Sunday, April 23, 2006

 

Netflix's Future

Netflix is riding a wave of success, having beaten back Blockbuster's challenge, which many so-called experts claimed would bury the company. Now it faces new challenges.

First, a look at the current state of the DVD industry:


Looking ahead, the landscape will certainly change by 2010. But how? First, a look at potential changes in important layers of capabilities:

The Layers

Physical Sales

This space is clearly at risk with digital downloading on the horizon, but will certainly continue to be a strong element in the stack for collectors, as gifts, the computer-averse, and as impulse buys.

Physical Rental

Netflix’s current home has the most to lose from the advent of digital downloading. The convenience of rental and instantaneous delivery is difficult to match in either the video store or the mail-rental models.

Digital Sales

A new layer only now starting to emerge, this can only succeed as the preferred mode of delivery if it is a cheaper option than physical sales with current technology. Until it is possible to purchase and have the movie instantly available on some transferable technology (like a DVD or memory stick), this will lag behind physical sales as the preferred mode of purchase without a cost advantage. Competing in this layer is only possible with a method of easily delivering the massive movie file to the user. The progress of WiMax and IP TV will likely be critical to this layer’s success, so as to lessen dependence on the cable companies.

Digital Rental

This layer, which has been around for a long time in the form of pay-per-view, is starting to take-off, due to improving on-demand selection and the advent of digital rental through the computer. Unlike the sales space, rentals do not need to be transferable or permanent and are thus more suited to the digital delivery method. But access, as with digital sales, is a prerequisite and thus digital rental will also rely on WiMax and IP TV to make an end-run around the cable companies.

Information

Amazon and Netflix dominate this space due to their recommendation engines, which generate additional sales for both companies and provide stickiness to lock-in consumers, as the engines get better the more a consumer purchases. This set-up also positions both companies to take advantage of the “long-tail” phenomena, the ability for these companies to have massive catalogues of available movies and profit from micro areas of customer interest. In fact, 2/3 of Netflix’s rentals come from its back-catalogue.

With these thoughts in mind, now a look at the individual companies who will play an important role in Netflix's future:

Netflix

Netflix created the online rental market and continues to dominate it today. It also is interested in entering the digital rental market and has an undisclosed partnership with Tivo. The key to Netflix’s advantage is its recommendation engine and customer review system.

Blockbuster

Netflix’s most direct competitor now, Blockbuster has not been successful in challenging Netflix in the online rental area. With that market projected to grow from 5.5 million subscribers to 20 million in the next 5 to 7 years, based on Adams Media Research data, Netflix is well-positioned to overtake Blockbuster. Blockbuster thus far has shown no interested in digital downloads.

Wal-Mart

After selling its online rental service to Netflix, Wal-Mart has not made any further forays into DVD rental. This does not mean that the company will not jump back in with digital downloads, but given that this is out of their core competencies, Wal-Mart would certainly need a partner to make it happen. In the meantime, Wal-Mart continues to dominate physical DVD sales with an estimated 30% of the market.

Amazon

The looming shadow of Amazon has scared off many Netflix investors in the past few years, but the online giant has yet to directly enter Netflix’ space. That is about to change, with Amazon starting to offer digital rentals, with the option for the downloader to put the cost of the rental toward purchasing the physical DVD. Movie studio agreement will be critical for this project to succeed, without the digital rights for the major studios, no digital download project can succeed. The other major hurdle to cross is getting the digital file from the computer to the TV screen. This seems likely to be entering the mainstream in the next 5 years. But Amazon still has its recommendation engine, which along with its control over imdb.com, the premier site on the web for movie information, should help it dominate the information layer and potentially the long-tail market. Along with its consumer reviews, these recommendations help create stickiness for Amazon that will increase switching costs the more the service gets used.

Best Buy/Circuit City

These two are lumped together due to their similar business models, which are currently under attack from Wal-Mart (cheaper) and Amazon (better inventory). These retailers have made-up for their declining DVD sales with video games, a trend that will likely continue in the future.

Comcast

The king of cable in the U.S., Comcast would be positioned to make the most money out of on-demand service. The current drawbacks are price, since it is a pay-per-view model a subscription service like Netflix can be more cost-effective, and selection. On-demand currently features mostly new releases and certainly not many of the more obscure titles Netflix has. Compounding the issue is the gap in time between a movie coming out on DVD and being available on-demand, currently around 30 days. One of the core advantages that Comcast and the other cable companies have now is their control of digital access to the TV. This will certainly disappear in the future with the proliferation of wireless networks, WiMax, and IP TV. But for the moment, it presents a problem for Netflix, who needs a way to get digital files to either its partner Tivo, or just to the TV.

MovieLink and CinemaNow

The movie studios attempt to avoid the fate of the record industry, these two companies are starting to offer digital purchase of DVDs and already offer digital rental, but only in pre-determined rental “windows” that coincides with the pay-per-view window. All of the major studios are on-board, but the pricing is out-of-whack. Some have even speculated that the studios want this to fail. If this vertical attempt works, companies like Netflix, Apple, Amazon, and Comcast who want to succeed in the digital download game could be shut-out by a movie industry that controls the digital rights and does not want to share in the profits. But without a significant decrease in price, this attempt is unlikely to succeed. The rental effort will not make any significant dent without a change in philosophy away from rental “windows”.

Apple

With the release of the video iPod, many observers assumed it was only a matter of time before movies became available in the iTunes store. But that has not happened, and with MovieLink and CinemaNow’s recent announcement, it seems unlikely in the near future. Only with the failure of these services will Apple get a chance and by then other players such as Amazon or Netflix may have gotten a strong foothold in the market.

Google

As the current king of search online, Google certainly has a potential part to play in the future of this industry. But exactly that will be is unclear. With its enormous war-chest and expertise, Google could decide to try to enter the digital download market, as it already offers TV shows online.

Toshiba

The champion of HD-DVD, one of the two new formats in the looming DVD format war, Toshiba obviously is banking on their format being victorious. For Netflix, who has already but thought into the upcoming battle, escalating inventory prices and the potential to need to stock both HD-DVD and Blu-Ray, along with the current format, could be a problem.

Sony

Blu-Ray’s creator and a major movie studio, Sony will likely try to learn from its mistakes in the music industry and may be a clear player in the success or failure of MovieLink and CinemaNow.

McDonalds

The fast-food giant has been quietly entering the digital rental market in the past few years, testing out a kiosk model at some of its locations. With this effort now expanding, McDonalds may become a player in the diminishing physical rental space in the future.

With these thoughts in mind, here are some potential scenarios of how the future will play out:

Best Case Scenario

The best case scenario for Netflix is that WiMax explodes as more and more cities follow the example of San Francisco and Philadelphia. This will enable Netflix, either with or without Tivo, to get its content to consumers without worrying about the cable companies. In addition, Blockbuster continues to trip over its own feet, Amazon and Apple cannot secure digital rights from major movie studios soon enough, which allows Netflix to get entrenched in the market. CinemaNow and MovieLink both succeed in their digital sales model, which helps keep Amazon, Apple, and others out of the market, but does not succeed in the digital rental market, since consumers prefer Netflix. The transition from computer to TV is made seamless, this is where the partnership with Tivo can benefit Netflix, and most importantly, Netflix gets no opposition from the major movie studios in its move toward offering downloads.

Worst Case Scenario

WiMax does not take off and cable companies start to charge tolls on their high-speed connections for large files. Blockbuster gets its act together and mounts a serious challenge to Netflix in the mail-delivery rental model in partnership with Amazon. CinemaNow and MovieLink flop and the movie studios cede the space to Amazon and Apple, which allows Amazon to tie a digital rental model to its Blockbuster partnership. Tivo either is bought out or goes bankrupt under competitive pressure and Netflix loses its partnership. In addition, Netflix cannot sort out digital rights issues with the movie studios who are concerned about piracy and is unable to enter the digital download spae at all. There is no clear winner in the DVD format war and Netflix is forced to maintain large quantities of each format to stay competitive with the digital companies who do not have to worry about it. This culminates in Netflix being bought out or driven into bankruptcy.

Likely Scenario

Widespread wireless high-speed Internet will come, but it likely will not happen in the next five years. Blockbuster and Amazon will not enter a partnership, as it seems Amazon wants to focus on digital rentals. CinemaNow and MovieLink will not work due to greed, after a few years of mounting piracy and losses, the movie studios will cede the space to anyone who is willing to pay for the digital rights, letting Apple and Amazon in. The rental space will be a different story, as the movie studios will let companies whose anti-piracy measures are strong enough to offer movies for download. The reason for the different attitude is price. In the rental market the prices from CinemaNow and MovieLink are competitive and the studios do not worry about price decreases affecting their physical rental market. This concern is very real in the sales market, which is why the studios will persist in their attempt to overcharge for digital sales. Netflix will therefore start to offer a digital download option, either to the computer or the consumer’s Tivo box.

The industry will most likely look something like this in 2010:

Netflix therefore needs to do the following:

· Make securing digital rights Netflix’s first priority. In the anticipation of the digital market becoming a major player, Netflix cannot afford to sit back and wait for someone else to do the heavy lifting with the studios.

· In conjunction, make sure that however Netflix delivers its digital content, that content is as piracy proof as possible. This will be a major stumbling block with the studios if Netflix cannot figure it out.

· Carefully monitor the DVD format war and offer popular movies in all formats. Since Netflix is the superior rental product, it cannot afford to alienate customers.

· Continue to improve its recommendation engine and look to add new technology that increases customer experience. Social network effects remain the key to Netflix’s future.


Comments:
Good analysis. See if you can punch up the recommendations. Can you make the compelling cases for the specific recomemndations you are making? Any numbers or analysis to make the recommendations more powerful? What happens if they do not do anything!? Otherwise, a good reasoned analysis.
 
how about a partnership od alliance with microsoft. the media center may enable netflix to jump the pc / tv gap.
 
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