Video Rental Developments and the Supply Chain: Netflix, Inc

Video Rental Developments and the Supply Chain: Netflix, Inc*.

In an age where everything from dinner to dry cleaning to prescription medication can be delivered to your home, it should come as no surprise that the entertainment field is following suit. While in-home on-demand movie entertainment is certainly not new-- VCRs have been around since 1976 and by 2000 nearly 90% of homes with televisions also owned VCRs5 --the advent of DVD technology along with sophisticated internet commerce has allowed for changes in the way rentals, and rental businesses, work.

Traditional Rental Stores

Traditional video rental, perhaps best illustrated by the ubiquitous video store Blockbuster, Inc. (BBI), involves brick and mortar stores located in strategic locations, each staffed by about a dozen employees, carrying about 1000 titles in both VHS and DVD format4. Members arrive at the location, make selections from the available stock, pay for their selection, about $4 for a new release, $2 for older movies and children's movies, and return home to watch their selection. After the designated rental period the member returns his selection or incurs late fees. These late fees account for 18-20% of revenues in traditional video rental stores5.

Traditional video stores base their inventory decisions on formulas using historical rental data, store size, and box office sales among other factors. As titles become less popular, inventory can be reduced by selling previously viewed copies to members for a low cost. Titles that are out of stock are often compensated with coupons good for a free rental when it is available again. Revenue sharing models, pioneered by Blockbuster and now common throughout the industry, lowered the cost of VHS inventory allowing for higher rental volume at a lower risk to the storeowner, but also set minimum and maximum levels for inventory and demand a percentage of rental revenue for the first six months of release. DVDs are traditionally sold to rental agencies at the same price consumers see, a low "sell-through" price, allowing for lower inventory costs without the revenue sharing contracts. Blockbuster owns all of its DVDs outright. However, even with higher inventories, rentals are limited by physical inventory and excess inventory can still be sold at a loss.

* This case was prepared by Julie Niederhoff under the supervision of Professors Lingxiu Dong and Panos Kouvelis. It is intended as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

BlockBuster Worldwide Stores

Blockbuster Revenue

10000

6000

5000

4000

5000 3000

2000

0 BlockBuster

1997 6049

1998 6381

1999 7153

2000 7677

1000 0

1997

1998

1999

2000

Worldwide Stores

Total Revenue in Millions Average Revenue Per Store in Thousands

(1)

(2)

Figure 1. Blockbuster's worldwide stores growth. (BBI 2000 Annual Report) Figure 2. Blockbuster Total Revenue and Average Revenue per store. (BBI 2000 Annual Report)

Netflix

Now add something new, the Internet, and something old, the postal system, and a new model for movie rentals takes form. Netflix (NFLX), launched in 1998, is the world's largest online subscription-based DVD rental service, currently accounting for 35% of all U.S. home video rentals9 but 90% of online DVD rentals. They offer over 15,000 titles to their one million customers12. For $19.95 per month a member can get up to three titles at a time sent to his house through first class postal service, up to eight for a higher subscription rate. There are no late fees and no due dates. Members fill out a rental queue in their online profile and Netflix sends them the first three selections immediately. When a member finishes with a movie he inserts it in the pre-paid envelope and drops it in any mailbox; Netflix mails the next movie on the list as soon as they process the return. Members can rate movies and update their queues as desired, getting recommendations from Netflix's CineMatch software. If a member chooses to cancel service, he has seven days to return his current selections or the retail value of the films will be charged to the credit card on file. Netflix reports about 7% churn monthly. Netflix offers only DVD format because shipping of DVDs is 37 cents as opposed to almost $4 for a VHS4. This somewhat limits the selection Netflix can offer--for example the original Star Wars trilogy is not yet available on DVD. However, even with this format limitation, the Netflix library of titles far outstrips the selection of any single video store.

Figure 3. Netflix subscription and Revenue growth. Source: Business 2.0 "How Netflix is Fixing Hollywood"

Cost Comparison

Revenue Sharing Contracts: Inventory Costs

For Netflix to effectively compete with Blockbuster in new releases, the fill rate on high demand "blockbuster" movies must be high. Customers will quickly become frustrated by a "long wait" status on a new release from Netflix when the local Blockbuster has a surplus of copies. While Blockbuster owns its DVDs outright, Netflix has established contracts with most studios wherein Netflix agrees to kickback a percentage of subscription fees for every movie rented in exchange for the opportunity to purchase DVDs at cost10. The lower purchase costs allow Netflix to purchase a deeper copy depth on a title and better meet demand for a title without the substantial capital investment of full ownership. According to Netflix's March 6, 2002 SEC filing, page 36:

After the revenue sharing period expires for a title, the agreements generally grant us the right to acquire for a minimal fee a percentage of the units for retention or sale by us. The balance of the units are destroyed or returned to the originating studio. The principal terms of each agreement are similar in nature but are generally unique to each studio. In addition to revenue sharing agreements, we also purchase titles from various studios and distributors, including Paramount and MGM, and other suppliers, including Ingram Entertainment, Inc. and Video Product Distributors, on a purchase order basis.

Under the agreements with most of the top studios, Netflix pays on average $1.40 to the studios each time a new release is sent to a subscriber's home, a significantly higher cost than the $1.00 Blockbuster shares with studios for a new release rental on VHS.11 See Table 1 for more information on revenue sharing agreements.

According to Fortune Small Business, these costs account for about 20% of subscription revenues, making the partnerships costly. The contracts generally expire one year after a film's "street date", meaning only new movies are factored into the

revenue sharing costs. Using the CineMatch software, Netflix can guide members to rent older movies or those released by independent studios, increasing their bottom line and improving customer service by guiding members toward movies that are more likely to be in-stock. This leads to the argument that perhaps Netflix should focus more on the niche market of older, foreign, and independent movies and leave the high demand new releases to Blockbuster.

Operational Costs: Distribution Centers versus Stores

Netflix's distribution system has cost advantages (Table 2). As opposed to the over 8000 retail locations for Blockbuster, Netflix has just 20 distribution centers across the nation, with plans to open one or two more each month in 20036 based on the movie market in that region. According to Reed Hastings, founder and CEO, the company is able to keep overhead low as the small distribution center facilities have low rent and require a low number of employees to operate.7 Each is staffed by approximately 12 employees and each processes about 15,000 DVDs per day9. As distribution centers move into areas, members in close proximity can expect to see turnaround drop from about one week to just two days, increasing the number of DVDs they can possibly view in a month. Netflix has experienced a popularity surge in cities with new local distribution centers. The drawback, however, is that faster turnover and higher viewing rates result in more postage fees for Netflix, creating a tradeoff between increased customer satisfaction and increased costs. Also, a typical revenue sharing agreement requires payouts for each rental of a new release during the first year, so a higher rental rate will result in more rentals of a film and therein more revenue sharing costs.

Traditional Revenue Sharing Economics for VHS Rentals*:

For the Retailer A. Number of Tapes Purchased B. Price Per Tape C. Purchase Cost (AxB) D. Number of Rentals E. Total Rental Revenue (Dx$4) F. Retailer's Share of Revenue G. Retailer Profit: H. Profit per Dollar of Inventory For the Supplier I. Number of Tapes Purchased J. Price Per Tape K. Revenue From Selling Tapes L. Number of Rentals M. Total Rental Revenue (Dx$4) N. Supplier's Share of Revenue O. Supplier's Total Revenue: P. Supplier's Production Costs I x $10 Q. Supplier's Profit

Traditional Pricing 10 $60 $600 300 1200 $1200 (100%) $600 $1.00 Traditional Pricing 10 $60 $600 300 1200 $0 (0%) $600 $100 $500

Revenue Sharing 30 $9 $270 500 2000 $1000 (50%) $730 $2.70 Revenue Sharing 30 $9 $270 500 2000 $1000 (50%) $1270 $300 $930

Revenue Sharing for DVDs

For the Retailer

Traditional Pricing (BBI) Revenue Sharing (NFLX)

A. Number of DVDs Purchased

10

30

B. Price Per DVD

$15

$1

C. Purchase Cost (AxB)

$150

$30

D. Number of Rentals**

300

500

E. Total Rental Revenue (Dx$4) ** $1200

$2000

F. Retailer's Share of Revenue*** $1200 (100%)

$1000 (50%)

G. Retailer Profit:

$1050

$970

H. Profit per Dollar of Inventory

$7.00

$32.33

For the Supplier

Traditional Pricing (BBI) Revenue Sharing (NFLX

I. Number of DVDs Purchased

10

30

J. Price Per DVD

$15

$1

K. Revenue From Selling DVDs

$150

$30

L. Number of Rentals

300

500

M. Total Rental Revenue (Dx$4)

1200

2000

N. Supplier's Share of Revenue

$0 (0%)

$1000 (50%)

O. Supplier's Total Revenue:

$150

$1030

P. Supplier's Production Costs I x $1 $10

$30

Q. Supplier's Profit

$140

$1000

*VHS Revenue Sharing table first appeared in Cachon and Lariviere, 2001

**Annual Rental Volume estimate is based on 3 tapes per month plan, average use of 5 DVDs per month with

a 25 day month and 3 day shipping. Demand for this release is assumed to be high to moderate.

Table 1: The Financial Effects of Revenue Sharing Agreements

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