Netflix was devoted exclusively to the new DVD format. DVDs were introduced in 1997, but the major Hollywood studios were initially reluctant to embrace it. By 2002, DVD sales surpassed VHS sales for the first time and would peak in 2006 generating approximately $24 billion in sales and rentals.
Netflix’s success relied heavily on the U.S. Postal Service. From its outset, the company made a concerted effort to understand the how the Postal Service operated and to utilize this infrastructure for its own purposes. The DVD format proved to be far more amenable to the Postal Service’s standard operating procedures than VHS cassettes.
As Netflix gained in popularity, Wal-Mart announced in 2002 that it was launching its own rent-by-mail service.
Though the service Wal-Mart offered was virtually identical to Netflix’s, it was unable to attract a significant subscriber-base. Wal-Mart terminated the service in May 2005.
While Blockbuster struggled, Netflix maintained a strong record in terms of customer satisfaction.
As Blockbuster began airing a series of commercials to support Total Access, the marketing campaign unintentionally helped to legitimize Netflix.
Apple’s portable media player known as the iPod gained considerable popularity following the release of iTunes in 2003. This particular combination helped to legitimize the digital music market. They were equally instrumental in acclimating users to a new generation of portable media devices and to interacting with these devices through different online interfaces. When Apple released a video version of the iPod in 2005, many assumed that the company would dominate video downloading in the same way it did with music downloading.
Multi-system operators like Comcast appeared to be in the best position to develop a viable video-on-demand service.
The success of Redbox marked another unexpected turn in home entertainment. The company specializing in automated kiosks that rent DVDs for a nominal nightly fee saw a dramatic growth in 2009 when it doubled its number of kiosks to 18,000 and staked a claim to 19% of the overall rental market. Similar to Netflix, Redbox featured an innovative hybrid approach that allowed it to leapfrog competitors like Blockbuster. Unlike Netflix, however, Redbox limited its inventory to mainstream new releases.
To underscore just how anachronistic Blockbuster had become, The Onion, a satirical, mock-news outlet, posted video coverage of a Blockbuster video store that had been transformed into a “living history” tour. [Link to video.]
A second, more important departure from Reel was that in September 1999 Netflix abandoned the pay-per-unit model and introduced a subscription plan. For a monthly fee, customers had access to unlimited rentals. The critical selling point of this approach was that customers could hold onto each rental as long as they liked without incurring late-fees. Inspired by his own $40 late fee from Blockbuster, Netflix CEO Reed Hastings recognized how much these penalties were widely abhorred. [open endnotes in new window] The new plan not only struck a chord with consumers but helped to address several practical issues as well. The subscription model had the advantage of guaranteeing a constant stream of revenues prior to individual transactions. Second, it allowed Netflix to tie its recommendation engine to its revenue source in a way that Reel was never able to devise.
Customers used CineMatch to build a queue or list of films they wanted to rent. The next film on the queue would automatically be sent as soon as the previous rental was received. This further let Netflix maximize its back catalog and guide customers away from new releases. For customers, the service seemed a better value. People always had something to see for their monthly fee even if wasn’t the exact film they wanted or if it sat unwatched for weeks at a time. The subscription fee was ultimately a voluntary commitment, with a very different valence than punitive late-fees. While these were all key advantages as Netflix began a period of dramatic growth, the most significant impact of the subscription model may have been that it exposed the extent to which brick-and-mortar rental services relied on late-fees as a vital source of revenues.
A year after introducing their new plan, Netflix had amassed more than 250,000 subscribers. By 2002 it had more than doubled that number, and in 2003 its customer base was well over a million. In May 2002 Netflix was one of the few Internet start-ups to enjoy a successful IPO, raising $82 million—used to pay off debt, acquire additional inventory, and construct ten new distribution centers to ensure next-day delivery across the country. Netflix continued to grow during this time and effectively established itself as a recognizable brand without having to spend extensively on marketing or advertising.
Wal-Mart acknowledged as much when they announced plans to start a competing rent-by-mail service in late 2002. Blockbuster, however, remained reluctant to enter the rent-by-mail business. The reigning rental empire still controlled 40% of the storefront market, and its main concern continued to be the fact that rentals had begun to flatten, as the new DVD format seemed to favor a sell-through approach. By the time Blockbuster finally rolled out its mail-order service in May 2004, it announced that it expected to gain 30% of the rent-by-mail market in the next year. It instead encountered several stumbling blocks and, despite its confidence, made at least one devastating miscalculation.
Blockbuster quickly learned that garnering a share of the online market would not be as simple as expanding its retail outlets. Setting up an e-commerce website for a national brand was an immense endeavor, requiring not only vast technical provisions but also additional business operations such as distribution centers that were completely outside of its current business model. There were additional obstacles as Netflix had received a broadly worded patent for its online subscription service in 2003. And whereas Netflix was focused exclusively on its Internet-based service, Blockbuster was wavering between different, and to some extent opposing, business principles. In 2006, Blockbuster announced a revised service, Total Access, in an attempt to take advantage of its expansive physical presence. Many thought that this new “bricks-and-clicks” approach, integrating a rent-by-mail subscription with an in-store option, would indeed give Blockbuster the leverage it needed to pose a more serious threat to Netflix. While the new plan gained some initial traction, it eventually resulted in the same uneven dynamic that undercut the match between Hollywood Video and Reel.com. One Netflix official coyly noted such an incongruity by suggesting that Blockbuster’s in-store promotion for the new online plan was akin to seeing an advertisement for bus travel inside an airport terminal.
As Blockbuster scrambled to build its rent-by-mail service, it made something of a fatal decision in December 2004 as it announced a plan to eliminate all late fees. At this point, Netflix was up to 2.5 million subscribers and growing steadily. In a first sign of panic, Blockbuster claimed that it needed to improve customer relations. The move was a complete disaster on several fronts. As the rental giant continued to focus on new releases, the absence of a late fee policy made it even more difficult to manage its inventory, which in turn further aggravated customers. More important, late fees, as a general rule, accounted for 15% of video store revenues. For a franchise the size of Blockbuster to lose late fees was a devastating blow. In 2005 it forfeited approximately $400 million in late fees. The subsequent cash crunch forced the company to cancel its third quarter dividend. Although Blockbuster maintained its 40% share of the rental market, it had descended into free fall.
The turmoil continued as “activist” investor Carl Icahnn tried to orchestrate a hostile take-over of Hollywood Video (which eventually merged with the third largest video chain, Movie Gallery). Blockbuster tried to cut costs by closing hundreds of outlets but saw its stock plummet despite its efforts. By 2010 the company would be forced to file for bankruptcy, having lost ground on multiple fronts.
While Netflix had established a clear advantage in terms of rent-by-mail and subscription services, discount retailers like Wal-Mart and Target had assumed a lead position in the sell-through approach that studios favored. At the same time, cable providers appeared to be best suited to offer various video-on-demand options, and technology firms like Apple with its iTunes platform seemed to have the upper hand in terms of developing the digital download market. In addition to these challenges, Blockbuster faced a new competitor in Redbox, the most prominent purveyor of automated self-service kiosks or vending machines that were located outside of supermarkets, gas stations, convenience stores, and fast food restaurants. Adopting a strategy that had once been Blockbuster’s bread-and-butter, these kiosks largely specialized in new releases and popular titles and in doing so, effectively provided a more convenient and efficient version of the video store experience. These challenges emerged in rapid succession, and all of them laid claim to some kind of leverage as home entertainment began an immense transition.
Although Blockbuster continued to control up to one third of a multi-billion dollar industry, as early as 2006 it had begun to be viewed as a relic. Traditional video retailers lost the leverage they once held and their value deteriorated sharply as Wall Street pronounced the brick-and-mortar video business a dead end. Netflix’s apparent triumph meanwhile rested on several factors. It succeeded where Reel had failed in three ways:
It was largely by virtue of this last feature that Netflix was ultimately able to out-maneuver Blockbuster. The subscription model allowed the Internet-based rental service to take advantage of changing consumer preferences, building a zealous membership at same time Blockbuster was increasingly alienating its own customers. Moreover, even as industry analysts repeatedly predicted that Blockbuster’s overall size and superior position would allow it to prevail, the rental giant was simply too late in recognizing the significance of its new competitors and too cumbersome to succeed in a new digital environment. Netflix may not have been the first tech firm to wed Internet technologies to the video rental business. It was, however, the first to prioritize technological innovation in formulating its business model and to do so in a way that gave it leverage over the existing rental retailers. Netflix had realized a major accomplishment in holding off Blockbuster, as well as Wal-Mart and the others that had tried to duplicate its service.
Nevertheless, a new wave of battles loomed on the horizon as the Web 2.0 generation began to take shape. Netflix would not only have to modify its rental service continually but also rethink its place within the overall film industry and, more specifically, re-evaluate how its impact on changing distribution and exhibition practices would affect its long-term viability.
The short end of the Long Tail
In October 2004 Wired editor Chris Anderson published an article on what he termed the “Long Tail,” a new economic model inextricably tied to the Internet and the digital technologies that it helped to shape. According to this new model, it was possible to build a profitable business on the low but steady demand for a wider range of inventory as opposed to the fleeting but large-scale demand for the most popular goods. In addition to this main principle, Anderson identified three key tenets that made Long Tail economics possible.
For instance, “more than a quarter of Amazon’s book sales come from outside its top 100,000 titles.” That means that when taken as a whole, content that appeals to a highly specialized or limited audience constitutes a market that begins to rival the revenue generated by hits. In Anderson’s book-length account of the shift toward the Long Tail, he observes that the trend is most obvious in entertainment and media. To emphasize this point, he consistently cites Amazon, Netflix, and RealNetworks’ music service—Rhapsody, as primary examples of the phenomenon. In the abstract, Anderson’s term had explanatory power. It seemed to pinpoint the underlying logic of the most successful Internet endeavors and it quickly became a mainstay in the lexicon of business gurus and aspiring entrepreneurs. For Netflix, however, the Long Tail only played a tangential role in its overall ascent. While the company often extolled the virtues of this approach, it would ultimately abandon the Long Tail strategy as it transitioned from novel start-up to a major force in the home entertainment industry.
Lost in Anderson’s fervor for new technology is the fact that the video rental industry as a whole spearheaded the Long Tail model long before the term was invented. That is to say, the entire industry turned on drawing in revenues without devoting additional expenditures to inventory. Even as rental stores had to purchase content at a higher wholesale price, each tape only “need[ed] to be rented 20 times at $3/rental to break even.” Everything after that point was pure profit. As retailers like Stuart Skorman realized early on, it was possible to optimize this principle by building an extensive selection of older and more marginal films and then finding innovative ways to direct customers to these titles instead of new releases. As profitable as this approach may have been, the rental industry by the end of the 1980s, led by rental chains like Blockbuster, was increasingly devoted to “stocking and promoting hit movies” at the expense of precisely the kinds of titles that were capable of generating higher profit margins. With its hit-driven approach, the rental industry ended up with the exact inverse of Anderson’s formula for the Long Tail: 80% of its revenues stemmed from 20% of its inventory. This reliance on hits underscored several additional problems. First, as the rental chains increased the number of new releases they carried, this approach helped studios reduce the overall manufacturing costs of producing home videos. So studios and wholesalers could lower sell-through pricing that, in turn, ate into the rental market. Second, the larger rental chains, again in conjunction with the shift toward popular new releases, attempted to leverage their growing scale by negotiating revenue-sharing deals with their suppliers. These deals typically lowered their up-front costs, allowing rental retailers to purchase VHS cassettes at cost in exchange for a percentage of the profits generated by specific titles. As a result, a larger percentage of the stores’ revenue was tethered to an inventory that they did not fully control. In undermining their own profit margins, rental stores began to focus on ancillary revenues such as video sales, video game rentals, merchandise sales (ranging from toys, posters, and apparel to concessions), as well as initiation and late fees to make up the difference.
With the shift to a hit-driven business model, the rental industry seemed to forfeit its innate affinity for Long Tail economics. While this might have resulted from a poor long-term strategy (tied in part to the rise of national chains that privileged all out growth and short-term profits over long term sustainability), the rental industry was also dependent on Hollywood studios and other content producers who were increasingly looking to maximize their own Long Tail interests. The major studios, ever since they were forced to relinquish their ties to theatrical exhibition, have looked to secondary markets as an important source of revenue. As vital as they have been, these secondary markets have also caused a certain degree of antagonism and ambiguity. The studios, for instance, have been extremely cautious when it comes to new technologies. In the most glaring example of kind of backward-thinking, the studios took legal action against the manufacturers of the VCR in the 1980s, not realizing that home video would soon be their most lucrative secondary market (far surpassing the money generated by licensing film rights to television and pay TV and even box office totals by the end of the 1980s). The studios were similarly leery of the new video rental business. Their apprehensions subsided only after rental retailers proved that they could provide studios a substantial source of additional revenues. Hollywood eventually both embraced these new opportunities but bemoaned the need to partner with third parties.
With the success of DVDs and the sell-through approach, Hollywood studios sought to expand their stake within secondary markets. More specifically, they tried to expand their control over the entire lifecycle of a given title and to maximize the profitability of their assets across different windows. With new digital formats and video-on-demand platforms looming on the horizon, Hollywood considered itself in an ideal position to realize these goals. There were, however, numerous unanswered questions regarding the future landscape of home entertainment. First, as the importance of downstream revenues increased, exhibition windows—the period of time in which a film is available in the theater, on pay-per-view, etc.—began to shrink. The accelerated availability of films, along with the interchangeability facilitated by new digital formats, paradoxically increased the pressure on studios to fabricate and then police periods of exclusivity. Second, while some assumed that new high-definition and digital formats would simply replicate the DVD’s success, the growing array of new and convergent forms of media along with changing consumer preferences suggested that this might not be the case. Such technological issues were further compounded as studios pursued their own proprietary digital platforms or negotiated strategic alliances with preferred partners. To some extent, it was the lack of industry-wide standards that allowed newcomers like Netflix to quickly carve out a commanding position. Despite all the excitement about new technology, then, the instability of the overarching industry necessitated a wait-and-see approach in which the status quo persisted for much longer than anyone expected. Also, while the studios and other content producers were more conscientious of the need to maximize the Long Tail value of their assets, they simply were not always in a position to do so.
Though the larger rental companies had abandoned the Long Tail in favor of a hit-driven approach, there were some efforts to counterbalance their dependence on new releases by moving up the supply chain and participating in the production process. Blockbuster, for example, launched DEJ Productions in 1998 to acquire or co-finance independent films for exclusive release in its retail outlets. Blockbuster publicized this new endeavor as part of its commitment to independent films and other niche genres. In several cases, DEJ proved that films such as Boondock Saints (1999), which performed poorly in a minimal theatrical release, could be extremely successful in terms of home video sales and rentals. DEJ soon began distributing to all retailers and quickly established itself as one of the biggest buyers at festivals like Sundance. Netflix, likewise hedging against its reliance on studio-controlled content, followed Blockbuster by establishing Red Envelope Entertainment in 2006. Like DEJ, Red Envelope aimed to participate in financing, producing, and distributing films in exchange for either exclusive DVD rights or some manner of revenue sharing. Even prior to the launch of Red Envelope Netflix had begun to seek out independent films as well as older, cult films such as Eraserhead that were languishing without home video distribution deals. Once Red Envelope was formalized as a subsidiary, it again followed DEJ’s lead and established itself as an aggressive presence at Sundance and Toronto. It also showed that it was willing to expand its involvement across the production process. In a co-distribution deal with Roadside Attractions for Puffy Chair (2005)—one of the founding films of the genre known as “mumblecore”– Red Envelope agreed to share marketing costs in exchange for a portion of the film’s overall profits.
In both cases, the move into production and financing focused almost exclusively on specialty content, namely independent films and documentaries. DEJ eventually shifted its focus to bigger independent productions such as the award-winning hits Crash (2004) and Monster (2003). Following its deal for Puffy Chair, Red Envelope purchased Hal Hartley’s The Girl from Monday (2005) and partnered with Samuel Goldwyn on Julie Delpy’s romantic comedy 2 Days in Paris (2007). It also worked with the Independent Film Channel (IFC) on Sherrybaby (2006) and Cannes winner 4 Months, 3 Weeks, 2 days (2007) as part of a ten-picture output deal. Red Envelope was even more aggressive in acquiring non-fiction films, essentially finding documentaries both inexpensive and highly marketable, with potential for additional revenues through theatrical and DVD release. Furthermore, documentaries meshed nicely with the programming interests of cable networks such as the Discovery Channel. At the same time that documentaries were enjoying an unprecedented box-office run with Fahrenheit 9/11 (2004), March of the Penguins (2005), and An Inconvenient Truth (2006), Red Envelope fully funded The Comedians of Comedy (2005) and acquired the rights to various biographies documenting well-known public figures such as Ralph Nader in An Unreasonable Man (2006) and Tony Bennett: The Music Never Ends (2007). Some of Red Envelope’s biggest hits included higher-profile documentaries such as This Film is Not Yet Rated (2006), No End in Sight (2007), and Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders (2006).
In addition to expanding its control over select inventory, the move into production allowed Netflix to bolster one of its most marketable features. As the rental service made its initial foray into the market, it built its brand around an extensive catalogue (which quickly expanded to include more than eighty thousand titles) and the ability to cater to its customers’ discerning tastes. Various commentators heralded Netflix’s allegiance to niche content in general and noted their broad selection of documentaries and foreign films in particular. The company further indicated that a majority of its catalog came from suppliers smaller than Lionsgate, and that it was able to significantly expand viewership for small-scale films and documentaries like Memento (2000), Capturing the Friedmans (2003), and Born into Brothels (2004). CEO Reed Hastings, additionally, highlighted the fact that Netflix customers rented Whale Rider—a 2002 New Zealand and German co-production made for approximately $4 million—as often as heavily publicized Hollywood blockbusters The Hulk and Charlie’s Angles II, which had been released at the same time. In short, Netflix was able to drive traffic to films that didn’t have the resources to compete in a media saturated, blockbuster driven entertainment market. According to chief content officer, Todd Sarandos, it was possible to put an actual dollar amount on this feature claiming,
While this approach allowed Netflix to effectively utilize the Long Tail potential of its inventory, it also enhanced its overall cultural cachet. By the company’s own account, it had, with its ability to ‘recommend’ specific films and encourage customers to sample a much broader spectrum of titles, effectively “taken the place of what college film societies did in the '60s and '70s, when they turned audiences on to new European films and old masters.”
The financing and acquisition that Netflix pursued under the guise of Red Envelope dovetailed with this marketing strategy. It allowed Netflix to further diversify its already extensive catalogue and to enhance its ability to target more discerning tastes. At a more practical level, Red Envelope allowed Netflix to foster better relations with independent producers and distributors, and it provided the possibility of generating supplementary revenue streams. In both regards, Netflix seemed to personify the Long Tail approach. On the one hand, the company was devoted to expanding its overall catalogue, providing a wider range of choices and using various customization and recommendation tools to match customers with this material. On the other hand, the business was taking advantage of its ability to optimize undervalued content. This premise underscored the entire video rental industry but was even more pronounced as DEJ and Red Envelope became involved in the production of specialty fare such as low-budget independent films and documentaries. These projects offered low-cost, low profile initial investments that promised modest but highly profitable long-term returns. Despite the apparent success of these endeavors and the Long Tail model more generally, both Blockbuster and Netflix decided to abandon their subsidiary production arms. Blockbuster sold DEJ to another studio for $25 million in November 2005 largely because of the financial pressures they were experiencing. And Netflix shut down Red Envelope a few years later in July 2008. The reason for Netflix’s decision was less immediately clear; however, it coincided with several larger shifts in the company’s overall approach.