Most of us know Netflix as the online streaming company that makes money by selling a monthly subscription pack to its customers in exchange for access to all the content available on their platform.
But that’s not how Netflix originally started.
Netflix was not in the online streaming business. Netflix was not a subscription based service.
The Netflix of today looks nothing like the Netflix of day one. In the course of its 22 years of existence, Netflix’s business model underwent four big strategic shifts.
Before delving into Netflix’s current financial standing, it is imperative that we know and understand the significance of those four events from a strategic point of view.
Let’s check them out one by one.
1. Why was Netflix started?
Before he started Netflix, Reed Hasting, Netflix CEO, was just another customer of a company named Blockbuster. Blockbuster was a leading America-based movie and video game rental shop at that time. The story goes that the idea for Netflix occurred to Reed Hasting in 1997 after he was slapped with a $40 late fee for Apollo 13 by Blockbuster.
In an interview with forbes magazine in 2009, Reed Hastings said, “I remember the fee because I was embarrassed about it. That was back in the VHS days, and it got me thinking that there’s a big market out there. So I started to investigate the idea of how to create a movie-rental business by mail. I didn’t know about DVDs, and then a friend of mine told me they were coming. I ran out to Tower Records in Santa Cruz, Calif., and mailed CDs to myself, just a disc in an envelope. It was a long 24 hours until the mail arrived back at my house, and I ripped them open and they were all in great shape. That was the big excitement point.”
Even though the true version of Netflix’s genesis story is up for discussion, Reed’s aforementioned version of the story is still helpful in understanding the general idea behind the founding of the company.
The then incumbent Blockbuster operated on a retail shop pay-per-rental model. Netflix launched in 1998 as an online movie rental service with the same traditional pay-per rental model. Netflix even charged the same late fees which apparently motivated Reed Hastings to get into the business, just like Blockbuster.
The only advantage Netflix had over BlockBuster at that time was better distribution. Instead of the customers going to a BlockBuster store to fetch a DVD, the DVD essentially came to them, at their house.
But the DVD mailing model had two major disadvantages:
1. While it eliminated the hassle of visiting a Blockbuster store for the customer, it took between one to four days for the DVDs to reach them, which was not a win-win, but a win-lose scenario for the customer.
2. To break even on the cost of purchasing a DVD to rent, Netflix had to generate 15-20 rentals for each DVD. And even though people tried the service, the number of repeat rentals were low. Moreover, people were inclined to rent out latest releases.
The company innovated their way out of both problems by adopting a subscription based model way back in 1998, when it wasn’t as ubiquitous as it has become today.
2. The Shift to a Subscription Based Model
The subscription based model acted as a forcing function for the customers to continue using Netflix’s DVD rental service, leading to an improvement in second-time movie rentals. Netflix even implemented a queue, giving users a method to select which movies they would like to watch next, in order to expedite the process of users receiving another DVD once they had returned their original one.
This move enabled Netflix to drop late fees because the idea of getting another DVD in exchange for their current one acted as a motivation for the customers to return their DVDs back to Netflix on time. On one hand, there was Blockbuster, which was still charging late fees and on the other there was Netflix, which had dropped them. Late fees contributed massively to Blockbuster’s revenue and it wasn’t until 2004 that the company decided to finally let go off it.
In order to improve user engagement and utilize their DVD catalogue efficiently, Netflix also developed a movie recommendation system named Cinematch. The system allowed Netflix to sell more movies which were not the latest releases, thereby uniformly distributing the sales of their DVD catalogue.
In 2002, Netflix went public at a share price of $15 and made a profit for the first time during the fiscal year 2003, reporting a US$6.5 million profit on revenues of US$272 million. By 2005, the company was shipping 1 million DVDs every day.
3. Moving in Online Streaming
Even at the pinnacle of its DVD rental business, the company was planning to get into online streaming. And they had been planning for it all along.
“We never spent one minute trying to save the DVD business,” said Ted Sarandos, who has been Netflix’s chief content officer since 2000.
They had only been waiting for broadband speed and streaming technology built into consumer devices to hit a critical mass before making a move. And when the timing was right, in 2007, the company launched its online streaming service in the United States with a collection of licensed movies and shows from Hollywood studios.
While DVD sales fell from 2006 to 2011, Netflix grew as a business.
The company first began its international expansion in 2010 with its launch in Canada. Today, Netflix is available in over 190 countries excluding a few like China, North Korea, Syria etc.
Image Source: Netflix
Note: The red territory represents the countries in which Netflix is present, while the grey territory represents the territories it is absent from.
4. Producing Original Content.
From 2007 to 2013, until Netflix’s next big strategic move, subscribers grew from around 7 million to 33 million.
Note: The red bars represent United States subscriber growth rate and the pink bars represent international subscriber growth rate
Seeing Netflix’s growth, Hollywood movies and series production house started demanding more money for licensing their content, pushing Netflix to get into original content in a bid to secure their future.
In 2013, Ted Sorandos, made another interesting comment with regards to the shift in Netflix’s strategy. He said, “The goal is to become HBO faster than HBO can become us.”
How Does Netflix Makes Money?
As per Netflix’s 2018 financial reports, it has three primary sources of income:
1. Domestic Subscriptions
The Domestic subscriptions represents revenue generated by selling monthly subscriptions to United States subscribers
Source: Netflix 2018 financial report
Netflix’s domestic streaming revenue grew by 24% in 2018 due to two factors:
1. The 11% growth in the average number of paid memberships
2. The 12% increase in the average monthly revenue per paying membership, which resulted from Netflix’s increasing the subscription charges in the US.
2. International Subscriptions
The International subscriptions represents revenue generated by selling monthly subscriptions to subscribers living outside of the United States.
Source: Netflix 2018 financial report
Netflix’s international revenue grew by 53%, which is higher than the revenue growth seen in the domestic segment. The reason why it is this way is because Netflix’s growth rate has slowed down in the United States. According to Statista, 54% of US households had a Netflix subscription in 2017. The US had around 126 million households in 2017, which explains why Netflix’s domestic growth has slowed down.
In the long-term, the company thinks it can achieve anywhere between 60-90 million members in the US alone.
Netflix attributed the 53% increase in international revenues to two factors:
1. The 40% growth in the average number of paid international memberships
2. The 9% increase in average monthly revenue per paying membership, which again resulted from Netflix’s increasing the subscription charges internationally.
3. DVD rentals
Source: Netflix 2018 financial report
While Netflix’s DVD rental segment has been declining for years now and contributes the least to revenue, Netflix still runs it because the entity is profitable as a standalone entity. In fact, Netflix has grown their entire online streaming business using profits from the DVD side and still continues to inject the DVD profit into its streaming segment. Netflix is well aware that the DVD segment won’t last forever and wants to allow it to die naturally
How much more room for growth does Netflix have?
According to 2019 Q2 reports, Netflix was present in over 150 million households worldwide. To put the numbers into context, there were 1.63 billion households with TV in 2017 alone, which is expected to grow to 1.74 billion TV households in 2023. Even excluding the TV households of countries Netflix is not present, the company is yet to capture a huge portion of the total addressable market. But the streaming landscape continues to get fiercely competitive day by day with players like Disney & Apple launching their own streaming services, to add to Netflix’s more obvious and older competitors like Amazon Video, Hulu, HBO and YouTube.
Further Recommended Reading:
Patty McCord, former chief talent officer at Netflix, is of the opinion that when it comes to recruiting, motivating, and creating great teams, most companies have it all wrong. During her 14 year long stint at Netflix, she played a vital role in creating a unique and high-performing culture at Netflix and she shares what she learned in Netflix and elsewhere in the Silicon Valley in her book ‘Powerful: Building a Culture of Freedom and Responsibility‘
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