Netflix: Valuing a New Business Model

113-018

Insider sales A final point that concerned some analysts was the high level of insider stock
sales. Noting that Hastings had been selling about 5,000 shares each week for the last several months,
and several other C-level executives had also been actively selling their stock, the analyst questioned
what they thought about their business.33

The Strategic Shift

In November 2010, Netflix offered its first streaming-only subscription: $7.99/month for
unlimited viewing. At this point, the most popular subscription offered by Netflix was $9.99/month
for an unlimited number of DVD rentals (with one DVD out at a time) and unlimited streaming.
However, the company had already begun to view streaming as the core future business and, as one
manager noted, "DVDs by mail was treated as a $2 add-on to our unlimited streaming plan." 34
On July 12, 2011, with Netflix's stock trading at $291/share, the company announced a major
change in subscription plans and pricing. Subscribers would no longer be able to combine DVD
rentals and streaming video in one account. Users could subscribe to a DVD-only plan for
$7.99/month, a streaming-only plan for $7.99/month or, if they wanted both features, they could sign
up for both plans independently for their combined cost, $15.98/month. This change amounted to a
60% price hike for those customers who wanted to continue to get DVDs and streaming video, which
was previously offered for $9.99/month. Customers were unhappy with the rise in price and many
threatened to drop the service when the price change went into effect on September 1. 35 Netflix's
stock started a swift decline, dropping about 3% per week for the next several weeks.

Despite customer complaints, Netflix kept its price change in place, and moved one step further
with an announcement on September 18 (as the company's stock was trading at $143/share) of plans
to rebrand its DVD-by-mail service as Qwikster. In a blog post, 36 Hastings described that the new
service would be housed on an independent website and require customers to create new accounts
on www.qwikster.com; the new service would not be integrated with Netflix's billing,
recommendation, or queue systems. The company's streaming service would remain under the
Netflix brand. In addition, Hastings announced that Qwikster would begin offering video game
rentals, something Netflix had never done. Customers reacted to this announcement with more
anger; almost 30,000 people commented on Hastings' blog post, many of whom announced their
plans to cancel their subscriptions.37
On October 10, with a stock price of $111/share, just 22 days after announcing Qwikster, Hastings
responded to the criticism with a simple statement: "no change: one website, one account, one
password ...in other words, no Qwikster." 38 DVD rentals would stay at Netflix.

What Should Netflix Order Next?

Would Netflix's recent subscriber losses in response to the price hike and Qwikster debacles
continue, or turn around? Even if the subscriber losses turned around, would the company be able to
generate enough revenue to pay for its current and future streaming commitments? In late fall,
Netflix was considering selling stocks and bonds to raise capital to shore up its balance sheet. 39
Would this quell investors' fears about the company's new direction or convince more investors to
sell the stock and more subscribers to jump ship? In October 2011, all of these concerns were reflected
by Netflix's stock trading at its lowest level in 18 months, and investors and analysts faced the
challenge of valuing the new, streaming-focused company (see Exhibit 8 for analysts' price ranges).

7
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910-026

Bank of America-Merrill Lynch

Background
Bank of America
Bank of America, headquartered in Charlotte, North Carolina, operated throughout the United
States and several countries around the world. Originally founded by Amadeo Giannini in San
Francisco as the Bank of Italy in 1904, the bank had opened 24 branches throughout California within
10 years. In 1928, Giannini orchestrated the acquisition of TransAmerica Corp. and Bank of America
in New York. At the height of the Great Depression, Giannini consolidated the various institutions
under the name "Bank of America," eventually creating one of the largest banks in the United States.
This was eventually acquired by NationsBank (formerly North Carolina National Bank) in 1998, one
of the largest mergers at the time, and the resulting institution became known as Bank of America
Corporation (BofA).
Ken Lewis assumed the position of CEO at BofA in 2001 after the retirement of Hugh McColl. A
lifelong employee who had moved up through the ranks, Lewis received his BA in finance from
Georgia State University and began his career in 1969 at North Carolina National Bank, a BofA
predecessor. Between 2001 and 2008, Lewis engineered acquisitions worth more than $162 billion,
including Countrywide Financial Corp., a failing mortgage giant, in July 2008. 2 By 2008, BofA was the
largest retail bank in the United States. Lewis had been celebrated on Wall Street for his business
acumen, and in late 2008, American Banker hailed Lewis as "Banker of the Year." 3

Merrill Lynch
Merrill Lynch was founded in the early twentieth century by Charles Merrill and his friend
Edmund Lynch. Merrill Lynch became one of the leading providers of wealth management, securities
trading and sales, corporate finance, and investment banking services. In the 2000s, Merrill Lynch
sought a position in the lucrative mortgage business as many of its competitors had already done. 4
Between January 2005 and January 2007, Merrill Lynch acquired 12 major residential or commercial
mortgage-related institutions and assets, including First Franklin, a domestic subprime lender. 5
(Subprime loans are loans to borrowers who have a bad credit history and therefore have a higher
risk of default.) Although a latecomer to the market, by 2006 Merrill Lynch was the largest
underwriter of collateralized debt obligations (CDOs), 6 financial instruments that repackage loans for
1:~s'a\~ m't() 'a s~C()TlU'aT)l ID.'al:Ke't.

Between 1997 and 2006, the global housing market boomed and banks expanded their lending to
subprime borrowers. By 2006, nearly 20% of all new mortgages were considered subprime.?
However, when the housing bubble burst in late 2006, mortgage holders suddenly found themselves
unable to make their payments, and the inventories of unsold homes increased substantially. As
house prices fell, the market for the securitized mortgages fell as well. With most U.S. banks holding
large portfolios of subprime assets, the banking industry went into a tailspin and Merrill Lynch was
among the biggest victims. In October 2007, Merrill Lynch announced a $7.9 billion write-down due
to its exposure to mortgage CDOs, resulting in a $2.3 billion loss for the quarter, the largest thus far in
Merrill's history.8 In fact, for the last quarter of 2007 and the first three quarters of 2008 combined,
Merrill wrote down more than $46 billion due to bad bets on real estate and other mortgage-related
investrnents.9
Merrill's board ousted CEO Stan O'Neal in October 2007, and chose John Thain as his
replacement. Prior to Merrill Lynch, Thain had served as the CEO of the New York Stock Exchange
from January 2004 to December 2007. He also worked at Goldman Sachs, serving as president and

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801-199

Adobe Systems Incorporated

through 1992. The number of PostScript fonts in the Adobe collection increased from 35 in 1985 to
2,000 in 1994. These fonts were valued most highly by graphic artists designing pages for professional
publishing.

Making Money from PostScript

The first PostScript products were introduced in 1985 through a strategic alliance among four
firms: Adobe, Apple, Aldus, and Linotype. The combination of products from these firms sparked the
desktop publishing revolution, or democratization of typesetting. For the first time, individual
desktop users could create newsletters and other documents that had a professional look and feel;
documents could integrate graphics and text, using professional quality fonts.
This result was accomplished through a system of products: Aldus PageMaker software, which
ran on the Apple Macintosh, enabled the creation of documents that integrated text and graphics.
PageMaker required a PostScript device for printing. The Apple LaserWriter was the first PostScript
printer and incorporated a PostScript interpreter licensed from Adobe. Finally, professional-looking
documents also required high-quality fonts such as Times Roman or Palatino, which typically were
only available to professional publishers. Linotype, a firm with over 100 years of experience in the
typesetter industry, licensed a set of its most popular fonts to Adobe so that Adobe could offer them
in PostScript format. The LaserWriter came with 35 PostScript fonts built in. Linotype also introduced
a high-end PostScript imagesetter, so that PageMaker documents could be used in professional
publishing.
By 1989 PostScript had become the defacto standard for printing in the graphic arts and
publishing industries. Almost 100% of high-end imagesetters on the market incorporated PostScript.
While penetration in the general laser printer market reached only about 25%, penetration of
PostScript in laser printers used by graphic artists was closer to 100%.
Adobe also leveraged the underlying graphics technology of PostScript in applications software
for the graphic arts community. (See Exhibit 3 for descriptions of Adobe's software product
portfolio.) The first end-user application, Adobe Illustrator, was introduced in March 1987 and
gained wide acceptance among graphic artists. Illustrator created PostScript output and helped to
create demand for PostScript printers. Adobe also acquired a number of software products, including
Photoshop, for digital image editing in 1989, and Aldus PageMaker in 1993. These products were
extremely successful, with Photoshop capturing over 90% of the market for photo-editing software.
Ownership and leveraging of the PostScript standard had reaped huge rewards for Adobe;
between 1984 and 1995, revenue had grown from $2.2 million to $762 million-a compound annual
growth rate of 70%. Adobe's share price growth had been equally impressive, increasing at an
average annual rate of 29% between 1986, when the firm went public, and 1995.

Establishing PDF
Adobe shipped the first version of Acrobat on June 15, 1993. Acrobat enabled users to convert any
electronic document into a universal document format called PDF (Portable Document Format). Once
in PDF format, a document could be transferred to other users and would display and print exactly
as it had in its original application-the receiving user simply needed to have an Acrobat Reader
installed on his or her computer. The PDF format could handle not only text but also graphics and
images. Given the variety of computer platforms and software used in corporations, Adobe felt that
Acrobat provided a compelling value proposition. Anyone in a corporation could share documents as
4
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705-448

Kodak and the Digital Revolution (A)

The idea that money came from consumables, not from hardware, emerged early. In selling
cameras, Kodak used a razor-blade strategy: it sold cameras for a low cost, and film fueled Kodak's
growth and profits. Over time, Kodak's managers paid progressively less attention to equipment.
One executive commented, "No matter what they said, they were a film company. Equipment was ok
as long as it drove consumables."6
With the advent of color film, which required substantial R&D, many firms lagged behind. After
the early 1960s, attempts to enter the market were rare; the film composition's balance of chemical
and physical properties and the know-how embedded in manufacturing made creating compatible
products expensive and risky.
Kodak had worked to develop color film since 1921 and spent over $120 million to do so by 1963.7
Its photo-finishing process became the industry standard. Most rival brands, although of excellent
quality when properly processed, fared badly in typical photo shops. 8
Within Kodak, corporate power centered on Kodak Park's massive film-making plant. Kodak's
CEOs typically came from manufacturing jobs in the Park. They were largely similar; most received
the same training, and attended MIT's Sloan School of Business as a sort of finishing academy. 'Since
mistakes in the manufacturing process were costly, and profitability was high, Kodak avoided
anything risky or innovative. It developed "procedures and policies to maintain the status quo."9
Kodak reached $1 billion in sales in 1962. In the 1960s and 1970s, it introduced new products like
the 126 and 110 cameras, which moved beyond consumer photography to medical imaging and
graphic arts. Most of these products exploited silver-halide technology and were incremental
improvements. By 1976, Kodak controlled 90% pf the film market and 85% of camera sales in the
United States. Its technological strength and speed to market precluded the emergence of serious
competitors. 10 In 1981, its sales reached $10 billion.
In 1981, Sony Corporation announced it would launch Mavica, a filmless digital camera that
would display pictures on a television screen. Pictures could then be printed onto paper. Kodak CEO
Colby Chandler contended people "liked color prints" and Kodak could introduce its own digital
camera, but managers became concerned about the longevity of silver-halide technology. A manager
said, "It sent fear through the company." The reaction was, "my goodness, photography is dead." 11

Exploration and Diversification, 1983 - 1993

Diversification into other businesses
Between 1983 and 1993, Kodak acquired IBM's copier services business; Clinical Diagnostics,
which produced in-vitro blood analyzers; Mass Memory, which sold floppy disks; and other
bioscience and lab research firms. It also acquired Sterling Drug, a pharmaceutical firm that sold
products like Lysol and aspirin, for $5.1 billion. Kodak's managers felt the pharmaceutical industry
was related to its core "chemical" business: R&D was pivotal, and margins were high. Between 1987
and 1992, Kodak's share of the film market decreased by 5%?

Competition in the core imaging business: Fuji Photo Film Co.

"We were the imaging company of the world. We literally had no competition for so long, management
hadn't become accustomed to it. Historically, if there was a competitor, Kodak would blow them away."
A former Kodak executive13

2
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