Netflix Seeks to Spur Growth in Sales, Streaming Video After 2011 Blunders as Rivals Like Verizon Enter

on February 06 2012 3:10 PM

Before Netflix was launched in 1997, co-founders Reed Hastings and Marc Randolph considered naming the company DVD-by-mail.

That name would have accurately described the business model: renting DVDs that came in the mail. But Hastings, the current CEO, believed the future of movie rentals would involve customers watching content on their computers.

Netflix introduced streaming 10 years later, so now it's trying to engage customers more as they use their laptops and PCs to enjoy entertainment. The challenge for the Los Gatos, Calif.-based provider is to stand out as others such as Hulu and Amazon,with its Prime service, try to gain an edge in the streaming business.

Coinstar's Redbox unit, a rival of Netflix, announced Monday it was partnering with Verizon Communications to offer streaming content in the second half of the year. This could be the beginning of large telecommunications companies trying to make their mark in the sector. 

Blockbuster 2.0

Netflix declined to make Hastings, 51, or other founding employees available. Spokesman Steve Swasey said Hastings initially came up with the concept of Netflix in 1997 after being charged a $40 late fee for failing to return a copy of Apollo 13 to a video rental store.

Netflix initially charged per rental, but in 1999 introduced a subscription-based model to allow customers to rent unlimited DVDs for a fixed monthly price without late fees.

The Netflix model was successful in part because it coincided with the rise of home Internet access.

Blockbuster initially got people in the mindset of going out to rent movies, said Alex Goldfayn, an advisor on corporate branding and author of Evangelist Marketing. And Netflix came out and said 'we'll save you a trip to the store.'

As a startup, the company didn't have a lot of money for marketing. Instead, Netflix relied on what Goldfayn called evangelists. He said the company was effective in building a loyal following, relying upon word-of-mouth to spur sales.

When Netflix filed for its initial public offering in 2002, it claimed around 600,000 paid subscribers. By 2006, the number had mushroomed to 6.3 million.

A New Model

The company finally incorporated the net into Netflix by 2007, when it introduced free live streaming.

Streaming didn't start as the mainstay, spokesman Swasey said. Customers were slow to catch on to streaming partially because the catalog was light at the time.

Subsequently, Netflix built up its film library and also began offering customers the opportunity to stream through their television set-top boxes, videogame consoles and tablets.

This strategy boosted the domestic Netflix subscriber base to 24.4 million in the fourth quarter ended Dec. 31. The company ranked 265th on the IBT 1000, a list published by International Business Times of the fastest-growing companies between 2008 and 2011.

But people who weren't interested in a DVD service could use other Internet outlets to get content. Netflix needed to find a way to capture revenue on the streaming service.

The Big Oops

Netflix's strategy went off the ramp last year. In July, Hastings decided to charge separate fees for the DVD-by-mail and online streaming services. For people who wanted both services, prices were hiked about 60 percent.

In September, Netflix announced plans to split its DVD-by-mail service, which was to be dubbed Qwikster, and streaming service into two separate companies.

The moves were disastrous. In the third quarter alone, more than 800,000 subscribers canceled. The Qwikster plan was quashed but price hikes remained.

But the damage had been done. Netflix shares, which reached a 52-week high of $304.79 in July before the changes, fell as low as $62.37 by October.

Lately, though, they've recovered and traded Monday around $129.81, valuing the company at $7.2 billion.

Goldfayn, the author, doesn't believe Netflix went wrong in raising prices, which needed to increase due to the move to streaming, but said the process was a disaster.

It was done very arrogantly, Goldfayn said. The company said [the increase] was 'a latte a month.' But it's not 'a latte a month'. It's a 60 percent increase for the customers who love you.

Price hikes could have been done more gradually, or grandfathered customers into the old subscription-based model, he added.

Netflix should also have quickly done something similar to Apple's reaction following problems with the iPhone 4 in 2010, Goldfayn said. Apple offered free cases to iPhone 4 users after the phone was found to cause interference problems.

We're not perfect; phones aren't perfect, Apple CEO Steve Jobs said at the time. We want to make all our users happy.

By December, Netflix began offering subscribers one extra disc a month for customer using the DVD service. But management never came out and did that one thing to placate its loyal base, Goldfayn said.

Trying to Rebuild

The last few months...have been difficult for shareholders, employees, and most unfortunately, many members of Netflix, Hastings wrote shareholders after the third-quarter earnings announcement. Although the company reported net income rose 66 percent to $1.16 a share on revenue that gained 49 percent to $822 million from the prior year, management predicted troubles were ahead.

We've hurt our hard-earned reputation and stalled our domestic growth, Hastings acknowledged.

Still, customers still want to be entertained and they still rely on Netflix. The company's shares experienced the biggest gains of any among the S&P 500 in January, rising 77 percent, data compiled by TheStreet.com show.

Big challenges remain.

The original DVD-by-mail service still provides about 80 percent of the company's profits, Janney Montgomery Scott analyst Tony Wible said in an interview, which could cause problems if people eventually lose interest in DVDs.

The company sees its biggest challenge as TV Everywhere types of programs run by the major networks, where subscribers can watch all available shows.

Netflix pointed to HBO GO, the streaming service of Time Warner's HBO, as a model that could pose a serious challenge. The networks behind the Hulu streaming service, including News Corp., Comcast's NBCUniversal and Viacom, kept the company rather than auctioning it in the second half of 2011.

Both broadcast and cable networks will effectively also become Internet networks like Netflix, Hastings and CFO David Wells predicted in the fourth-quarter earnings commentary.

To stand out, Netflix will require exclusive content deals with networks and movie studios. But with the market becoming increasingly saturated, the cost of that exclusive content is escalating.

With Netflix, Amazon, Hulu and others all competing for exclusive content deals margins could likely be under pressure, Bank of America analyst Nat Schindler wrote recently.

Netflix is also creating its own exclusive content. It will release Lilyhammer, the first of five original series, on Monday. The series stars Steven Van Zandt, who played a mobster The Sopranos and remains a member of Bruce Springsteen's E Street Band.

Netflix is also trying to pierce overseas markets. It launched service throughout Latin America and the Caribbean in 2011, and announced it was introducing streaming in the UK and Ireland in January. As a result, Wall Street analysts forecast a first-quarter loss of loss of 30 cents a share reversing 2011's net income of $1.11 a share.