International Strategics Management

UNIVERSITAS INDONESIA Fenny P. Chandra 1506772782

MM-MBA 2015
I. BACKGROUND
Harvard Business School professor Clayton M. Christensen first coined the term disruptive in his
1997 best-selling book, The Innovators Dilemma. The term is used to explain a certain type of
technology that is inferior and low-performer in the beginning but becomes better and better in
time, ultimately favorable to any other alternative.

In 2010, Mark W. Johnson in Seizing the White Space: Business Model Innovation for Growth
and Renewal linked disruptive innovation with business model innovation. An innovation can be
disruptive with the right business model and lose out with the wrong one. Apple, with iTunes
provides a perfect example. While other digital music players were available in early 2000, only
Apple successfully combined music player with an online music store which allowed customers
to buy music directly to their device.

The same technology with two different business models can deliver different economic values
(Chesbrough, 2010). The explanation is that some new business opportunity cannot be captured
by existing business model.

Netflix growth in several stages will be explained using disruptive innovation and business model
frameworks. Some recommendations for Netflix to sustain its growth will also be explored.

II. FRAMEWORKS
Disruptive Innovation

Disruptive is first introduced by (Bower & Christensen, 1995). It is described as a process

whereby a smaller company with fewer resources is able to successfully challenge established
incumbent businesses. Specifically, as incumbents focus on improving their products and
services for their most demanding (and usually most profitable) customers, they exceed the
needs of some segments and ignore the needs of others. Entrants that prove disruptive begin by
successfully targeting those overlooked segments, gaining a foothold by delivering more-suitable
functionalityfrequently at a lower price.

Disruption theory differentiates disruptive innovations from what are called sustaining
innovations. The latter make good products better in the eyes of an incumbents existing
customers: the fifth blade in a razor, the clearer TV picture, better mobile phone reception. These
improvements can be incremental advances or major breakthroughs, but they all enable firms to
sell more products to their most profitable customers.

Disruptive innovations, on the other hand, are initially considered inferior by most of an
incumbents customers. Typically, customers are not willing to switch to the new offering merely
because it is less expensive. Instead, they wait until its quality rises enough to satisfy them. Once
thats happened, they adopt the new product and happily accept its lower price. This is how
disruption drives prices down in a market. (Christensen, Raynor, & McDonald, 2015).

The term was also broadened to allow service and business model innovation to be disruptive.
(Christensen & Raynor, 2003) It is proven to be a powerful way of thinking about innovation-
driven growth.

Business Model Innovation

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 The concept of business models has become increasingly popular in management literature
(Johnson, Christensen, & Kagermann, 2008). In spite of differing opinions on the definition, it has
been widely accepted that business models explain how value is created and delivered.
(Chesbrough, 2010). Business model is four elements creating and delivering value, namely :
customer value proposition, profit formula, key resources and key processes (Johnson,
Christensen, & Kagermann, 2008). While the business models are understood to classify
businesses, they are also considered as sources of innovation. To illustrate, (Teece, 2010) claims
that technological innovation often requires a business model innovation to capture value and
emphasizes the role of discovery, learning and adaptation.

III. NETFLIX CASE STUDY

Company overview

Netflix was created in 1997 by Reed Hastings and Marc Randolph in Scotts Valley, California
The two had previously worked together at a company called Pure Software. Randolph was co-
founder of MicroWarehouse, a computer mail order company, and later worked as vice president
of marketing at Borland International. Hastings founded Pure Software, which he had recently
sold for $700 million, and he invested $2.5 million in Netflix for start-up cash. Netflix website was
launched on 14 April 1998 with a more traditional pay-per-rental method. In September 1998,
Netflix introduced the monthly subscription method. Since then, Netflix has built its reputation for
flat-fee unlimited rentals without complications such as due dates, late fees, or shipping and
handling fees. Randolph eventually left the company in 2002.

By 2005, Netflix had 35,000 different film titles available, and shipped out 1 million DVDs per day.
In February 2007, the company delivered its one billionth DVD, but began to move away from its
original core business model of mailing DVDs and introduced video-on-demand via the Internet,
live streaming. Netflix has licensed and distributed independent films through a division called
Red Envelope Entertainment.

Today, Netflix is the worlds leading Internet television network with over 86 million users in over
190 countries enjoying more than 125 million hours of TV shows and movies per day, including
original series, documentaries and feature films. Members can watch as much as they want,
anytime, anywhere, on nearly any Internet-connected screen. Members can play, pause and
resume watching, all without commercials or commitments. Video on demand industry is a
crowded one, with multiple players and business models. Players in the industry compete on
price, exclusivity and range of content, user experience in terms of personalization and
compatibility with different devices. Some of the large competitors include Hulu, which uses a
hybrid business model partly based on advertising revenues, and Amazons Prime offering as a
complementary to their retail business.

Growth Strategy

1997-2000

Reed Hastings and software executive Marc Randolph co-found Netflix to offer online movie
rentals in 1997. The company was originally only a DVD-by-mail service in which a customer
paid for a certain level of membership that determined how many DVDs could be rented at one
time. DVDs were then mailed to the customer and later on returned by the customer when they

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had completed viewing. The target customers were early adopters of DVD players. The profit
formula was similar to the competitors: charging for each rental including the potential late fee.
However, the rapid adoption and availability of DVDs in rental and at retails weakened Netflixs
customer value proposition quickly. Customers had to wait longer to receive the DVD by paying
the same fee.

Two years into the business, Netflix debuted a subscription service, offering unlimited DVD
rentals for one low monthly price. This would provide customers access for movie at home.
Although this undeniably strengthened customer value proposition, it posed new challenges for
the business model. The demand for newly released movies was high and movie acquisition was
pricey, particularly for smash hit movies.

To solve this problem, in the year 2000, Netflix introduced a personalized movie recommendation
system, which used Netflix members ratings to accurately predict choices for all Netflix members.
One big advantage of this Netflixs movie selection software was the ability to steer customers to
lesser-known movies of interest (which helped generate revenues across a larger number of
titles). The Oracle-based software provides subscribers with detailed information about each title
in the Netflix library and personalized movie recommendations every time they visited the Netflix
website. The information included for each title included length, rating, cast and crew, screen
formats, movie trailers, plot synopses, and reviews written by Netflix editors, third parties, and
subscribers. The personalized recommendations were based on a subscribers individual likes
and dislikes (determined by their rental history, their personal ratings of movies viewed, movies
in the subscribers queue for future delivery, and titles posted to a wish list), movie ratings, and
the average rating by all subscribers. Subscribers often began their search for movie titles by
starting from a familiar title and then using the recommendations tool to find other titles they might
enjoy.

This enabled Netflix to control the demand towards blockbuster movies and at the same providing
added value to customers. Indeed, the feedback from the customers was positive. The customer
value proposition always a movie at home became a threat for retail video rentals.

2001-2006

While customers were enjoying unlimited watching and discovering new movies based on the
recommendation system, Netflix started taking operational measures to optimize its key
processes. For example, Netflix partnered with U.S. Postal Service to provide overnight service
and rapidly expanded the regional distribution centers. On top of that, catalog and smaller titles
had been receiving increasing frequency of rentals. To supply the lower-profile and independent
movies, Netflix developed special distribution channels and improved its delivery of customer
value proposition. Ultimately, Netflix made it easier for customers to leave and come back
allowing more flexibility to cancel membership.

In 2002, Netflix made its initial public offering (IPO on Nasdaq under the ticker NFLX with
600,000 members in the US.)

2007-2011

Several developments were gradually reshaping the movie rental marketplace (Thompson,
Peteraf, Gamble, & Strickland, 2012):

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 The 2009 requirement that all TV stations in the United States use digital technology and
equipment to broadcast all their programs had resulted in far more programs being
transmitted in high-definition format.
Prices for wide-screen HDTVs had been dropping rapidly, and picture quality was
exceptionally good, if not stunning, on most all models.
Increasing numbers of devices were appearing in electronics stores that enabled TVs to
be connected to the Internet and receive streamed movies from online providers with no
hassle. These devices made it simple for households to order streamed movies with just
a few clicks instead of traveling to a video rental store or waiting for a disk to be delivered
through the mail.

In 2007, Netflix introduced streaming. Streaming technology was introduced in early 1990s and
improved almost jointly with the development of the Internet bandwidth. In mid-2000, the quality
of streaming was similar to the quality of DVD in terms of video resolution. Netflix had the vision
that the DVD-by-mail service will fade away and be gradually substituted with video streaming,
the next disruptive technology in video rentals. In the next two years, Netflix partnered with
consumer electronics companies to stream on the Xbox 360, Blu-ray disc players, TV set-top
boxes, PS3, Internet connected TVs and other Internet connected devices. Netflixs subscriber
base is growing rapidlyfrom 292,000 in 2000 to 12,268,000 in 2009. From 2005 through 2009,
Netflixs subscribers grew from 4,179,000 to 12,268,000, a compound average growth rate of
30.9%. First-mover advantages and late-mover disadvantages are in play here.

Since 2010, Netflix has been available on the Apple iPad, iPhone and iPod Touch, the Nintendo
Wii, and other Internet connected devices. Furthermore in this phase, Netflix started expanding
internationally. That same year, Netflix launched its service in Canada. In 2011, Netflix launched
throughout Latin America and the Caribbean.

In February 2011, Netflix announced its financial results for full-year 2010. Highlights included
the following (Thompson, Peteraf, Gamble, & Strickland, 2012):

Revenues of $2.16 billion, up from $1.67 billion in 2009.

Operating income of $283.6 million, up from $191.9 million in 2009.
Net income of $160.9 million, compared to $115.9 million in 2009.
Dilted EPS of $2.98 versus $1.96 in 2009.
Year-end cash and cash equivalents of $194.5 million, compared to $134.2 million in
2009.
7.7 million net subscriber additions in 2010 (as compared to net subscriber additions of
2.9 million in 2009, 1.9 million in 2008, and 1.2 million in 2007).

2011 was a crucial year for Netflix. In the summer of 2011, Netflix announced the separation of
its DVD rental and video streaming service introducing new pricing for each service. The
proposed new business model was that Netflix would continue the streaming under Netflix
whereas DVD rental will be operated by its new sister company Qwikster. What Netflix did not
take into account was the dilution of the customer value proposition. Many old movies were not
available at streaming but were complemented by the DVD rental. The separation of the
combined services meant customers need to have two subscriptions to keep the same customer
value proposition (paying 60% more than before).

Customers were unhappy with the result. Following this, Netflix announced to drop Qwikster and
will continue the DVD rental service under the Netflix brand. Yet, the cost for introducing Qwikster

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 was high. 800,000 customers canceled their membership in the third quarter of 2011. On the
other hand, Netflix was proven right with the vision that the once disruptive DVD-by-mail service
will fade away and be gradually substituted with video streaming. As expected the number of
DVD subscriptions reduced significantly after the break-up from close to 14 million to roughly 9
million in less than a year while the numbers for streaming grow continuously.

2012-present
Over time, movie studios have had considerable bargaining power and leverage over Netflix,
Blockbuster, and other movie rental enterprises because of their power to heavily influence the
price and other terms and conditions under which their movie DVDs will be supplied to movie
rental providers. Movie studios are already in a powerful position to dictate the dates when their
movie DVDs will be released to all the different movie rental providers. The movie studios has
become even more powerful and able to command higher prices in making their movies available
for streaming. Netflix and other video on demand (VOD)/streaming providers can expect to pay
higher fees in gaining the agreement of movie studios to stream their titles. Why? Because VOD
providers will compete on the basis of having a large library of titles available for streaming. Since
the movie studios own these libraries, they will be able to secure bigger fees in making their titles
available to particular VOD providers (Thompson, Peteraf, Gamble, & Strickland, 2012).

Netflix started to realize that and in 2012 began developing its first original series, the political
drama, House of Cards. When the show premiered in 2013 to both critical and audience acclaim,
it gave way to a flood of new, original, on-demand content.

Orange is the New Black, the 4th season of Arrested Development, The Unbreakable Kimmy
Schmidt, Bloodline, even the next 4 Adam Sandler feature films; all of these and more were lined
up to be available exclusively via the streaming platform. They had a monopoly. They now had
a self-sustainable way of generating revenue and attracting new users. They were calling all the
shots and increasing their share of the streaming entertainment market in the process. (Sukhraj,
2015)

2012 - Netflix became available in Europe including the United Kingdom, Ireland and in the Nordic
Countries. Netflix won its first Primetime Emmy Engineering Award

2013 - Netflix expanded to the Netherlands. Netflix garnered 31 primetime Emmy nominations
including outstanding drama series, comedy series and documentary or nonfiction special for
House of Cards, Orange is the new black, and The Square respectively. House of Cards
won three Primetime Emmy Awards. Netflix was the first internet TV network nominated for the
primetime Emmy.

2014 - Netflix launched in 6 new countries in Europe (Austria, Belgium, France, Germany,
Luxembourg and Switzerland). Netflix won 7 creative Emmy Awards for House of Cards and
Orange is the New Black. Netflix had over 50 million members globally.

2016 - Netflix is available in 130 countries worldwide, except China. In December 2016, Netflix
released an update for its iOS and Android free application so that a selection of movies and
television shows are now available to download for offline viewing, This download feature is
included in all of Netflixs subscription plans.

IV. DISCUSSION
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Netflixs original subscriber base consisted of three types of customers: (1) those who liked the
convenience of home delivery, (2) bargain-hunters who were enthused about being able to watch
unlimited movies a month at an economical price, and (3) movie buffs who wanted access to a
very wide selection of films (Thompson, Peteraf, Gamble, & Strickland, 2012).

The term disruptive innovation is misleading when it is used to refer to a product or service at
one fixed point, rather than to the evolution of that product or service over time. The fact that
disruption can take time helps to explain why incumbents frequently overlook disrupters. For
example, when Netflix launched, in 1997, its initial service was not appealing to most of
Blockbusters customers, who rented typically newly released movies on impulse. Netflix had an
exclusively online interface and a large inventory of movies, but delivery through the U.S. mail
meant movies took time to arrive. The service appealed to only a few customer groupsmovie
buffs who didnt care about new releases, early adopters of DVD players, and online
shoppers. (Christensen, Raynor, & McDonald, 2015)

A disruptive company targets segments of the population that have been overlooked by its
competitors, delivering an inferior (but more tailored) alternative, often at a lower price. Then,
eventually, a disruptive company like Netflix moves upmarket. It keeps the advantages it had at
the beginning, and adds the things mainstream customers want. When Netflix pioneered delivery
of DVDs by mail using a subscription system, Blockbuster video responded with a similar offering.
But Netflix held on to its lead, both because it was not handicapped by Blockbusters
cannibalization concerns, and because it had patents on the ordered list (which it later accused
Blockbuster of infringing) by which subscribers indicated online their movie preferences (Teece,
2010). All of a sudden, there is no reason to have Blockbuster anymore.

In the case of Netflix, the huge shift came with the rise of streaming video. Netflix was able to
appeal to Blockbusters core audience by providing, a wider selection of content with an all-you-
can-watch, on-demand, low-price, high-quality, highly convenient approach. The reason why
disruptive companies are often able to rise so quickly is that their larger competitors overlook
them. They are not initially competing for the same customers, so the big guns brush them off
and in Blockbusters case, even refuse to acquire them for only $50 million in 2000. (McAlone,
2015). It was a costly mistake for Blockbuster who ultimately filed for bankrupcy ten years later
with about $100 million debt.

Reed Hastings indicated in various media interviews in late 2010 that Netflix was quickly
becoming primarily a streaming video company delivering a wide selection of TV shows and
films over the Internet. The switching of customers to Internet streaming was occurring faster
than Hastings had expected. The company expected streaming to replace the bulk of DVD
rentals over the next five years. Compared to DVD delivery, streaming underperformed on the
predominant performance criteria for the business: availability of first run movies. But it was
simpler, faster and less costly, attractive to new users or existing users who were overserved by
the DVD business. The results since then demonstrate that Netflix is one of the rare companies
that has successfully disrupted itself. In the third quarter of 2011, Netflix had 14 million DVD
subscribers. By the third quarter of 2015, that number was 5 million. That looks like an incumbent
being disrupted. But from 2011 to 2015, Netflixs annual revenue rose from $3.2 billion to $6.7
billion. This growth demonstrates that it was successfully able to create the new market and
disrupt itself without being displaced. But doing so has come at a cost. Netflixs 2011 net income
was $226 million. In 2015 it was $122 million. (Ostrower, n.d.)

Altogether Netflix has been through three stages of innovating the business model:

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 (1) exploration and experimentation with different business models,
(2) exploitation of the functioning business model and
(3) once again experimentation to find the right business model for streaming and international
expansion.

Netflix case has proved that overall business model innovation is a process rather than a single
event. This implies that business model innovation happens through a number of business model
changes and is continuous. (Aksuyek, Hacklin, & Sidhu, 2013)

V. RECOMMENDATIONS
With over 86 million users, Netflix is a service that almost everyone knows and many people use.
And with that, they have a new problem: how do you continue growing when you are that big
already? This is exactly what Netflix has to deal with at this moment. Netflix forecasted an
increase of 2.5 million subscribers in the second quarter of 2016. In reality, this only was 1.7
million, shareholders were not happy with this news. And the stock market took notice and
punished Netflix hard with a slump (Netflixs growth slows down, n.d.).

It is clear that Netflix is already approaching saturation in its home market, the United States.
Last quarter, Netflix missed its own US subscriber growth estimates for the second quarter in a
row. It also raised its subscription prices in the US and Europe last year to further fight costs of
international expansion and costly development of original content. (Murgia, 2016)

Its clear that the price of Netflix has a large impact on its membership growth, a trend
exacerbated by the increase in competition and commoditization of the offering. If Netflix tries to
raise prices, customers have more options than ever to take their business since the switching
cost to the competitor is practically zero (monthly subscription requires no contract). (Trainer,
2016)

The question is how to keep growing when your product is used by more than 86 million users?
A reasonable set of action recommendations might include the following:
Leverage Mobile Technology Giving the growth of mobile hardware and software,
entertainment is now mobile, Netflix should create additional value for customers by
offering easy to use applications and interfaces to access Netflix across multiple mobile
platforms.
Explore what can be done to increase subscriber retentions and minimize subscriber
cancellations. If Netflix can learn what the main reasons are for the cancellations, it may
be able to come up with a subscription which addresses the reasons for cancellation.
Continue to refine and invest in the companys analytics which has worked wonders, and
use it to attract advertisers for highly personalized ads for its users. It is time for Netflix to
bring in advertisements on its sites to finance its costly internal expansion and content
development.
License its original content to other distribution channels to finance more original content
developments.
Cut back global expansion in countries with regulatory restrictions and focus growth in
high-potential markets.

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Netflix business model. The Ratio Colloquium for Young Social Scientists .
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McAlone, N. (2015, November 18). The father of disruption theory explains why Netflix is the perfect
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Murgia, M. (2016, March 26). Inside Netflix: How Reed Hastings is building the first global TV network.
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https://ir.netflix.com/index.cfm
https://media.netflix.com/en/about-netflix

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Exhibit 1. The Disruption Innovation Model

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Exhibit 2. Netflix Timeline

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Exhibit 3. Group Map of the DVD Rental Industry in 2010

Exhibit 4. SWOT Matrix of Netflix in 2011

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Exhibit 5. IP Traffic Growth 2011-2016

Figure 6. Netflix Stock Price 2003-2014

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Exhibit 7. Netflix Profit Margins 2000-2009

Exhibit 8. Netflix Key Profitability Ratios 2010-2015

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Exhibit 9. Netflix Standardized Statement of Cash Flows 2010-2015

Exhibit 10. Netflix Subscribers Growth

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Exhibit 11. Growth of Netflix Competitors

Exhibit 12. Monthly Subscription Price of Netflix Competitors

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Exhibit 13. International Market Size in 2017

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