Introduction - Berkeley Haas



Introduction

This paper explores the application of Game Theory to the Online DVD Rental Industry. At approximately five years of age, the Online DVD Rental industry is a young industry, and is therefore still in the growth phase of its lifecycle. The dynamics of the industry are changing rapidly and the industry is finally seeing entry of new players, a trend we expect to continue. Because of its rapid rate of change, the Online DVD Rental industry provides fertile ground for many game theory situations to arise. Signaling, in particular, plays a rich and potentially pivotal role in markets marked by such rapid change. Throughout our discussion we will point out various players’ attempts at signaling and the resultant effects on the market. We will primarily explore these game theoretic issues from the perspective of industry pioneer, NetFlix, but where applicable, we’ll address the perspectives of Blockbuster and also potential rival, Amazon.

We start with assumptions and a brief background of the Online DVD Rental Industry. Then we present the current competitive situation, and by developing a payoff model for industry participants, describe how the industry evolved. Building on that foundation, we’ll provide possible explanations for the behavior of current industry participants and go on to analyze potential threats to the industry. We’ll conclude with our predictions for the effect of new entrants on the industry and propose recommended actions for NetFlix.

Assumptions

In the following sections, we analyze the game-theoretic aspects of the Online DVD Rental Industry and seek to understand how the industry evolved into its current state. In order to perform the analysis, we developed a payoff model for each of the players. Our analysis going forward is predicated on the following assumptions.

• For simplicity, we consider the US Online DVD Rental Market only. In doing so we recognize there are international components to some of our players’ strategies, but we expect these to have a negligible effect on our analysis.

• We consider only the “all-you-can-eat” plans which allow unlimited monthly rentals for a fixed monthly fee. These are by far the most popular plans. Although other plans and pricing options have become available as of late, they are not considered.

• For our first set of games we only consider NetFlix v. Blockbuster, since they are the two largest players in the US market.

o We ignore extremely small players. These players are statistical outliers and are unlikely to have a large influence on the overall market. Wal-Mart, for example, provides an Online DVD Rental service but its customer base and growth rates are negligible in comparison with Netflix. Further, we feel there is minimal overlap between Wal-Mart’s customers and those of NetFlix and to a lesser extent, Blockbuster.

• We assume that participants are trying to maximize long term value of their online operations.

• We use NPV as a measure of company value. This assumption is reasonable if the participants are trying to maximize long-term value.

• We compare only companies’ online units to each other. Therefore, we compare NetFlix to Blockbuster’s online unit, but we do not consider the effect of NetFlix competing with Blockbuster as a whole.

• We assume the maximum size of the Online DVD Rental Market is approximately 20 million customers. This estimate is based on estimates from multiple sources.

• Whenever possible, we use actual cost or other financial data. When such data is not available, we derive our numbers using comparables.

How It Came To Pass – Industry Background

The Online DVD Rental industry was launched in 1999 with the founding of NetFlix by Reed Hastings. Mr. Hastings was frustrated by late-fees for movie rentals at his local Blockbuster. A busy professional, he rarely had the time to view and returns movies in the allotted time and realized that other busy professionals faced a similar predicament. Mr. Hastings created a service that allowed customers to rent DVDs online and receive them through the mail, charging no late fees for prolonged rental periods. NetFlix launched with a “pay-per-view” model where customers paid for each rental, sans late fees. From the outset, the company experienced marginal success with this model and Netflix’s long term viability was in question. The value-add of Netflix was not great enough to counter the strength and convenience of Blockbuster. Customers perceived few if any cost savings from using NetFlix and were irritated by the wait times resulting from postal delivery. NetFlix therefore discovered its customers had a lower willingness to pay than Blockbuster’s customers and that it had to find a means to compensate them for the inconvenience of using an online service.

After some experimentation, NetFlix innovated the “all-you-can-eat” model where customers enjoy unlimited rentals for a fixed monthly price (initially about $20 per month). This model proved to be wildly popular and NetFlix soon attracted scores of subscribers, many of whom formerly rented from Blockbuster. By mid-2004, NetFlix, flush with confidence over its rapid growth, raised prices for all subscribers to $22/month. Customer churn didn’t accelerate appreciably, as would be expected in the absence of any other comparable online competitors. NetFlix’s success did not go unnoticed however by the traditional video rental industry, and various small competitors began encroaching on NetFlix’s turf. In particular, the rising star of NetFlix caught the attention of Blockbuster, the 800-pound gorilla of the video rental business. Blockbuster purchased a small NetFlix competitor, , in 2002. It used this acquisition to study the online rental model for two years, to fully prepare for its market entry in late 2004. As of early 2005, NetFlix and Blockbuster together represented the largest portion of the Online DVD Rental Market.

With the entry of Blockbuster, NetFlix faced its first true competitor. While trying to resolve how to respond to Blockbuster and the level of threat it posed, NetFlix was assaulted on another front – Amazon announced it was considering entering the market. With one formidable competitor, NetFlix was still cool, calm and collected, but with two potentially large competitors, NetFlix sprung into action and cut prices. From all indications, NetFlix is more threatened by the entry of Amazon, than the entry of Blockbuster, most likely because its customers are more similar and Amazon has potential cost advantages in customer acquisition.

Hence began the grab for market share, precipitated by the Amazon announcement and initiated by NetFlix’s price cuts. Blockbuster responded to NetFlix’s drastic moves with two rounds of price cuts of its own ultimately arriving at $14.99 to maintain its discount relative to NetFlix. This then brings us to the present situation of a price war between NetFlix and Blockbuster. We will next examine the effects such a war has on its players and potential rationale for its occurrence.

A Look Under the Hood – The Online Rental Business Model

Before delving into an analysis of the current price war in the Online DVD Rental industry, it is essential to understand the business model of the online rental space and a few of the unique attributes of our two players, NetFlix and Blockbuster. Until very recently, this industry boasted robust margins; about 50%. However, with the current downward price pressure generated by the market share grab, gross margins decreased to around 38% and are expected to move even lower in the near future.

One of the first things to note in reviewing the online business model is that the primary cost drivers for fixed costs are the acquisition costs for the movie library, about $100 MM for 40,000 titles, and setting up distribution centers around the nation, about $30 MM for the first year and $10 to $15 MM ongoing. The start up time is relatively fast, given that movies can be procured very quickly and distribution centers are leased with a nominal amount of employees at each. As a case in point, Blockbuster completely replicated NetFlix’s infrastructure in only eight months. Therefore, given the national scope of this business, the barriers to entry are fairly low for companies with deep pockets.

Once the business is up and running, the largest national players require about 30 distribution centers of about 5000 ft2 each with about 12 employees. The technology for pick and pack is very basic. With 30 distribution centers, online providers can reach 90% of customers within 1 mailing day and 100% of customers within 2 days. Speed of turn-around is a key competitive metric in this industry. The USPS is the method of delivery for large players. Perhaps the biggest challenge in maintaining margins is limiting the number of movies customers rent each month. With the advent of the online, fixed fee model, the opportunity cost to customers for renting a movie, is virtually nill. If they don’t like it, they simply return it quickly and get another movie from their list. This is in stark contrast to the traditional rental model where the customer would be out his/her time to drive to the store to pick up and return the movie as well as about $4.30! Therefore, it makes perfect sense that the average number of rentals per customer doubled under the online model vs what they were renting under the traditional model. The average NetFlix customer currently rents 6.7 movies/month. If you refer to the table above that shows the estimated variable costs per movie rented, you can see that at a monthly rental fee of $18/month, and 6.7 rentals per customer, NetFlix doesn’t have much money left over ($4.60) to cover marketing, infrastructure, administrative, and library costs. Speaking of marketing, the current estimated customer acquisition cost is nearly $38! Given these costs, the name of the game for NetFlix and Blockbuster is to control the number of movies its customers rent per month.

With an understanding of the online rental business model, we can now discuss the costs, benefits, and probable outcomes from the current price war.

The Hatfields & The McCoys – Wars of Attrition

By engaging in a price war, NetFlix and Blockbuster have chosen to engage in a war of attrition. In this situation, both competitors pay a price (i.e. lower prices) in the hopes of outlasting the competition (i.e. competitors raises prices before you do) and winning a payoff for being the strongest player. “Winning” in this context means, among other things, that the last man standing gets a larger share of the market going forward, and thus greater revenue given that both players raise prices to sustainable levels and maintain them for the long term. In examining this scenario, it is important to note that not all reasons for entering a price war necessarily make sense from a financial standpoint and we will examine both financial and non-financial drivers of such wars. The putative reasons for engaging in this price war are:

• Leverage economies of scale. It is believed that more customers will translate into lower average cost to service a customer due to efficiencies in distribution centers and with utilization of movie libraries, thus resulting in higher margins.

• Customers are sticky. Race to build your market share otherwise competitors will have much of the subscriber base locked in and it will be more difficult to get customers later. Customers are sticky and will stay with you later when other competitors appear.

• Customers, over time, will use an online DVD service more for the convenience value than for the ability to watch many movies at a low cost. As a result the average rentals per month will go down and profits will go up. In this case, it may be worth losing a large sum of money up front in order to lock in even larger profits later.

• If you can hold out long enough, you will win the majority of the market, forcing an equilibrium with one overwhelmingly dominant player and many stragglers, similar to the “Amazon and everyone else” dynamic in the online book market.

• It is worth it to sacrifice some profits and potentially shareholder value for pride and bragging rights. Each firm wants to be a “winner” by being the biggest on the block. NetFlix pioneered the market and it thinks it should own the market due to first mover advantage. Blockbuster is the overall king of home entertainment and feels NetFlix is encroaching on its turf and needs to defend.

With so many assumptions and viewpoints, we can already begin to see the importance of signaling in this market setting. For instance, Blockbuster has sent NetFlix many signals since its entry late last summer. Blockbuster’s CEO, John Antioco recently announced, “we are determined to do whatever it takes to be the leader in the online rental space.” He went on to posit, “…we believe we have the brand, store base, customer relationships, and the commitment, as well as the necessary strong balance sheet.” The company is going out of its way to advertise that its online unit will be at breakeven-to-profitable by Q1 2006[1] despite another massive round of capital infusion in FY2005. Another, very commonly seen signal that Blockbuster used was its projection of customers: at least two million customers by Q1 2006. There’s little question here, that Blockbuster is telling NetFlix that it is the big fish in the sea, it will stay in the game, and has built its future around the online space. In short, NetFlix better stay out of its way, or else! Blockbuster is trying to leverage its supposed operational strengths and years of entertainment expertise to teach NetFlix its place in the market.

Not to be pushed around, NetFlix has engaged in its fair share of signaling as well. It’s intentionally stated several times that it would forego profits for several years should that be necessary to fight off competitors. Interestingly, this threat was issued soon after Amazon’s announcement of potential market entry; a very similar phrase we heard Amazon utter in its infancy. NetFlix has further bolstered its verbal threats by cutting prices drastically. Lastly, its publicly stated grab for market share before Amazon enters signals to Blockbuster and the market that NetFlix feels its customers are sticky and will likely stay with NetFlix in the face of competition. Just as signaling can be intentional, it can also be unintentional and carry some adverse consequences. For example, NetFlix exhibited its naiveté in announcing, “…we underestimated the likelihood and significance of competition, primarily from Blockbuster and Amazon.” This is valuable information for NetFlix’s competitors. NetFlix claims to be tough and on the ball, but some of its signals indicate otherwise.

Are these threats credible? How concerned should NetFlix be about the threat from Blockbuster? The answers to these questions depend on what the payoffs for each competitor are, and what each has to gain or lose by engaging in aggressive price competition.

What’s it Worth? – Projecting Payoffs

To develop a payoff model for the industry participants, we designed a spreadsheet that allowed us to change key variables and observe the effect on each competitor, as shown in Figure 1 below.

Figure 1. Payoff Model Spreadsheet (Payoffs for Blockbuster Shown)

[Numbers are hard coded were data is available from research]

A detailed view of this spreadsheet is provided in Appendix A at the end of the paper.

In developing this spreadsheet, we were careful not to introduce needless complexity by adding irrelevant variables or variables which we could not justify as having significant and predictable effects on the payoffs. At a high-level, the spreadsheet simply calculates Profit as (Revenue – Expenses) for each year and discounts the profits back to 2005 to calculate NPV. We allowed several variables to directly or indirectly modify Revenue or Expenses (described in greater detail in Appendix A):

• Monthly Price

• Gross Margins under a Price War

• Marketing Expenses to acquire new Customers

• Other (non-Marketing) SG&A Costs

• Customer Attrition

• War/No War Conditions in Each Year

• Total Market Size

• Discount Rate (for calculating NPV)

A Baker’s Dozen – Interpreting Payoffs

Given the payoff model described above, we simulated the outcome of competition under both price-war and non-price-war conditions. For the price-war scenario, we simulated a price-war for three years. We projected outcomes through 2010 and discounted the profits back to 2005 (including a terminal value for 2011 to represent the future value of the firms). We’re confident our model generates realistic figures with results that are in line with estimates from our research; hence we believe that the model is at least coarsely reliable, especially when considering relative outcomes as opposed to actual values. Figure 2 below presents the payoffs for the market dynamics of NetFlix and Blockbuster.

|  |NFLX |  |No War | |War |

|BBI |  |  | |  | |

|No War |  |$1050MM |  |$942MM |

| |$915MM |  |$891MM |  |

|War |  |$1021MM |  |$921MM |

| |$823MM |  |$815MM |  |

Figure 2. Payoffs for Blockbuster (BBI) and NetFlix (NFLX) with a 3-Year Price War.

The payoff matrix in Figure 2 presents a surprising result – both firms are better off by not engaging in a price war. This is the only Nash Equilibrium in this scenario.

Based on our earlier discussion regarding price wars and wars of attrition, and also on the behavior of the firms in the market, we fully expected to find a all-time favorite, prisoner’s dilemma. We were perplexed that our analysis did not reveal one, and as a check of our model, we ran through many scenarios with varying assumptions for customer stickiness, cost of sales, length of price war, etc. Each outcome led to an outcome similar to that presented in Figure 2.

After some deliberation, we were left to conclude that there is in fact no prisoner’s dilemma in this situation. Both firms would flatly be better off by not engaging in a price war. This is consistent with the fact that this is a new and growing market, the level of customer stickiness is questionable, and the market leader, NetFlix, in a bit inexperienced at playing competitive games. At this point, the price elasticity is simply not sufficiently large to sustain a prisoner’s dilemma.

Once again, we note the role of signaling in this market. By engaging in a price war, one firm may be trying to signal to the other that it has the corporate wherewithal to outlast the other. However, evidence suggests that price signals are generally not very credible, since prices can be changed with relative ease. Despite this fact, the players may consider the cost of price signaling to be sufficiently low, as we can see from Figure 2, in which case they may engage in this low-cost tactic.

Are These Guys Nuts? – Competitor Analysis

We can glean other possible explanations for the price war by performing a competitor (behavioral) analysis on the firms. Since our analysis above didn’t support a prolonged War of Attrition, we surmise that there may be irrational behavior at play in this market. In particular, we can use our competitor analysis tools to arrive at possible explanations for why this war is needlessly continuing. We will examine both competitors, starting with NetFlix.

NetFlix views itself as an innovator and is immensely proud that it pioneered the Online DVD Rental industry. In performing a competitor response profile on NetFlix, we uncovered several inconsistencies in its actions which strongly indicate NetFlix doesn’t fully understand its market or competitors, thus explaining its seemingly irrational behavior in starting and perpetuating a price war with Blockbuster.

Based on NetFlix’s public comments, it appears it is suffering from the common Overconfidence Bias. In response to the market entry of Blockbuster and Amazon’s potential entry announcement, NetFlix claimed it was shocked. To the outside observer, this seems absurd. Most any individual could have predicted that Blockbuster would enter the online space in a straddle strategy to maintain its customer base in the brick and mortar world. There are numerous examples of companies who’ve done this, but most notable is Barnes & Noble’s online foray in response to Amazon. This then brings us to Amazon…while not as closely linked to Online DVD Rentals as Blockbuster, Amazon sees itself as having laid claim to the entire online world, and given its extensive DVD sales, it isn’t much of a stretch to see them entering as well. Another instance of overconfidence bias is NetFlix’s assumption about customer stickiness. NetFlix feels online customers are relatively sticky, or that they have fairly high lock-in. Supporting this premise are its deep price cuts undertaken to capture as much market share as possible. It is only useful to lower price to acquire customers if you feel the customers will stay with you after you raise prices. While we acknowledge there may be minimal to moderate customer stickiness in Online DVD Rentals, we don’t feel it is of the level NetFlix assumes and don’t support its move of lowering prices to capture market share quickly.

Confirmation bias also helps to explain some of these inaccurate assumptions about NetFlix’s environment. It appears NetFlix is basing its market assumptions on historical experiences with the market, where it had a virtual monopoly and lacked any strong direct competitors. The high expectations for customer stickiness, while validated by past churn rates, won’t necessarily hold true once Blockbuster hits its full online stride, or if and when a large online competitor enters such as Amazon.

In sum, there seems to be a significant amount of irrational behavior on NetFlix’s part which could be distorting the market and contributing to this fight. Probably of greatest concern to other players is the above mentioned faulty assumption of customer stickiness.

While not afflicted as severely as NetFlix, Blockbuster may also suffer from similar biases. In contrast to NetFlix, whose false assumptions seems to largely stem from the fact that it’s a young company, Blockbusters erroneous conclusions developed as a result of its traditional model being attacked by a substitute offering, namely online rental, and its aversion to customer loss. We know from studies that while not necessarily rational, companies and people will go to greater lengths (and costs) to avoid losing an asset than they will to gain the same asset (Loss Aversion). NetFlix is now threatening Blockbuster’s core business – movie rentals, and it has vowed to fight to the ends of the Earth to defend its turf. Blockbuster also may be fighting due to overconfidence of its probability of beating NetFlix into submission. It has a long history of beating down competitors and has probably factored those past successes into its present day analysis.

Do the outcomes of this behavioral analysis completely explain the behavior of these two firms? To a great extent, yes. We see that NetFlix has some erroneous assumptions about the market, namely in customer stickiness, that are driving it to quickly grab market share despite the high cost of doing so. Also, we saw that both companies were more confident of their probabilities of success than it warranted. NetFlix in particular has made some big moves and big claims, and based on the above it doesn’t seem possible that the threat of Blockbuster was the only factor. What other threat could elicit such a response as being willing to forgo profits for up to five years in order to win this market[2]?

The Pink Elephant –

The main catalyst of all this market upheaval probably is a company that isn’t even in the Online DVD Rental market – Amazon! Amazon has stated publicly that it may enter the Online DVD Rental market, and that customers have been requesting such a service from the largest online retailer. Of late, the company has been sending many and mixed signals to both NetFlix and Blockbuster. Why would Amazon be interested in entering the Online DVD Rental market? In many respects, Online DVD Rentals are a departure for Amazon, since the company is for the most part an internet-based retailer that doesn’t hold inventory or offer fixed fee services. It is optimized to ship items to customers, but not to accept every item as a return (as would be the case for rentals). Further, an online rental offering would require much larger capital outlays than Amazon is accustomed to. Lastly, opening 30 distribution centers is in direct conflict with Amazon’s stated strategy of winnowing its warehouse footprint and relying increasingly partners to handle distribution. There are several reasons, however, why a subscription would be attractive to Amazon.

First, DVD rentals have higher margins that most of Amazon’s other businesses. Amazon’s average margins are about 24%, but Online DVD Rentals boast around 35-40% gross margins. Another way in which online rentals builds Amazon’s financial performance is by virtue of its regularity of revenues and non-seasonality, both of which have the effect of smoothing revenues and decreasing volatility. From a capability perspective, DVD rentals plays to Amazon’s operational and marketing expertise. Both of these could be sources of cost advantage, particularly in customer acquisition costs. Amazon can leverage its massive installed customer base for marketing, driving its customer acquisition costs to near zero. By cross selling DVDs to rental customers, Amazon could use the DVD service to bolster sales on the main web site. And ultimately, DVD rentals are a complementary good to DVD sales, which would likely receive a boost from cross-promotion and increased exposure.

While it is clear Online DVD Rentals is an appealing market for Amazon, the company’s true intentions with respect to entry are still murky. Is it seriously considering directly entering the market as it initially threatened, or is it hatching a more deeply seeded plan more consistent with its partnering query.

Give Me Your Lunch Money – The Credibility of Threats

To date in the online DVD market, Amazon has issued a few, very strong signals to NetFlix and Blockbuster. It first claimed it was interested in entering the Online DVD Rental market in October of 2004. This sent NetFlix into a price cutting frenzy, almost assuredly igniting the War of Attrition between current market players. Then, in just April of this year, Amazon amended its original statement by saying it was interested in a partnership for the Online DVD Rental market. While it seems obvious now that we can largely blame the current price war on a non-market participant, it still remains to be seen what designs Amazon has on this industry and what benefits it expects from its signals.

A first place to start is in assessing the credibility of each signal. We know Amazon has incurred real costs to enter the Online DVD Rental market in the UK. Incurring real costs is a surefire way to signal a credible threat. However, it is not clear with what strength this threat transfers to the US market, a region geographically and operationally distinct from that of the UK. The costs for Amazon to enter the UK were arguably much lower than for it to enter the US. Amazon can serve the entire UK through its two existing warehouses. In the US, however, it’s a different story. Amazon has only six warehouses, not nearly enough to service the US within one mailing day. It would need to build out about 25 additional distribution centers as well as build a competitive movie library. Given these increased costs, Amazon may be thinking twice about the US market, and hence its threat is less credible. Further weakening its initial claim of entry is the large time lag of inaction on that claim. As more time elapses without committing activities, the less credible Amazon’s threat.

The plot thickens once Amazon’s more recent announcement of looking for a partner in the Online DVD Rental market is considered. It seems this may have been Amazon’s original plan from the beginning and it was using the initial signal to increase its bargaining position with the incumbents, NetFlix and Blockbuster. It cost Amazon nothing to make its market entry threat, but should a partnership, or even acquisition ensue, Amazon is in a much stronger position given that its potential partners have been emptying their coffers in a protracted price war. NetFlix’s valuation in particular has been hit heavily. Based on Blockbuster’s best-alternative-to-a-negotiated-agreement (BATNA, the opportunity from the physical stores), NetFlix is the most realistic target of Amazon’s signaling.

Assuming Amazon is in fact interested in partnering or acquiring one of the players, what incentives do these parties have to seriously consider this option? We’ve established that Amazon benefits by not having to invest the $100 MM plus start up costs to build a movie library and augment its distribution network. The potential partners could reap significant advantage from Amazon’s massive installed customer base and marketing expertise. Amazon claimed that its customer acquisition costs would be near zero and this could represent a much needed life preserver from the undercurrent of rapidly rising marketing spend. Further, partners could cross-promote DVD rentals with DVD sales on Amazon, one of Amazon’s differentiators in the UK market. Lastly, by taking a potential third player out of the market, prices can resume their higher levels prior to Amazon’s entry threat, and profitability will return. Given the signaling, most severely impacted party and the benefits, who then is the likely partner/acquisition target, Blockbuster or NetFlix?

Be Vewy, Vewy, Quiet. I’m Hunting NetFlix.

Our analysis shows that if Amazon were to enter the market, it would grow the overall market by reaching new customers who would not otherwise have tried an Online DVD Rental service. In estimating the total market size and payoffs with Amazon as a player, we used the following assumptions. Firs, we started with the 20 million subscribers NetFlix estimates a mature market will support. Against that number, we weighed the fact that Amazon has a very large existing customer base to which it could market a DVD rental service and our belief that NetFlix and Blockbuster have attracted most of the consumers who would be interested in such a service. Based on the latter observation, we do not believe that a third entrant, even Amazon, will be able to grow the total size of the market significantly. This led us to predict an Amazon entry would grow the total size of the market in each year by 15% over what we projected it would have been without Amazon’s entry. The end result is a market that grows to 23 million subscribers by 2013. This is shown in Figure 1 of the Appendix.

Of course, Amazon would never enter the market for the prospect of a measly 3 million total customers, so we assume it would also steal share from Blockbuster and NetFlix. We’re confident it would impact NetFlix more heavily than Blockbuster for several reasons. First, NetFlix customers are much more similar to Amazon’s than Blockbusters. Second, Blockbuster has a unique value proposition for its customers by leveraging its brick-and-mortar presence. Hence, it has a more attractive BATNA than NetFlix. Lastly, Amazon is a direct threat to NetFlix because it has deep expertise in building user-friendly, convenient web sites, which is a key differentiator for NetFlix.

What would be the effect on NetFlix if Amazon were to directly enter the market? We used our payoff analysis to calculate NetFlix’s payoffs in the face of entry by Amazon. We assumed that Amazon would continue its business strategy of being a price leader and would charge subscribers $13.99 per month, undercutting both NetFlix and Blockbuster. The payoff matrices are shown below in Figure 4.

Without Amazon

|  |NFLX |No War |War |

|BBI |  | | |

|No War |1050 |942 |

| | | |

|War |1021 |921 |

| | | |

With Amazon

|  |NFLX |No War |War |

|BBI |  | | |

|No War |814 |709 |

| | | |

|War |769 |702 |

| | | |

Figure 4. Payoffs for NetFlix with and without Amazon Entry.

As we can see from Figure 4, entry by Amazon would deal a serious blow to an already weakened NetFlix. What should the company do?

Our Recommendation: A Shotgun Wedding

Having explored what seems like every facet of the Online DVD Rental market, there’s little doubt NetFlix and Blockbuster are needlessly mauling one another at the behest of Amazon. Amazon poses a serious threat to the viability of the market, and individually to NetFlix. It now seems less likely Amazon will directly enter the Online DVD Rental market in the US, opting instead for a partnership or acquisition facilitated entry. Taking into account NetFlix’s bleak prospects as an Amazon pawn, we recommend it call Amazon’s bluff and preemptively offer a partnership. In doing so, there are benefits to be had for NetFlix, and more importantly, it prevents an unwanted low-value takeover attempt. Having recognized the manipulative actions of Amazon, NetFlix should seize this window of opportunity and change the rules of the game in its favor.

Recalling the predicament of our other player, Blockbuster, we offer some game theoretic advice for it as well. Blockbuster realizes it is a price taker in this market as it currently doesn’t offer the same value proposition as NetFlix due to operational start-up bugs and reputational issues. Therefore, Blockbuster must maintain a price discount relative to NetFlix in order to equalize customer perception of their services. Because Blockbuster would like to raise prices, but has little ability to do so, it needs to signal to NetFlix to raise prices and better both their predicaments. One ideal means of doing so is to leverage the fact discovered earlier that NetFlix likely made the wrong assumption about its customer stickiness and thus launched the current price war erroneously. A credible way for Blockbuster signal this mistake would be to commission an independent on customer loyalty in the Online DVD Rental market and then release it, showing NetFlix is got the market dynamics wrong. NetFlix would then hopefully raise prices and Blockbuster could follow suit, ending the war of attrition early. This is an excellent example of how signaling can be used not to distort market perceptions but actually to correct them. Throughout our discussion of game theory in the Online DVD Rental market, we’ve seen the profound and often highly disruptive effects of signaling.

Appendix Payoff Model

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Appendix – Payoff Model

The spreadsheet model used in this report to calculate payoffs allows several critical variables to be changed to model various aspects of competition in the Online DVD Rental market. The following is a detailed explanation of each of these variables, along with assumptions used in calculating the actual numbers presented in the report:

Monthly Prices for each service. These numbers are derived from actual prices in effect as of this writing. Price War Prices are derived from observed prices during the price slide after Blockbuster entered the market. NetFlix was then priced at $22/month. Blockbuster entered at $20/month. NetFlix followed suit, and Blockbuster in turn went down to $18/month. NetFlix again followed and Blockbuster went down to $15/month. NetFlix did not follow Blockbuster in this last gambit, and prices have since remained stable at $18/month and $15/month for NetFlix and Blockbuster, respectively.

Price War Gross Margins. Gross Margins under a price war. This number is derived from NetFlix’s Q1 ’05 financial statements. The spreadsheet uses this number to calculate margins under non-price-war conditions. This is done by calculating actual costs, adding the non-price-war price increment, and then dividing by the non-price-war price. For example, if the price-war price is $15, gross margins are 50%, and the non price war price is $20, this would yield (15*50% + (20 – 15)) / 20 = 62.5%.

“Other” SG&A. This number encapsulates all non-marketing expenses. Since we are in a growth industry, marketing expenses required for customer acquisition will be a significant portion of sales. In addition, competitors will expend larger portions of their revenue for marketing when they engage in a price way. This number models all non-marketing expenses as a percentage of sales. This number is derived from NetFlix’s Q1 ’05 financial statements.

Percentage of Revenue Spent on Marketing. This number is an estimate of how much will be spent on marketing (i.e. customer acquisition) in any given year. These numbers are derived from actual numbers and projections based on statements made in earnings releases. This number is the largest single expense affecting profitability during price war years.

Effect of Price Differences on Customer Retention. This is a measure of customer stickiness. This is a measure of customer attrition when one firm prices high and the other prices low. These numbers are measured relative to the maximum number of customers that are available (when both firms engage in a price war). Hence, when one firm prices high and the other low, the high firm will typically lose customers while the low-priced firm will gain most of these customers. The percentages need not be equal, however, since each firm has a different-sized customer base.

War/No War. This is a toggle that allows us to model whether each firm chooses to engage in a price war in any particular year. If a firm chooses to engage in a price war, the spreadsheet will adjust the actual subscribers (and hence the revenues) for the firm by the attrition rates mentioned above.

Total Subscribers in the Market. This number is an estimate of the total market size. These numbers are derived from the existing market size and market shares, project subscriber acquisitions goals for 2005 and 2006, and analyst projects of total market size. Based on these estimates, we expect a market of approximately 20 million subscribers by 2013.

Market Share Under Price War. This number allows us to estimate the market share that each firm will garner under a price war. The spreadsheet will adjust the actual share number based on price differences. If both firms engage in a price war, they will each garner the market share given by this number. If one firm engages in a price war and the other does not, their subscriber count will be modified by the attrition numbers as mentioned above.

Discount Rate. Discount Rate to use for NPV calculations. Since the stock market returns on average 12%, we used 15% to represent the additional riskiness of these firms in a growing and unproven market.

Appendix – Growth of Market with Amazon

Figure 1 – Estimated effect of Amazon’s entry on size of Online DVD Rental market

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[1] Blockbuster Q4 FY2004 Earnings Release

[2]

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“We have invested a significant amount of money in this business and we’re not going to allow a competitor to come in and offer better price value and service…” – Blockbuster CEO, John Antioco

“It’s going to be a much more competitive market than we ever expected…” – Netflix CEO, Reed Hastings

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