NetFlix and its Business Paradox

On July 25, 2005, NetFlix released its second quarter earnings, which were slightly higher than expected (view press release).

The home rental marketplace in the US now has several competitors in a few key verticals. From GameFly for video games, RentSexFlix for the adult market, BlockBuster, GreenCine and possibly Amazon in the future, NetFlix has competition from all corners. Then there are the substitute markets, such as Video On Demand (VoD) (e.g. ComCast, TimeWarner, CinemaNow, Hollywood.com, etc.), vending machines at grocery stores and apartment complexes, retail rental stores (i.e. Blockbuster, Hollywood Video), and all other entertainment alternatives to DVD's (movies, sports, outdoor recreation, etc.).

With so much competition, NetFlix relies on its first-mover advantage, enormous customer base (which pales in comparison to Blockbuster's total customer base), well-known brand supported by strong Internet advertising, economies of scale through its many regional distribution centers, loyal customer base with low churn, and large library of hard to find movies. By leveraging its regional centers and large customer base, NetFlix can enjoy significant margin advantages over traditional competitors.

However for the purpose of this post, I would like to focus on the Netflix paradox -- its pricing and distribution strategy. On the surface, it would seem that building distribution centers in key geographic locations and large market cities would help it serve its customers better. While that is true, it is contrary its pricing strategy. Net estimates say that at its current pricing (around $17/month for 3 DVD's at a time), NetFlix is profitable as long as the customer rents less than 5 to 7 DVD's per month. Longer geographic distances, which increase the actual calendar time to send and receive DVD's, helps NetFlix lower the maximum number of DVD's a person could rent in a month. However with a local distribution center and one day shipping times, its theoretically possible for a person to rent up to 30 movies in a month. Most people will not rent that many movies, but a person may rent 10. At 10 DVD's per customer, NetFlix is losing money.

NetFlix considers some its more frequent users, "loss leaders" who are good for business. These users are often opinion leaders who spread the gospel of NetFlix and help bring in new customers. These customers offset their unprofitability by brining in new, more profitable customers. On the flipside, there are those customers who sign up and do not rent many movies at all -- perhaps the first few months they do, but then their activity trails off. These customers help NetFlix in many ways: 1) they are NetFlix's highest margin customers, 2) NetFlix does not have to invest in increasing capacity to meet additional demand, and 3) the longer they stay passive, the less likely they are to churn and leave NetFlix. How is the last point known? Health clubs, amongst others, have a similar strategy. Its well known that if all health club members actually used the health clubs, the health clubs would not have enough capacity to satisfy demand.

For NetFlix to improve its profitability while expanding distribution centers, it needs to do three things (primarily): 1) increase its customer base to spread the fix costs over a larger number of customers, thereby increasing its margin; 2) lower its operating margins by investing in better fixed cost processes and technologies; 3) increase price. A controversial fourth option may be to lower the usage habits by customers -- there may be ways to do this overtime, but it could be a dangerous road to take.

Increasing the price is perhaps the easiest option, but maybe not the most useful. Companies should focus on having customers value their brand for non-price purposes allowing them to have prices higher than competitors. Its not clear yet whether NetFlix has achieved this purpose. NetFlix does have strong consumer appeal with its no late fees, wide selection, convenience, etc., but by raising the price, its more profitable (low usage) consumers may drop out. And if the high usage, unprofitable customers still think the new price is a bargain, they will stick around, lowering NetFlix's profitability even further.

Investing in fixed costs processes is a must for NetFlix in all situations -- for a volume based business like Netflix, Netflix needs to lower its marginal cost by investing in overhead.

NetFlix is probably going to try to always increase its customer base by expanding into new areas such as video games and VoD, new markets like Europe, purchasing competitors (GameFly?), and partnering with channel participants (i.e. Wal-Mart). However this can be a long and expensive process, and does not solve the final problem that as customers increase usage due to geographically closer distribution centers, profitability per customer will drop.

One option for NetFlix is for NetFlix to reconsider its pricing strategy totally. The following scenario is a sample strategy that NetFlix could pursue -- it makes assumptions to NetFlix's actual operating numbers. NetFlix should employ a fix plus per use pricing strategy. NetFlix could have a $8 to $10 fixed monthly fee, almost like a club due. Then for each DVD rented by a customer, NetFlix would charge $2 flat. This should cover the shipping and return fees plus processing costs. Consider that if a customer rents 5 movies, the total fee would be between $18 to $20 -- the same as it is now for NetFlix's current break-even. However at increased usage, NetFlix does not bear the burden -- its profitability is still built into the $10 fixed cost. The $2 per use cost ensures that NetFlix does not lose money on more rentals. What about the higher usage users? Some of them may leave, but many may still find the conveniences, selection, etc. a bargain -- that is if NetFlix brands itself properly, then price will not be a central selling point. For lower usage customers, NetFlix is an even better deal, and therefore NetFlix may actually increases its new customer base without having to increase capacity much. Also customers who do not use NetFlix for a few months are less likely to leave and be content with paying the $8 to $10 monthly fee; whereas with NetFlix's current pricing structure, the customer may not want to pay a $17 monthly fee for no usage.

There are also other concerns to be considered with my pricing model -- namely cash flow and the effects on operational processes. From a cash flow point of view, potentially cash flow could become spread out more evenly over the month. I consider this a positive as it makes managing treasury much easier. However it is also possible, especially in the beginning, that revenue (and therefore cash flow) would drop as customers become accustomed to the new pricing model. Also I assume here that NetFlix charges clients as the movies are rented. This brings up a micropayment issue (which I will discuss as a broader topic in a later blog). Charging a client a $1.50 a time has a transactional cost which affects the bottom line immediately. So NetFlix may choose to charge the clients once or twice a month to pool their transaction costs, in which case there would be little affect on cash flow.

The idea with this blog is to consider that there are many ways for NetFlix to approach its future competitiveness. This is just option, but I would love to hear what you think!