What can you do when competitive boundaries change dramatically? Let’s take a look at the challenges and choices facing Netflix as their market shifts from DVDs to digital distribution. In doing so, we’ll see how environmental boundary changes can quickly overpower the best business and organization models.
How Netflix Won
Netflix’s initial success can seem almost too obvious. By combining a large library of DVDs with a monthly subscription rather than per video rental, super speedy delivery to your door and no late fees, Netflix knocked Blockbuster into bankruptcy. Its stock is up 1800% since 2002. It’s hard to write a better success story than that.
But in business, the story never ends.
Netflix built its business by solving a physical distribution problem. Prior to Netflix, watching a recent movie required renting a DVD or waiting for it to show up on premium cable. Downloading a movie over the internet required above average technical skill and equipment. Because of this, there were few legitimate services one could rent or buy from.
After watching the music industry get caught flatfooted until Apple’s iTunes created an efficient and legal digital distribution system, movie and television studios have tried to stay ahead of the game. Often appearing like an awkward teenager going through hormonal changes, they’ve experimented with stricter piracy enforcement, streaming directly from their web sites to launching broader marketplaces such as Hulu.com. In contrast to the physical distribution problem Netflix solved, digital distribution is an opportunity.
Opportunities invite competition. In addition to the studios and traditional cable companies, the phone companies now distribute content over cable and the web. Retailers such as Amazon and Best Buy offer video on-demand services. Apple’s added movies and TV episodes to the iTunes store. And there’s Google’s YouTube which now has some pay-per-view.
Why Netflix Could Lose
Let’s look at Netflix through the leadership boundaries introduced in my last post. Leaders drive change by setting, crossing and changing boundaries.
1. Personal – How one bounds one’s thinking, time and relationships
2. Organizational – How one invests, groups resources and confines risk
3. Business – How one defines the playing field, partners and adversaries
4. Environmental – How one probes, reacts and responds to societal forces & technology changes
Leaders have the greatest control over their personal boundaries. Control dissipates as one moves down the list. Netflix is changing their business boundaries due to changes in the broader environment. Fast bandwidth and capable hardware enabled digital distribution and made it easy. Netflix’s physical distribution advantage doesn’t add differentiation or value in digital distribution.
Netflix has not stood still. 60% of revenue now comes from streaming video. However, increased competition is already pressuring Netflix’s cost of customer acquisition. Comparing year over year in Q2, they rose from $23.88 to 24.37. Competitors with larger customer bases will likely be able to negotiate lower prices for content further pressuring Netflix margins. Plus, the new competitors have many other cards they can play.
Perhaps Google will continue its tradition of subsidizing free service through advertising as they widen their boundaries via Google TV. Surely there are many who would live with a crawler-like ad to see first-run movies for free. Maybe Apple will change their business boundaries with a subscription model that includes their music and movie libraries. One could paint multiple scenarios that threaten Netflix’s current model.
Netflix Options: Redrawing the Boundaries
The critical question is what boundary changes can Netflix leaders make that win in the new environment? Before going there, let’s underscore how difficult this challenge is. We hear a lot about disruptive innovation yet changing one’s business boundaries to compete in a new environment is quite rare. Success depends as much on others’ missteps and luck.
First, they can, and are, expanding their geographical reach. They recently introduced a streaming service in Canada for $7.99 vs. $8.99 in the U.S. for DVD and streaming – a noticeable discount for entry. Canada offers 33mm potential subscribers though at $7.99, not the same margins.
Their service model could work outside the U.S. but they’d have to adapt to foreign tastes, capabilities and legal requirements. If done organically, it would require establishing a significant non-U.S. presence that would change organizational and personal boundaries. Geographical expansion always takes more time than expected. Well established brands such as Disney and McDonalds needed several years to create success outside the U.S.
Alternatively Netflix could buy a similar, existing operation but at least in Europe, that has its own problems. Amazon already owns 42% of Lovefilm, the most established European competitor, and is rumored to be buying the remainder.
Second, they could deliver additional content. The challenge there is finding content people are willing to pay for and lacks good distribution. For example, on-line gaming continues to grow but even a leader such as Linden Labs, creator of Second Life only has $100 million in revenue in 2009 vs. Netflix’s nearly $2B. While paid content is growing, it’s still relatively small and well distributed. A corollary and clearly a stretch beyond their current competencies, is to enter the content creation business as Comcast has done through acquisitions such as buying NBC.
Third, they can continue to compete through customer experience and distribution excellence as they embed themselves in every new electronic device including wireless. Essentially, Netflix would target being the Amazon of digital content distribution. Leveraging terrific customer experience and customer base, Netflix has inked revenue sharing deals with Samsung, LG and Vizio that embed their service within flat screens and Blue-Ray DVD players.
A fourth choice would be to merge or a similar strategy that acknowledges the changing environment. Companies rarely re-invent themselves and maintain their original growth rates. Obviously, those that beat the odds garner enormous attention but that doesn’t change the fact that most don’t. If the competitive picture I’ve painted holds, Netflix’s most promising opportunities are before their momentum has withered. Noting their holdings in Lovefilm, Amazon is a potential suitor.
Netflix is in a very tough situation. No matter how you cut it, they are facing more and larger competition. None of the alternatives identified are surprising or innovative per se.
Can Netflix continue to grow? In the near term, the answer is yes but at increasingly lower rates as competitors gain share. Can Netflix redefine themselves, outmaneuver the new competitors and continue to grow as fast as they have? Possible; but not probable.
What this illustrates is that environmental boundary changes have enormous power. Seeing them coming is one challenge. Timing their arrival is another. But finding a path and making the necessary changes is the toughest. I’m sure Reed Hastings and his team has thought about this long and hard. It will be interesting to see if they are one of the rare ones who can change their business boundaries to address the changing environmental conditions; and win.