers will feel dissatisfaction because of restricted
title access on e elease o ies. A % e e ue de ease is e pe ted i as usto e s
are forced to deal with this inconvenience. Netflix executives are not worried about this slight
d op. I thei ea i gs all, the stated that the e elease de og aphi o l constitutes
roughly 20% of their entire revenues. This small portion, they predict, will only see a slight
reduction in subscriptions (Netflix 10-K: 2009).

The true benefits of the deal are realized on the expense side of operations. The primary cut will
come from the lower title acquisition costs offered by Warner Bros. As the deal progresses,
Netflix expects to see a 10% reduction in technology and development as new titles will be
provided in a streaming content, reducing shipping and packaging costs. As Netflix does
purchase a large portion of their titles permanent, the transition to streaming video is expected
to yield a 25% increase in cost of disposal of these DVD’s o e the -year period( Netflix 10-K:
2009 . )

Netflix Value

As a result of the deal, a total enterprise value is expected to be close to $3,229,000,000. The
primary reason for the major increase stems from this deal heading the major strategic move
into streaming video. Despite the cutbacks in revenue, the savings in expenses is expected to
raise the value of Netflix. As a result, the new expected fair market value in stock is $52.97 per
share.

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 Enterprise Value
PV of FCF $ 7,693,510,681

Enterprise Value $ 3,229,352,885

Shares Outstanding 60,961,000

Stock Price $ 52.97

Implication of the Warner Bros. Deal

What this case signifies is the potential impact of an industry that becomes completely
reinvented. Instead of consumers leaving their homes, driving to the nearest video rental store
and renting a title, Netflix suggest the industry is headed toward access directly from computers
and wireless enabled TV sets. With the technology already present online via computer,
PlayStation 3, and Xbox 360, Netflix executives have decided to completely shift their focus from
mail delivery of titles to direct selection. This deal with Warner Bros. is a major step in achieving
this new business model. As a result, the company can expect to see at least a $1,067,000,000
increase in firm value and a 33% increase in value for stockholders.

IV. Analysis of the Effectiveness of the Strategy

After a detailed analysis, Netflix is headed in the appropriate direction to achieve their strategic
goals and capitalize on growth. Market analysis shows that the DVD rental industry is trending
toward streaming. By making content available for streaming, consumers will have access to
titles via wireless technology. As the improvement of streaming technologies in video game
consuls and computer increases, more consumers will have access to the industry in a
convenient manner. Developments in wireless technology directly in television will only help
improve the streaming market. Netflix was the first rental company to offer video rental
management over the Internet, which has drastically set them apart from their competitors for
so many years. As the market shifts toward streaming, Netflix already is strategically placed to
offer titles via the Internet.

The deal they have struck with Warner Bros. is highly beneficial to both firms. Netflix will gain
access to more titles that is highly geared toward streaming capabilities. A greater selection of
movies will ultimately place Netflix at the top of the industry as it shifts into streaming
technology. With the ability to cut costs, Netflix will ultimately be able to spend money to
improve streaming technologies. While they will not have access to new release titles, Netflix
has made its name off of serving people who want to browse through a large catalogue opposed
to already knowing the title they wish to view by nearly three times. Capitalizing on this portion
of their customers will improve satisfaction and help retain subscriptions.

As the industry shifts toward streaming technology, Netflix already has an established catalogue
system and server technology to offer streaming content on a variety of platforms. This will
greatly set themselves above the competition in the future as no resources and capital will need
to be spent in developing this technology. Streaming technology will also cut down on the price
to acquire physical titles and shipping costs to consumers. Decreased expenses will help improve
profit margins, as well as leave resources available for acquiring new titles. Netflix, according to

34 | P a g e
executi es, is ot o ied a out losi g a f a tio of thei % a ket that desi e e
release titles. Even with short-term projected revenue losses, Netflix executives
strongly believe that their shift into new technology will position themselves nicely in the future.

Netfli ’s st ateg to o e i to st ea i g ill positi el affe t the fi as a hole. O li e

streaming is a growing industry that is predicted to continue to expand rapidly in the future.
Since Netflix has already begun moving into the industry they are steps ahead of many of their
direct competitors. By moving forward in streaming and potentially cutting back in physical
e tals, Netfli ’s alue ill i ease hile its osts d a ati all de ease o e sa ed o
warehouses, factories, and shipping). According to their VRIO framework analysis, Netflix is in a
moderately sustainable position with advantages that are not easy to imitate in the short term
and long term. Even given the 28-day gap in ability to rent out new releases, Netflix is in a
comfortable position that should continue to keep the firm ahead of competitors and the fan
favorite.

While all market predictions indicate that the market is headed toward streaming technologies,
the e a e se e al issues that ould affe t Netfli ’s position among competitors. They are
essentially placing all of their eggs in the basket of streaming. Netflix is completely on Internet
capable T.V sets being developed and being integrated into households. Without this technology
component, the streaming market will be limited to computers and video game consuls. Netflix
also signs long term contracts with all of their title suppliers. With the contracts that are
relatively new such as Starz, Netflix will need to be successful in re-negotiating terms of their
contracts to enable streaming possibilities in order to be successful. If either of these
components is not successful, Netflix may be too highly leveraged into streaming technologies
and could potentially struggle to re-enter the physical DVD markets as a leader.

V. Recommendations
V A. Short-Term and Long-Term Recommendations
V A. 1 Short-Term Recommendations
Partnerships with Content Providers

In September of 2008, Netflix partnered with the premium movie broadcast network Starz to
increase its selection of streaming titles. Netflix began to offer Starz titles to its customers
through Starz Play, an online streaming library of more than 2,500 (at the time) current new
releases, concerts, and older titles. (Hoffman) This helped Netflix improve its selection of
streaming titles. As the industry moves toward streaming content, Netflix will be able to attract
more consumers and improve its market share by continuing to improve its selection of online
current releases, and more popular movies.

Netflix has long prided themselves on their deep selection of titles, and their unorthodox profits,
70% coming from older titles, the opposite of traditional profits in the home video rental
market. (Spinola) As they continue to move into streaming rentals, it will be important that they
can also leverage new releases, which have the highest demand. Partnerships such as the one
with Starz will enable them to expand their selection at low cost, because they do not have to
acquire it from the studios. The Starz Play service also offers two unique opportunities that put
Netflix in direct competition with cable providers, at a very low price: viewing of the Starz
channel online, through Netflix service, and access to original Starz shows. Hence, Netflix could
stand to gain viewership by partnering with other premium cable content providers such as HBO

35 | P a g e
and Showtime, and other cable stations like MTV, Comedy Central, TNT, TBS and
others, all of whom offer award winning series, and other popular shows. With the
ability to stream shows and movies in the libraries from these sites will vastly increase the
online viewership of Netflix, and pose a real threat to cable providers, whose prices are much
more expensive and offer less interactivity and control over viewing.

Such partnerships will prove to be mutually beneficial for both parties. By making video
available whenever consumers want it, it enables them to watch more, around their own
schedule, without the hassle of dealing with a DVR library. This will beg a lot of questions of the
industry; especially for content providers whose TV ratings will likely decrease further with even
more flexible viewing. In fear of retaliation from larger networks, we encourage Netflix to enter
slowly, pursuing this opportunity on a short term, but potentially long-term basis.

Smartphones

Smartphones introduce another market for Netflix to potentially grow their streaming market.
According to Dilanchian.com, a news and law articles website, smartphone sales in 2009 were
176 million and in 2010 they are projected to be at around 223 million. This statistic shows that
we are moving into a new area where smartphones are taking over the cell phone market.
More and more people have been given access to the mobile Internet. Currently Netflix has an
application on the iPhone for people to manage their account and pick which movies they will
be receiving next in the mail. Moving forward, Netflix should look to expand this application to
allow the mobile phone user to stream movies and television titles directly onto their phone to
allow instant viewing anywhere the user might travel. If this strategy is going to be effective
Netflix, they will need to expand their current streaming library in order to create more interest
for the consumer to use this application.

VA. 2 Long-Term Recommendations

Partnering with Airlines

The video entertainment industry can be broken down into four main markets as mentioned in
the industry overview. Airlines are one of four markets, in-home is another. Major airlines have
begun installation of Wi-Fi broadband routers in aircrafts this year. For instance, Southwest has
planned to begin installation of routers into 15 of its aircrafts per month beginning in April, and
will accelerate to 25 per month. (Patricia) The whole fleet will be outfit with wireless capability
for consumers by 2012. (Patricia) Other airlines, such as Virgin already offer Wi-Fi connections
to their customers. Broadband antennas are already installed in most aircraft, and new fleets
come with antennas built-in to the chassis. (Patricia) With broadband capabilities in aircraft for
all major airlines, Netflix could distribute through airlines to airline and Netflix customers alike.

This could work in a few ways: Netflix could offer their streaming library to airlines, who in turn
could offer it to their passengers for a flat trip fee, and to accompany the complementary
selection. Airlines could also choose to eliminate the complementary selection and go Netflix all
the way (either complementary or not). This might be challenging for airlines because Netflix
does not provide streaming access to new-releases, and to-be-released films, as are currently
offered as in-flight entertainment. Netflix could also be available solely to their subscribers
through entertainment systems in the airplane. With the expansion of broadband access to
passengers, current subscribers would be able to access their accounts during the flight, but

36 | P a g e
incur large in-flight broadband usage fees, which characterize current in-flight access
offered in select carriers. In any of these scenarios, selection could be limited or
Netfli ’ e ti e st ea i g li a ould e ade a aila le fo i -flight entertainment. Such a
deep selection is otherwise impossible for carriers to provide in their planes due to secondary
storage constraints of electronic hardware, and the costs associated with procurement and
implementation of the video systems.

As the airline industry is still working out the kinks in these plans, Netflix should work to
establish partnerships with major carriers to be one of, if not the exclusive content provider for
flights. This will provide a good opportunity for airlines by establishing yet another medium
through which they can engage in price discrimination. The partnership would most likely
function around a revenue-sharing model if Netflix content was provided complementary with
flight service, as is typical of streaming content. Netflix could also take a majority of access fees
from the airline, in return offering increased value to passengers and increased ticket sales. This
will prove to be a huge opportunity for Netflix, who currently competes in a growing segment of
a market within a greater industry. This will plant them firmly in two of the markets in the video
entertainment industry, making them a unique competitor in the overall industry without
swaying from their core competencies.

Greater Title Selection

This idea has been mentioned a number of times throughout our report, and ties in with a
number of the key industry trends. With technology convergence, the growing proportion of
savvy consumers is expecting a full selection of titles at their fingertips, on their schedule.
Netflix will be able to capture more of the market with increased selection, an elementary
supply concept. Furthermore, if Netflix can establish itself as a one-stop shop for titles,
consumers will be able to depend on them for their video entertainment. This will lead to more
suppliers wanting their titles offered through Netflix, leading to a network effect which will
greatly benefit Netflix.
International Growth

Recently Netflix had attempted to create a deal that would introduce streaming online content
overseas into the UK. The current main distribution method of physical transportation of DVD
and Blu-ray discs would not be able to transfer over to the UK in a cost effective manner. The
only way to make Netflix an international means of movie and television program distribution
center would be to increase the technology level Netflix is able to offer in online streaming.
Going international is considered to be a long-term transition because in order for it to be
successful, Netflix will need to increase their library of downloadable content. Currently Netflix
only offers viewers 10,000 titles, most of which are not highly demanded. Along with increasing
their total number of movies, they also need to gain access to higher quality movies, which they
can distribute internationally. Netflix is primarily used in the United States; it will take a
considerable amount of time in order to establish relationships with countries that Netflix
wishes to distribute to. We recommend that Netflix focus primarily on expanding into Europe
where they have a huge potential to gain a large audience. The roadblock that needs to be
overcome is their current streaming abilities, as well as their actual title library for streaming
content.

37 | P a g e
V B. Strategy Implementation
V B. 1 Short-Term Strategy Implementation: Video Game Industry
Netflix is in a position to make a push into a new market, one which has been historically well-
blended with the video rental industry. Currently Netflix only specializes in the distribution of
DVD and Blu-ray disc titles, while some competitors have been able to gain the upper hand by
also renting out video games to their consumers. In Netflix’s current business model, they have
made all of the necessary arrangements to gain the ability to stream movies directly onto the
three major gaming systems, the PlayStation 3, Xbox 360, and the Wii. The next step that Netflix
should make is to arrange deals with major video game companies to allow the ability to rent
out video games by directly streaming them onto the consumers gaming consol.

This move would open up a brand new market for Netflix, and would attract new customers
who are less interested in movies, and more interested in games. For the consumer who is only
interested in the videogame rental aspect of this move, it would be wise for Netflix to create a
fifth pay structure that was purely for the rental of videogames, as well as including videogame
rentals in their existing pay structures. This move also has the added benefit of contributing to
customer retention because now Netflix is offering a new product to keep the consumer happy.

When looking at the V-C model, it is easy to see that value is going to increase due to the
expansion into a new market. Video store rentals have always offered the option to rent
videogames as well as movies; now that Netflix has the streaming ability they have positioned
themselves to compete effectively and raise the value of what they can offer the consumer.

V B. 2 Long-Term Strategy Implementation: Streaming

In the long-te , Netfli ’s ai focus should be to fully implement and dominate online
st ea i g. The i dust ’s su fa e is just o ei g ushed upo , ut ith the i easi g
popularity of Internet in all aspects of everyday life, it is undoubtedly going to expand vastly.
Netflix is in an ideal position, as they already have invested in streaming technology, so the next
step is to increase the number of titles. Management should not have many problems
implementing this recommendation, as they are already in the process. However they need to
act quickly to ensure that they dominate the industry. Brand recognition and equity have been
huge for Netflix, and by acting quick to step ahead as they did with online DVD rentals, they
have the opportunity to have consumers link online streaming directly to Netflix.
Netflix has already invested in online streaming technology; since the main expenses have
already been taken care of, it will not be much added cost to expand the streaming feature. The
main steps now are greatly increasing the number of titles available as well as increasing
consumer awareness and accessibility. First Netflix should execute agreements with
entertainment firms, such as Warner Bros., to allow for more titles to be available.
Simultaneously they should begin to implement advertising campaigns to promote awareness of
the streaming feature, highlighting its convenience. They should also emphasize that the
streaming can be part of a previously owned monthly contract with Netflix for current
consumers, and create an alternative pricing plan for streaming alone, without the DVD rental
option. This will slowly shift Netflix into the streaming industry, ideally more so than the DVD
rental industry in the long run.
Financially, moving from streaming while slowly decreasing DVD rentals will lower costs for
Netflix. Ideally current users as well as new customers will use the streaming feature, so even if
the DVD rental service declines, revenues will not decline as well. If this shift is significant

38 | P a g e
enough Netflix will be able to shut down some of its warehouses as well as enjoy
de eased aili g osts. These a tio s ill g eatl lo e Netfli ’s Cost, hile
simultaneously increasing Value by moving into a new industry and targeting a new market
while satisfying current markets at the same time. It is an ongoing process that will continue to
be in the works as deals are made, titles are added and customers are converted, but in the long
run will significantly benefit Netflix.
Furthermore, if Netflix is able to exploit streaming, it will also have the opportunity to gain
international customers. We recommend that they implement international segments—
exclusively through streaming—in order to control the industry even further. When they
focused solely on online DVD rentals, it would have been incredibly costly and tedious to serve
to an international market, and completely unnecessary. But as their streaming feature grows,
Netflix should definitely look into offering service to international customers.

V C. Corporate Social Responsibility and Ethical Decision-Making

Practices
Short Term
Netflix, started in California, could help support the University of California school system by
streaming video to classes for free. If students needed to watch a movie for class or if an
instructor needed to show a movie in class, Netflix could help with the U i e sit of Califo ia’s
current budget deficit and stream video for free. Netflix could also stream free video to
Califo ia’s pu li K-12 schools, which are also in a major cash crunch.
Long Term
In the long term, Netflix could recycle its DVD and Blu-ray discs when deleting part of its
inventory. The company could do this in a variety of ways. It could donate its old titles to
libraries, which could lead to a possible tax credit. Netflix could also donate the DVDs it wants to
dispose of to Operation Showtime, a service that allows you to donate your old or unwanted
DVDs to troops overseas. Netflix could also donate some of its old DVDs to schools or
u i e sities. All of these optio s ould edu e aste, sa e people o e , a d oost Netfli ’s
reputation.

VI. Conclusions
With the current strategic agreement resulting from the Warner Bros. deal, Netflix is in a good
space provided technology can successfully aid the formation of this market evolution. The
analysis in this document proves that market trends are clearly pointing toward a streaming
market. Executives are prepping the company for a complete move into streaming and are
assured that this is the best strategic move for Netflix. Netflix is already poised as a industry
leader, and will continue to do so in the emergence of a complete streaming space. The
valuation in this Netflix demonstrates a significant value increase as a direct result of the Warner
Bros. deal. Stock prices are forecasted to rise about 30%, a strong indication of the potential of
the company when they completely shift into streaming (as seen below). As an investor, Netflix
should be closely monitored as a strong buy in the near future as they will continue to remain
on the cutting edge of the video rental industry.

39 | P a g e
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VIII. Main Appendix

Exhibit 1: Video Entertainment Industry Diagram

*This displays the four industries Netflix is in, focusing mainly on the Home Video Entertainment Industry

Exhibit 2:

Average Weekly Hours of Consumption by Age

All 18-24 25-34 35-44 45-54 55-64 65+
Total hours with video content 22.1 25.1 20.4 22.4 23 20.6 22.1
Watching TV programming at its
broadcast time on your television 11.4 6.6 7.7 9.6 12.9 15.9 15.6
Watching TV programs on your digital
video recorder (DVR) on your television 2.4 2 3 3.1 2.3 2.5 1.3

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Watching DVDs or Blu-ray discs on your
television 1.8 2.5 2.9 1.6 2 1.4 0.6
Watching TV or movies in a movie
theater 1.5 1.6 1.6 1.3 1.7 1.1 1.8
Watching short videos on a PC 1.2 2.2 1.9 1.3 0.8 0.6 0.6
Watching a TV show on a PC 0.9 2.2 1.6 0.9 0.5 0.2 0.1
Watching a movie on a PC 0.8 2 1.7 0.7 0.4 0.3 0.1
Watching TVs or movies on a portable
DVD player 0.8 1.1 1.2 0.8 0.9 0.4 0.2
Watching pay-per-view (PPV) or video
on demand on your television 0.7 0.8 1.3 0.7 0.7 0.4 0.2
Watching streaming or downloaded
videos or television on a cell phone 0.2 0.4 0.9 0.1 0 0.1 0
Watching TV or movies on another
portable device, such as a handheld
game player or a GPS device or camera 0.2 0.3 0.7 0.1 0.1 0 0
Watching TV shows or movies on a set-
top box such as Unbox or Apple TV or
Hulu, or on a PC media center
connected to your TV 0.2 0.4 0.6 0.2 0.1 0.1 0.1
Base: 2,000 internet users aged 18+
Source: Mintel 2010

44 | P a g e
 Exhibit 3: Average Weekly Hours of Consumption by Age

Exhibit 4:
Leisure Activities at Home, by Age, April 2007-June 2008
All 18-24 25-34 35-44 45-54 55-64 65+
% % % % % % %

Card games 41 51 47 44 38 35 32
Gardening 33 12 26 35 40 40 38
Board games 31 41 43 40 29 23 15
Needlework/quilting 9 4 8 7 9 14 13
Painting, drawing, sculpting 9 21 12 8 7 6 5
Base: 24,581 adults 18+
Source: Mintel/Experian Simmons NCS/NHCS: Spring 2007 Adult Full Year—
POP

45 | P a g e
Exhibit 5:
Hours Available For Leisure Per Week,
1973-2008
Median number of leisure
Year hours

2008 16
2007 20
2004 19
2003 19
2002 20
2001 20
2000 20
1999 20
1998 19
1997 20
1995 19
1994 20
1993 19
1989 19
1987 17
1984 18
1980 19
1975 24
1973 26
Base: 1,010 Americans aged 18+
Source: Mintel/Harris Interactive

46 | P a g e
Exhibit 6: Industry Six Forces Analysis
Complements – Extremely Favorable (1)
Force and Underlying
Streng
Factors Effect on
th Explanation of Factor
(Factors By Rank of Industry
(1-5)
Importance)
With the rate of technology convergence, ease of
Ease of Bundling Favorable 1 bundling is becoming the most important and
favorable factor for the industry
Bundled with other complements, such as Video
Players, consoles, set-top boxes, and increasingly
Television (Hardware) Favorable 2 with computers and internet, making bundling with
online rentals easier.
Not bundled with many technologies, other than
Video Players Neutral 3 output to television. Video players are parts of
computers and consoles.
Computer Favorable 1 Very easy to bundle because of multi-functionality
Accessed through computers, consoles, and set-tops.
Internet Favorable 1 Blu-ray video players now access the internet as well,
so it is becoming easier and easier to bundle
Consoles are essentially computers, with more
dedicated operating systems and restrictive GUI, but
Consoles Favorable 1 like computers,,, Very easy to bundle because of their
trend toward multi-functionality
More dedicated to specific services, but, like consoles,
Set-top boxes Favorable 2 are becoming more like computers and more multi-
functional.
All complements increase pull-through, multi-
Differences in Pull- function devices that have greater bundling
Favorable 1 capabilities will increase pull-through in all
through
market segments.
Very strong pull-through, greater for needy
Television (Hardware) Favorable 1 consumers
Strong pull-through, but very dedicated purpose and
Video Players Favorable 2 function.
Very strong pull-through, vast capabilities for
Computer Favorable 1 bundling and increased ease of use and channel
access.
Very strong pull-through, good for convenience
Internet Favorable 1 consumers
May have the greatest pull-through because of ease
of use, and multi-functionality with substitutes, and
Consoles Favorable 1 appropriateness for most needy consumers and all
convenience consumers
May have the second greatest pull-through because of
Set-top boxes Favorable 1 ease of use, and appropriateness for most needy
consumers and all convenience consumers
Steady growth in entertainment video industry
around 10%. This combined with increasing
Rate of Growth of bundling will lead to continued breakthrough
Favorable 1 technologies and continued market expansion
Value Pie
through innovation. Ease of use and channel
access is driving up value at a breakneck pace.
Complement suppliers are for the most part
Concentration Neutral 3 unconcentrated.
CR3 = 30%. Not very concentrated, and competitively
Television (Hardware) Favorable 1 priced generics (Lawler)

47 | P a g e
 Video Players Favorable 1 Not concentrated, generics are extremely common
Pretty concentrated, CR4 = 71%. However, basic
technology required to access online rentals and TV-
Computer Neutral 3 viewing, is inexpensive and offered through generic
products. (Foresman)
CR4 = 46%. Not very concentrated. Percentage of
Internet Favorable 2 Americans with broadband access is increasing
rapidly. (StatOwl)
Very Concentrated, online rentals and sales come
Consoles Unfavorable 5 through Microsoft’s Xbox, Sony’s Playstation3, and
Nintendo’s Wii, given broadband access.
Boxes such as Roku and AppleTV, and TiVo are very
Set-top boxes Unfavorable 5 concentrated.
Threat of Vertical Vertical Integration is a threat from MSOs, but
Neutral 3 other complements are not much of a threat.
Integration
There is no threat of vertical integration of television
manufacturers moving into video rental, some large
Television (Hardware) Favorable 1 corporations such as Sony, with entertainment arms,
may pose some threat, but reaching into the space is
still a reach.
There is no threat of vertical integration of video
Video Players Favorable 1 player manufacturers moving into video rental
There is no threat of vertical integration of computer
Computer Favorable 1 manufacturers moving into video rental
MSOs also providing cable pose a threat in online
Internet Unfavorable 5 rentals as well as their established position in VOD
provision.
Console manufacturers with business arms in video
entertainment and video entertainment distribution,
Consoles Unfavorable 3 such as Sony pose a fair threat of vertical integration.
Microsoft may also pose a threat through their (Xbox)
Live Marketplace.
Specifically, AppleTV is already vertically integrated,
and other set-tops continue to establish beneficial
partnerships that may lead to eventual mergers into
Set-top boxes Unfavorable 3 fully vertically integrated cores (Amazon and TiVo,
Netflix and Roku—though Netflix has partnerships
with many hardware providers).
Buyers have almost non-existent switching costs,
Relative whereas supplier switching costs come in the
form of lost opportunities, and lost revenues, so
(Buyer/Supplier) Favorable 2 buyer has lower switching costs, leading to a
Switching Costs relative push from suppliers, which should
increase margins for industry members

Threat of Entry – Moderately Unfavorable (4)

Force and Underlying
Streng
Factors Effect on
th Explanation of Factor
(Factors By Rank of Industry
(1-5)
Importance)
The end product is undifferentiated, while
Product
Unfavorable 5 strategic groups/segments differentiate from
Differentiation each other through their respective channel
End-product is the same, immediate viewing
Online Rental Segment Unfavorable 5 separates segment from brick and mortar and mail

48 | P a g e
 delivery segments, because of ease of use and
immediate access. Can be watched on computer or
TV with access through set-top boxes (AppleTV,
Netflix) and gaming consoles
End-product is the same, immediate viewing
Video-On-Demand separates segment from brick and mortar and mail
Unfavorable 5 delivery segments, because of ease of use and
(VOD) Segment
immediate access. Viewing only on TV.
Brick and Mortar
Unfavorable 5 End-product is the same
Rental Segment
Mail Delivery Segment Unfavorable 5 End-product is the same, longer access times
End-product is the same, medium accessibility
DVD Vending Kiosks
Unfavorable 5 compared to other segments, less selection, but easy
Segment to use and very inexpensive
End-product is the same, immediate viewing
separates segment from brick and mortar and mail
delivery segments, because of ease of use and
Digital Sales Segment Unfavorable 5 immediate access. Can be watched on computer or
TV with access through set-top boxes (AppleTV,
Netflix) and gaming consoles
End-product is the same, some customers prefer
Physical Sales Segment Unfavorable 5 ownership of hardcopy over softcopy
Access to Distribution Firms differentiate by capturing distribution
Unfavorable 4 channels, which are becoming easier to access
Channels
Online Rental Segment Unfavorable 5 Very easy access, trend toward more online rentals
Video-On-Demand Harder to obtain distribution channels because they
Favorable 1 are dominated by MSOs, trend toward VOD rentals
(VOD) Segment
There is access to distribution channels here, but
Brick and Mortar
Unfavorable 4 trend is away from this traditional channel toward
Rental Segment online and delivery
Mail Delivery Segment Unfavorable 5 Easy access to this segment
DVD Vending Kiosks Access controlled by retailers and grocery stores but
Unfavorable 4 easy
Segment
Digital Sales Segment Unfavorable 5 Very easy access, trend toward more online rentals
There is access to distribution channels here, but
Physical Sales Segment Unfavorable 4 trend is away from this traditional channel toward
online and delivery
Economies of scale are falling as the industry
Economies of Scale Neutral 3 moves more toward streaming content.
High ratio of fixed costs to variable costs for
hardware and software versus title acquisition and
consumer access, revenue sharing deals and digital
Online Rental Segment Unfavorable 4 copies lead to decreased cataloguing expenditures.
This segment is moderately easy to enter based solely
on economies of scale.
Video-On-Demand
Favorable 1 Segment controlled by MSOs, high network costs.
(VOD) Segment
Leasing can lower costs, but relatively small
Brick and Mortar
Unfavorable 4 economies of scale to enter market. True competitive
Rental Segment entry requires much larger economies of scale.
Almost no barriers to entry, cataloguing expenditures
Mail Delivery Segment Unfavorable 5 increase with additional usage.
DVD Vending Kiosks
Favorable 1 High costs of kiosk manufacturing and distribution.
Segment

49 | P a g e
 High ratio of fixed costs to variable costs for
hardware and software versus title acquisition and
consumer access, revenue sharing deals and digital
Digital Sales Segment Unfavorable 4 copies lead to decreased cataloguing expenditures.
This segment is moderately easy to enter based solely
on economies of scale.
Video sales mostly done through large retailers such
as Wal-Mart and Best Buy, few committed media
Physical Sales Segment Neutral 3 entertainment stores, most has transitioned into
online spaces.
There are experience effects associated with time
Cost Advantages in the industry and relationships established with
Favorable 2 suppliers build trust and lead to lower acquisition
Independent of Scale
costs and greater selection.
Supplier trust/relationship, moderate experience
Online Rental Segment Neutral 3 effect
Video-On-Demand Supplier trust/relationship, moderate experience
Neutral 3 effect
(VOD) Segment
Brick and Mortar Supplier trust/relationship, moderate experience
Neutral 3 effect
Rental Segment
Mail Delivery Segment Favorable 2 Supplier trust/relationship
DVD Vending Kiosks Supplier trust/relationship, learning effects and
Favorable 1 experience effects
Segment
Supplier trust/relationship, moderate experience
Digital Sales Segment Neutral 3 effect
Supplier trust/relationship, moderate experience
Physical Sales Segment Neutral 3 effect
Capital Requirements vary immensely across
Capital Requirements Favorable 2 segments, but are relatively sizeable, leading to a
favorable factor
Online Rental Segment Neutral 3 Low-medium capital Requirements, but good ROA.
Large capital requirements, VOD offered through
Video-On-Demand
Favorable 1 telecom providers and Multi-service operators
(VOD) Segment (MSOs), operates as secondary business.
Brick and Mortar Medium capital requirements. Total current and PPE
Favorable 2 assets make up 70-80% of total assets.
Rental Segment
Very low capital requirements, almost completely
Mail Delivery Segment Unfavorable 5 dependent on scale, distribution centers cost Netflix
$60,000 set-up (Spinola)
Medium-high capital requirements. Manufacture of
DVD Vending Kiosks
Favorable 2 kiosks is large cap requirement substituted for
Segment traditional labor costs.
Low capital requirements, similar to online rentals,
Digital Sales Segment Unfavorable 4 with less distributional and cataloguing capabilities.
Video sales mostly done through large retailers such
as Wal-Mart and Best Buy, few committed media
Physical Sales Segment Favorable 1 entertainment stores, most has transitioned into
online spaces, large overheads and capital
requirements
There is no contrived deference against entrants
Contrived Deference Unfavorable 5 in any of the segments.
There is little regulation in the industry, and
Government Barriers
Unfavorable 5 almost no government BTE except for in the MSO
to Entry (BTE) segments, which are the least likely to be entered.

50 | P a g e
Supplier Power – Moderately Unfavorable (4)
Force and Underlying
Streng
Factors Effect on
th Explanation of Factor
(Factors By Rank of Industry
(1-5)
Importance)
Product There is perfect product differentiation at the
Unfavorable 5 supplier level
Differentiation
Perfect differentiation, video rental is a pull-through
Online Rental Segment Unfavorable 5 product and trend toward broad differentiation
requires full access to titles from all suppliers.
Perfect differentiation, video rental is a pull-through
Video-On-Demand
Unfavorable 5 product and trend toward broad differentiation
(VOD) Segment requires full access to titles from all suppliers.
Perfect differentiation, video rental is a pull-through
Brick and Mortar
Unfavorable 5 product and trend toward broad differentiation
Rental Segment requires full access to titles from all suppliers.
Perfect differentiation, video rental is a pull-through
Mail Delivery Segment Unfavorable 5 product and trend toward broad differentiation
requires full access to titles from all suppliers.
Perfect differentiation, video rental is a pull-through
DVD Vending Kiosks
Unfavorable 5 product and trend toward broad differentiation
Segment requires full access to titles from all suppliers.
Perfect differentiation, video sales are a pull-through
Digital Sales Segment Unfavorable 5 product and trend toward broad differentiation
requires full access to titles from all suppliers.
Perfect differentiation, video sales are a pull-through
Physical Sales Segment Unfavorable 5 product and trend toward broad differentiation
requires full access to titles from all suppliers.
Television studios pose a small threat into online
Forward Integration rentals and VOD, but suppliers risk a lot by
Favorable 2 straying from core competencies to distribute
Threat
directly to consumers.
Television producers especially pose a great forward
integration threat as they have continued to enable
online viewing of their shows through respective
studio websites. However, they lack a large catalogue
of titles and do not provide old (archived) episodes
for online viewing. As the video rental industry
Online Rental Segment Neutral 3 continues to move more towards online and
immediate viewing media, movie studios may pose
more of a threat because of the ease of entry into the
immediate viewing space, which might lower
distributional costs, increasing total surplus, and
straining market power of industry members.
Studios and distributors do not have pre-existing
Video-On-Demand
Favorable 1 access to this channels and are unlikely to invest to
(VOD) Segment integrate vertically into this segment.
Studios and distributors do not have pre-existing
Brick and Mortar
Favorable 1 access to this channels and are unlikely to invest to
Rental Segment integrate vertically into this segment.
Studios and distributors do not have pre-existing
Mail Delivery Segment Favorable 1 access to this channels and are unlikely to invest to
integrate vertically into this segment.
Studios and distributors do not have pre-existing
DVD Vending Kiosks
Favorable 1 access to this channels and are unlikely to invest to
Segment integrate vertically into this segment.
Studios and distributors do not have pre-existing
Digital Sales Segment Favorable 2 access to this channels and are unlikely to invest to

51 | P a g e
 integrate vertically into this segment, however,
historical partnerships, such as the Movielink
partnership started in 2002 with a number of studios
is evidence of their concerted interest in this area, as
well as online rentals.
Studios and distributors do not have pre-existing
Physical Sales Segment Favorable 1 access to this channels and are unlikely to invest to
integrate vertically into this segment.
Strategic Importance There is a mutually dependent relationship
of Industry to Neutral 3 between industry incumbents and suppliers for
product to reach consumers.
suppliers
While the portion of studio revenues is not published,
post-theatrical release sales and rentals must account
for a great portion of revenues. Traditional brick and
mortar copies are sold for $80. Online viewing and
VOD has spawned increased licensing and mutually
Online Rental Segment Favorable 2 beneficial revenue-sharing agreements between
industry members and suppliers. The trend toward
online rentals will increase the strategic importance
of this segment to suppliers, increasing favorability in
the near future.
Video-On-Demand A similar trend toward VOD access will increase the
Favorable 2 importance of this segment for suppliers
(VOD) Segment
This rental segment is important to suppliers, but
Brick and Mortar likely makes up a small portion of the gross margin.
Unfavorable 4 Suppliers are looking to new industry technologies
Rental Segment
and consumer demands for best target segments.
This rental segment is important to suppliers, but
likely makes up a small portion of the gross margin.
Mail Delivery Segment Unfavorable 4 Suppliers are looking to new industry technologies
and consumer demands for best target segments.
This rental segment is important to suppliers, but
DVD Vending Kiosks likely makes up a small portion of the gross margin.
Unfavorable 4 Suppliers are looking to new industry technologies
Segment
and consumer demands for best target segments.
A great deal of post-market sales likely come through
Digital Sales Segment Neutral 3 this segment, because of its ease of use.
A great deal of post-market sales likely come through
this segment, because of its ease of use and the
Physical Sales Segment Neutral 3 proximity of other consumer goods—the visibility of
the supplier’s product.
Acceptable substitutes for the convenience
consumer, but lack-thereof for the needy
Substitutes Unfavorable 4 consumer make substitutes for the suppliers
product somewhat ineffectual, increasing
supplier power.
Suppliers face little switching costs, because they
maintain ownership over the end-product,
Switching Costs Unfavorable 3 termination of contracts will lead to lower
distribution and lower sales for the supplier,
discouraging termination or switching.
Suppliers face little switching costs, because they
maintain ownership over the end-product,
Online Rental Segment Unfavorable 3 termination of contracts will lead to lower
distribution and lower sales for the supplier,
discouraging termination or switching.
Suppliers face little switching costs, because they
Video-On-Demand
Neutral 3 maintain ownership over the end-product,
(VOD) Segment termination of contracts will lead to lower

52 | P a g e
 distribution and lower sales for the supplier,
discouraging termination or switching.
Suppliers face little switching costs, because they
maintain ownership over the end-product,
Brick and Mortar
Unfavorable 3 termination of contracts will lead to lower
Rental Segment distribution and lower sales for the supplier,
discouraging termination or switching.
Suppliers face little switching costs, because they
maintain ownership over the end-product,
Mail Delivery Segment Unfavorable 3 termination of contracts will lead to lower
distribution and lower sales for the supplier,
discouraging termination or switching.
Suppliers face little switching costs, because they
maintain ownership over the end-product,
DVD Vending Kiosks
Unfavorable 3 termination of contracts will lead to lower
Segment distribution and lower sales for the supplier,
discouraging termination or switching.
Suppliers face little switching costs, because they
maintain ownership over the end-product,
Digital Sales Segment Unfavorable 3 termination of contracts will lead to lower
distribution and lower sales for the supplier,
discouraging termination or switching.
Suppliers face little switching costs, because they
maintain ownership over the end-product,
Physical Sales Segment Unfavorable 3 termination of contracts will lead to lower
distribution and lower sales for the supplier,
discouraging termination or switching.
CR6 = 73.93%: 6 of the top studio/distributors are
responsible for a great deal of industry revenues,
Concentration Ratio Unfavorable 4 and own a large portion of popular titles. (the-
numbers.com) Nonetheless, every supplier has
power because of product differentiation.

Buyer Power – Moderately Favorable (2)

Force and Underlying
Streng
Factors Effect on
th Explanation of Factor
(Factors By Rank of Industry
(1-5)
Importance)
Bargaining Power Neutral 3 Bargaining power is neutral
Concentration Favorable 1 No concentration in consumer segments
Needy Consumer Favorable 1 Not Concentrated
Convenience Consumer Favorable 1 Not Concentrated
Product Suppliers offer similar titles, leading to no end-
Unfavorable 5 product differentiation.
Differentiation
No product differentiation. The needy consumer
places more demand on certain titles, pushing
Needy Consumer Unfavorable 5 industry members to have greater selection to meet
broad market.
No product differentiation. Channel is most
Convenience Consumer Unfavorable 5 important, easy access to product may differentiate
one supplier from the next.
Switching costs are low, and do not change from one
Switching Costs Unfavorable 5 consumer to the next, though the needy consumer
may develop a relationship with a given supplier

53 | P a g e
 based on title selection.
Low switching costs, hard for incumbents to increase
Online Rental Segment Unfavorable 5 switching costs. Monthly memberships can be
terminated with no penalties
Some switching costs may exist. For consumers that
use free VOD services as opposed to pay-per-view
VOD, access to VOD comes as a part of monthly fees.
Video-On-Demand Subscribers under contract with MSOs face
Neutral 3 termination penalties. Hence, MSO consumers have
(VOD) Segment
higher propensity to use included VOD, and maintain
usage even as they expand their market segment
participation.
Low switching costs, hard for incumbents to increase
Brick and Mortar
Unfavorable 5 switching costs. Monthly memberships can be
Rental Segment terminated with no penalties
Low switching costs, hard for incumbents to increase
Mail Delivery Segment Unfavorable 5 switching costs. Monthly memberships can be
terminated with no penalties
DVD Vending Kiosks Extremely Low switching costs, hard for incumbents
Unfavorable 5 to increase switching costs.
Segment
Extremely Low switching costs, hard for incumbents
Digital Sales Segment Unfavorable 5 to increase switching costs.
Extremely Low switching costs, hard for incumbents
Physical Sales Segment Unfavorable 5 to increase switching costs.
Backward Integration There is almost no backward integration threat
Favorable 1 from either consumer.
Threat
There is little threat of entry into the market from
consumers into this segment, though startup costs
Online Rental Segment Favorable 1 are low. Typical consumer is not in a position to
enter.
Video-On-Demand
Favorable 1 No threat of backward integration, scale creates BTE
(VOD) Segment
There is little threat of entry into the market from
Brick and Mortar consumers into this segment, though startup costs
Favorable 1 are low. Typical consumer is not in a position to
Rental Segment
enter.
There is little threat of entry into the market from
consumers into this segment, though startup costs
Mail Delivery Segment Favorable 1 are low. Typical consumer is not in a position to
enter.
There is little threat of entry into the market from
consumers into this segment, though startup costs
DVD Vending Kiosks
Favorable 1 are low. Typical consumer is not in a position to
Segment enter. Threat of franchising, but not autonomous
entry.
There is little threat of entry into the market from
consumers into this segment, though startup costs
Digital Sales Segment Favorable 1 are low. Typical consumer is not in a position to
enter.
There is little threat of entry into the market from
consumers into this segment, though startup costs
Physical Sales Segment Favorable 1 are low. Typical consumer is not in a position to
enter.
Price Sensitivity Favorable 2 The product is not a major cost to the consumer
Video rentals are not a major cost to the
Significant Cost to
Favorable 1 consumer, needy consumer values product more
Buyer than convenience consumer

54 | P a g e
 Needy Consumer Favorable 1 Video rentals are not a major cost to the consumer
Video rentals are not a major cost to the consumer,
Convenience Consumer 1 are more likely to use cheap or free channels, such as
online rentals and free online viewing.
Current economic factors and consumer trends
Product Effect on show that entertainment budgets are shrinking
Neutral 3 and consumers are more prone to be price
Other Costs
sensitive.
Affects consumer’s ability to consume other
entertainment or recreational goods or services. In
Needy Consumer Neutral 2 this industry, price is more relevant as a determinant
of the propensity to substitute.
Affects consumer’s ability to consume other
entertainment or recreational goods or services. In
Convenience Consumer Neutral 3 this industry, price is more relevant as a determinant
of the propensity to substitute. Has higher baseline
propensity to substitute.

Rivalry – Moderately Favorable (2)

Force and Underlying
Streng
Factors Effect on
th Explanation of Factor
(Factors By Rank of Industry
(1-5)
Importance)
There is great diversity of competitors in different
Diversity of segments of the entertainment video industry.
Unfavorable 4 Corporate and business level strategies differ greatly
Competitors
across competition, leading to increased rivalry.
Demand is very strong in the industry. The media
entertainment industry is predicted to grow from 7-
Demand Favorable 1 10% per year.(BBI) Demand that continues to grow
keeps supply up and allows for stable firm expansion
without severe competition.
Exit barriers in the industry are moderately high,
with Blockbuster at 56% of assets tied up in PPE,
Exit Barriers Unfavorable 4 inventory, and other long-term assets. Netflix has a
similar asset structure, with these costs around 51%.
Exit barriers are thus moderately high.
There are many, large competitors in the
entertainment video industry. Most competitors are
Consolidation Neutral 3 strong in their primary industry, but have small share
of revenues in this industry. CR4 = 69.7%.
(Respective Financials)
Capacity is added in small increments, with additional
titles added as they are released. Cataloguing and
inventory costs slowly rise as a result. Some addition
Addition of Capacity Favorable 2 of old titles may also increase costs.
Studios/suppliers often demand large contracts to
expand rental catalogue, making capacity addition a
little less favorable between competitors.
Compared to other industries, the fixed cost to
variable cost ratio is neutral, with a trend toward
greater fixed costs, as online viewing becomes a
Fixed Costs : Variable
Unfavorable 4 larger accessing medium, driving up the need for
Costs investment in electronics to catalogue media and
distribute it at high bandwidth and high resolution to
the consumer.

55 | P a g e
Substitutes – Moderately Favorable (2)
Force and Underlying
Streng
Factors Effect on
th Explanation of Factor
(Factors By Rank of Industry
(1-5)
Importance)
There is higher propensity to substitute within
Propensity to
Neutral 3 the convenience consumer segment, which is
Substitute growing in proportion to needy consumers
The needy consumer has little to no propensity to
substitute. He or she is more interested in watching
Needy Consumer Favorable 2 high quality video as a preferred form of
entertainment
The convenience consumer has a moderate
propensity to substitute video entertainment for
video games, music, books, and other traditional
Convenience Consumer Unfavorable 4 forms of recreation. Video game revenues have been
increasing at over 20% per year (2008 3YWA) as they
become more popular across age groups since the
introduction of the Wii. (BBI)
Price Performance of There is low price performance of substitutes in
Favorable 2 relation to rental video.
Substitutes
Assuming video games are the best substitute for the
needy consumer, price performance is low, games
require one-time investment around $60, or monthly
Needy Consumer Favorable 1 mail-delivery rentals cost twice as much per disc
($16/1 rental at a time), Brick and mortar rentals run
approximately $9/week. Very low price
performance. (BBI)
Given price information for games, their price
performance is very low, but other acceptable
Convenience Consumer Favorable 2 substitutes are more affordable, such as music, books,
playing cards, board games, etc., increasing price
performance.

56 | P a g e
Exhibit 7: Market Share

Digital Retail
(iTunes,
Amazon.com) Other
2% 21%
Walmart
DirecTV 30%
1% Dish
1%
Comcast
1% Blockbuster
Time 20%
Warner Best Buy
1% 13%
Amazon.com
Netflix (physical)
5% 5%

Numbers from 2008.

Other includes: Time Warner Inc., Walmart, Amazon.com, Apple iTunes, Echostar, AT&T, DirecTV, Best Buy

Exhibit 8:

Netflix
13%
Other
30%

Comcast
3% Blockbuster
Time Warner 52%
2%

57 | P a g e
Exhibit 9:

Average Annual Sales Growth

45.00%
40.00%
35.00%
Annual Sales Growth (%)

30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00% Netflix Blockbuster Comcast Industry
Competitor

Exhibit 10:

Average Gross Profit Margin

80.00%

70.00%
Gross Profit Margin (%)

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
Netflix Blockbuster Comcast Industry
Competitor

58 | P a g e
Exhibit 11:

Average Return on Assets

15.00%

10.00%
Return on Assets (%)

5.00%

0.00%
Netflix Blockbuster Comcast Industry
-5.00%

-10.00%

-15.00%

-20.00%
Competitor

Exhibit 12:

Average Debt-to-Equity

5
4.5
Debt-to-Equity (times)

4
3.5
3
2.5
2
1.5
1
0.5
0
Netflix Blockbuster Comcast Industry

Competitor

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Exhibit 13:

Current Ratio
3
Current Ratio (times)

2.5
2
1.5
1
0.5
0
Netflix Blockbuster Comcast Industry

Competitor

Exhibit 14:

Average Collection Period

30
Collection Period (days)

25

20

15

10

0
Blockbuster Comcast Industry
Competitor

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Exhibit 15:

Average Asset Turnover

2.5
Asset Turnover (times)

1.5

0.5

0
Netflix Blockbuster Comcast Industry
Competitor

Exhibit 16:

Average Inventory Holding Period

90
Inventory Holding Period (days)

80
70
60
50
40
30
20
10
0
Blockbuster Industry
Competitor

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63 | P a g e
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Exhibit 18: Netflix, Inc. Organizational Chart

Exhibit 19: BCG Matrix

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Exhibit 20: Netflix, Inc. VRIO Framework

Capabilities Valuable? Rare? Difficult To Exploited Competitive

Imitate? By Firm? Implications

DVD Rental Yes No No No Temporary

Blu Ray Rental Yes No No No Temporary

Physical Distribution Yes Yes Yes Yes Sust/Temp

Online Streaming Yes Yes Yes Yes Sustainable

Title Variety Yes Yes No Yes Sustainable

Convenience Yes Yes Yes Yes Sustainable

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Exhibit 21: Netflix, Inc. Value Chain

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Netflix 2008 Valuation*
*All justification and methods for valuation can be found in the Financial Background Appendix

Exhibit 22: Netflix, Inc. Income Statement (2008)

Income Statement
(values in 1000 $USD) 2008

Revenues $ 1,364,661

Cost of revenues:

Subscription $ 761,133

Fulfillment expenses $ 149,101

Total cost of revenues $ 910,234

Gross profit $ 454,427

Operating expenses:

Technology and development $ 89,873

Marketing $ 199,713

General and administrative $ 49,662

Gain on disposal of DVDs $ (6,327)

Gain on legal settlement $ -

Total operating expenses $ 332,921

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Operating income $ 121,506

Other income (expense):

Interest expense on lease financing $ (2,458)

obligations

Interest and other income $ 12,452

(expense)

Depreciation and Amortization $ 19,988

Income before income taxes $ 131,500

Provision for income taxes $ 48,471

Net income $ 83,029

Exhibit 23:

Cost of Debt
(values in 1000 $USD)

Tax Rate 36.86%

Long Term Debt $ 37,988

Interest Payments $ 2,458

Interest Rate On Long Term Debt 6.47%

After Tax Cost of Debt 4.09%

Cost of Equity

Risk Free Rate 4.71%

S&P 500 80 Avg Return 10.36%

10 Year Treasury Note 3.78%

Market Risk Premium 6.58%

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 Beta 0.58

CAPM 8.53%

Exhibit 24:

WACC Weights
(values in 1000 $USD)

Debt Equity
Straight Debt $ 37,988 Common Stock $ 812,433

Other Debt $ 16,694 Conversion Value of Bonds $ 19,466

Current Bond/ Investables $ 157,306 ESO's and Warrants $ 10,900

Total $ 211,988 Total $ 842,799

*No Preferred Stock Outstanding

Wd 20.10%

We 79.90%

WACC
Calculation
WACC = (Wd * Kd)(1-T) + (We
* Ke)(1-T)

Cost f Debt 4.09%

Weight of
Debt 20.10%

Cost of Equity 8.53%

Weight of
Equity 79.90%

Tax Rate 36.90%

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 WACC 4.82%

(Free Cash Flow and Enterprise Value Tables Can Be Found in the Financial
Background Appendix)

Netflix 2008 Valuation + Warner Bros. Agreement*

*All justification and methods for valuation can be found in the Financial Background Appendix

Exhibit 25: Netflix, Inc. Income Statement (2008) Plus Warner Bros.
Agreement Changes

Income Statement
(values in 1000 $USD) 2008 (CHANGES)

Revenues $ 1,419,247 5% Rev Decrease

Cost of revenues:

Subscription $ 761,133

Fulfillment expenses $ 149,101

Total cost of revenues $ 910,234

Gross profit $ 509,013

Operating expenses:

Technology and development $ 80,886 10% Decrease

Marketing $ 199,713

General and administrative $ 49,662

Gain on disposal of DVDs $ (7,909) 25% Increase

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Gain on legal settlement $ -

Total operating expenses $ 322,352

Operating income $ 186,661

Other income (expense):

Interest expense on lease financing obligations $ (2,458)

Interest and other income (expense) $ 12,452

Depreciation and Amortization $ 19,988

Income before income taxes $ 196,655

Provision for income taxes $ 72,133

Net income $ 124,522

Exhibit 26:

Cost of Debt
(values in 1000 $USD)

Tax Rate 36.7%

Long Term Debt $ 37,494

Interest Payments $ 2,426

Interest Rate On Long Term Debt 6.47%

After Tax Cost of Debt 4.10%

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Cost of Equity

Risk Free Rate 4.71%

S&P 500 80 Avg Return 10.36%

10 Year Treasury Note 3.78%

Market Risk Premium 6.58%

Beta 0.58

CAPM 8.53%

Exhibit 27:

WACC Weights
(values in 1000 $USD)

Debt Equity
Straight Debt $ 37,494 Common Stock $ 812,433

Other Debt $ 16,694 Conversion Value of Bonds $ 19,466

Current Bond/ Investables $ 157,306 ESO's and Warrants $ 10,900

Total $ 211,494 Total $ 842,799

*No Preferred Stock Outstanding

Wd 20.06%

We 79.94%

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Exhibit 28:

WACC
Calculation
WACC = (Wd * Kd)(1-T) + (We
* Ke)(1-T)

Cost of Debt 4.10%

20.06
Weight of Debt %

Cost of Equity 8.53%

Weight of 79.94
Equity %

36.68
Tax Rate %

WACC 4.84%

Exhibit 29:

Capital Expenditure
(values in 1000 $USD)

2008 2007

Net Property and Plant $ 124,948 $ 77,326

CAPEX $ 47,622

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Exhibit 30:

Net Working Capital

(values in 1000 $USD) 2008 2007

Accounts Receivable $ 5,617 $ 2,254

Inventory $ - $ -

Accounts Payable $ 131,738 $ 140,911

NWC $ (126,121) $ (138,657)

Change In NWC $ 12,536

(Free Cash Flow and Enterprise Value Tables Can Be Found in the Financial Background
Appendix)

IX. Financial Background Appendix

IX A. Netflix Current Value 2008
IX A. 1 Justification of Approaches
Free Cash Flow Analysis is the valuation technique used for Netflix. In principle, the value of
Netfli is dete i ed the p ese t alue of its’ futu e ash flo s. As futu e ash flo ha ges,
the alue of Netfli ha ges. A o pa ’s a ilit to i ease futu e ash flo s is a p imary value
building technique for investors. The major downfall of this technique is the dependency on
forecasted growth rates into perpetuity. All estimations were created from an analysis of the
Netflix 2008 10-K, and a recent earnings call by Netflix in February of 2010.

IX A. 2 FCF Analysis
 Cost of Capital

Cost of Debt

The cost of debt is a combination of the long term debt and interest on debt. The cost of debt is
a combination of Netfli ’s isk premium. The interest rate of 6.47% was calculated from the
2008 10-K.

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  Cost of Debt: 4.09%

Cost of Equity

The Capital Asset Pricing Model (CAPM) is used when determining the cost of equity. The main
components of this model are the risk free rate of return, the Beta of the stock and the market
risk premium (MRP). The beta was found using historic prices from Yahoo!Finance.

 Risk Free Rate: 4.71%

This is the 30-year US Treasury Bill rate at February 20, 2008. The thirty year rate was chosen
because stocks, in theory, last into perpetuity. The reason for using the US Treasury Bill is that it
is as close to a risk free rate as possible (Daily Treasury Rate Returns:2008).

 MRP: 6.56%

Using Ibbotson data on the S&P 500 from the 80 years an average market risk premium was
calculated. 80 years was chosen instead of 60 years or 30 years because it gives the longest
time horizon and in turn encompasses the most fluctuations in the economy. 6.56% is the
average year over year MRP for the previous 80 years (S&P 500:2008).

 Beta: .58

Fo si pli it sake, the sto k’s u e t Beta as used a o di g to Yahoo! Fi a e. As the

company has not undergone major structural transformations in the past year, the Beta of 2008
ould ha e ee i tuall u ha ged f o toda ’s beta.

 Cost of Equity: 8.53% (calculated using the Capital Asset Pricing Model)

Capital Structure

The weight of debt (Wd) is given by:

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 Wd = total debt / (total debt+ total equity + total preferred stock)

For Netflix: Wd = 20.10%

The weight of Equity (We) is given by:

We = total equity / (total debt+ total equity + total preferred stock)

For Netflix: We = 79.90%

Weighted Average Cost of Capital (WACC)

The WACC is derived from weighting the cost of debt and the cost of equity in relation
to the capital structure of the company.

Cost of Equity 8.53%

Cost of Debt 4.90%

Tax Rate 36.90%

WACC is calculated through the following equation:

WACC = (Wd * Kd)(1-T) + (We * Ke)(1-T)

Where:

Kd = Cost of Debt

Ke = Cost of Equity

T = Tax Rate

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From the e uatio , Netfli ’s WACC = 4.82%

IX A. 3 Growth Metrics

The following table is the project growth of Netflix:

Growth Rate

Growth
Year Rate

2008 -

2009 13.20%

2010 14.45%

2011 12.45%

2012 10.45%

2013 8.45%

2014 6.45%

2015 4.45%

2016 2.80%

2017 2.75%

Terminal 2.45%

Growth in 2009 and 2010 were calculated by averaging revenue growth over the past three
years, which is equal to 1.125%. Three years was to encapsulate both before, during, and after
the recession to give a true picture of how Netflix will stand in years to come. From 2011 on, a
straight line growth rate decline was used of 2% until 2015 to demonstrate the company
ea hi g its’ atu e stages. F o the e o , g o th is e pe ted to le el out. Te ea s e e used
to determine the terminal growth point because Netflix signs contracts with the suppliers for 10
years out. This would ensure that their growth with these firms will at least continue to the
extent of the contract.

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 IX A. 4 Free Cash Flows
Fo Netfli ’s -K and applying the growth metrics, the future cash flows can be calculated:

Free Cash Flow Projections

(in 1000s of $ USD)
Terminal
Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Value

Growth Rate 13.20% 14.45% 12.45% 10.45% 8.45% 6.45% 4.45% 2.80% 2.75% 2.45%

$ $ $ $ $ $ $ $ $
EBIT 131,500 148,858 $ 170,368 191,579 211,599 229,479 244,280 255,151 262,295 269,508

$ $ $ $ $ $ $ $ $
EBIT(1-t) 82,977 148,858 $ 170,368 191,579 211,599 229,479 244,280 255,151 262,295 269,508

Non Cash $ $ $ $ $ $ $ $ $
Expenses 618.9360 701 802 902 996 1,080 1,150 1,201 1,235 1,269

Capital $ $ $ $ $ $ $ $ $ $
Expenditure 47,622 53,908 61,698 69,379 76,629 83,105 88,465 92,401 94,989 97,601

$ $ $ $ $ $ $ $ $ $
Increase in W/C 12,536 14,191 16,241 18,263 20,172 21,876 23,287 24,324 25,005 25,692

$ $ $ $ $ $ $ $ $ $ $
Total 23,437 81,460 93,231 104,838 115,794 125,578 133,678 139,627 143,536 147,483 6,383,539

The same growth metrics can be applied to the debt structure of Netflix.

Future Debt
Projections
(values in 1000
$USD)
Terminal
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Value

$ $ $ $ $ $ $ $ $
Debt $ 37,988 $ 43,002 49,216 55,344 61,127 66,292 70,568 73,708 75,772 77,856 3,369,855

F o the ash flo s, the E te p ise Value a e al ulated su t a ti g the FCF’s f o the
Debt.

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 Enterprise Value
PV of FCF $ 4,633,303,785

Enterprise Value $ 2,162,955,933

Shares Outstanding 60,961,000

Stock Price $ 35.48

IX B. Netflix Valuation Incorporating the Warner Bros. Deal

IX B. 1 FCF Analysis

 Cost of Capital

Cost of Debt

The cost of debt is a combination of the long term debt and interest on debt. The cost of debt is
a combination of Netfli ’s isk premium. The interest rate of 6.47% was calculated from the
2008 10-K.

 Cost of Debt: 4.10%

Cost of Equity

The Capital Asset Pricing Model (CAPM) is used when determining the cost of equity. The main
components of this model are the risk free rate of return, the Beta of the stock and the market
risk premium (MRP).

 Risk Free Rate: 4.71%

This is the 30-year US Treasury Bill rate at February 20, 2008. The thirty year rate was chosen
because stocks, in theory, last into perpetuity. The reason for using the US Treasury Bill is that it
is as close to a risk free rate as possible.

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  MRP: 6.58%

Using Ibbotson data on the S&P 500 from the 80 years an average market risk premium was
calculated. 80 years was chosen instead of 60 years or 30 years because it gives the longest
time horizon and in turn encompasses the most fluctuations in the economy. 6.56% is the
average year over year MRP for the previous 80 years.

 Beta: .58

Fo si pli it sake, the sto k’s u e t Beta as used according to Yahoo! Finance. As the
company has not undergone a major structural transformations in the past year, the Beta of
ould ha e ee i tuall u ha ged f o toda ’s eta.

 Cost of Equity: 8.53% (calculated using the Capital Asset Pricing Model)

Capital Structure

The weight of debt (Wd) is given by:

Wd = total debt / (total debt+ total equity + total preferred stock)

For Netflix: Wd = 20.06%

The weight of Equity (We) is given by:

We = total equity / (total debt+ total equity + total preferred stock)

For Netflix: We = 79.94%

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Weighted Average Cost of Capital (WACC)

The WACC is derived from weighting the cost of debt and the cost of equity in relation to the
capital structure of the company.

Cost of Equity 8.53%

Cost of Debt 4.10%

Tax Rate 36.90%

WACC is calculated through the following equation:

WACC = (Wd * Kd)(1-T) + (We * Ke)(1-T)

Where:

Kd = Cost of Debt

Ke = Cost of Equity

T = Tax Rate

Fo the e uatio , Netfli ’s WACC = 4.84%

IX B. 2 Growth Metrics

The following table is the project growth of Netflix:

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 Growth Rate

Growth
Year Rate

2008 -

2009 13.20%

2010 14.45%

2011 12.45%

2012 12.45%

2013 10.45%

2014 8.45%

2015 7.45%

2016 2.80%

2017 4.40%

Terminal 3.40%

Growth in 2009 and 2010 were calculated by averaging revenue growth over the past three
years, which is equal to 1.125%. Three years was to encapsulate both before, during, and after
the recession to give a true picture of how Netflix will stand in years to come. From 2011 on, a
straight line growth rate decline was used of 2% until 2015 to demonstrate the company
ea hi g its’ atu e stages. F o the e o , g o th is e pe ted to le el out. Te ea s e e used
to determine the terminal growth point because Netflix signs contracts with the suppliers for 10
years out. This would ensure that their growth with these firms will at least continue to the
extent of the contract.

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 IX B. 3 Free Cash Flows

Fo Netfli ’s -K and applying the growth metrics, the future cash flows can be calculated:

Free Cash Flow

Projections

Terminal
Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Value

Growth
Rate 13.20% 14.45% 12.45% 12.45% 12.45% 10.45% 8.45% 7.45% 4.40% 3.40%

$ $ $ $ $ $ $ $ $ $
EBIT 124,522 140,959 161,328 181,413 203,999 229,397 253,369 274,779 295,250 308,241

$ $ $ $ $ $ $ $ $ $
EBIT(1-t) 78,847 140,959 161,328 181,413 203,999 229,397 253,369 274,779 295,250 308,241

Non Cash $ $ $ $ $ $ $ $
Expenses 618.9360 $ 701 802 902 1,014 1,140 1,259 1,366 1,468 1,532

Capital $ $ $ $ $ $ $ $ $ $
Expenditure 47,622 53,908 61,698 69,379 78,017 87,730 96,898 105,086 112,915 117,883

Increase in $ $ $ $ $ $ $ $ $ $
W/C 12,536 14,191 16,241 18,263 20,537 23,094 25,507 27,663 29,724 31,031

$ $ $ $ $ $ $ $ $ $ $
Total 19,308 73,561 84,191 94,672 106,459 119,713 132,223 143,396 154,079 160,858 11,580,593

The same growth metrics can be applied to the debt structure of Netflix.

Future Debt Projections

(values in 1000 $USD)
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Terminal Value

$ $ $ $ $ $ $ $ $ $ $
Debt 37,494 42,443 48,576 54,624 61,425 69,072 76,290 82,737 88,901 92,812 6,681,798

PV of $
Debt 4,464,158

F o the ash flo s, the E te p ise Value a e al ulated su t a ti g the FCF’s f o the
Debt.

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 Enterprise Value
PV of FCF $ 7,693,510,681

Enterprise Value $ 3,229,352,885

Shares Outstanding 60,961,000

Stock Price $ 52.97

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