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.

N

nw51thriaprswNatfv

BlockBuster Worldwide Stores

0

5000

10000

BlockBusterWorldwideStores

6049 6381 7153 7677

1997 1998 1999 2000

Blockbuster Revenue

0

1000

2000

3000

4000

5000

6000

1997 1998 1999 2000

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)

etflix Now add something new, the Internet, and something old, the postal system, and a

ew model for movie rentals takes form. Netflix (NFLX), launched in 1998, is the orld’s largest online subscription-based DVD rental service, currently accounting for 3-% of all U.S. home video rentals9 but 90% of online DVD rentals. They offer over 5,000 titles to their one million customers12. For $19.95 per month a member can get up o three titles at a time sent to his house through first class postal service, up to eight for a igher subscription rate. There are no late fees and no due dates. Members fill out a ental queue in their online profile and Netflix sends them the first three selections mmediately. When a member finishes with a movie he inserts it in the pre-paid envelope nd drops it in any mailbox; Netflix mails the next movie on the list as soon as they rocess the return. Members can rate movies and update their queues as desired, getting ecommendations from Netflix’s CineMatch software. If a member chooses to cancel ervice, he has seven days to return his current selections or the retail value of the films ill be charged to the credit card on file. Netflix reports about 7% churn monthly. etflix offers only DVD format because shipping of DVDs is 37 cents as opposed to

lmost $4 for a VHS4. This somewhat limits the selection Netflix can offer—for example he original Star Wars trilogy is not yet available on DVD. However, even with this ormat limitation, the Netflix library of titles far outstrips the selection of any single ideo 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 Traditional Pricing Revenue Sharing A. Number of Tapes Purchased 10 30 B. Price Per Tape $60 $9 C. Purchase Cost (AxB) $600 $270 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: $600 $730 H. Profit per Dollar of Inventory $1.00 $2.70 For the Supplier Traditional Pricing Revenue Sharing I. Number of Tapes Purchased 10 30 J. Price Per Tape $60 $9 K. Revenue From Selling Tapes $600 $270 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: $600 $1270 P. Supplier’s Production Costs I x $10 $100 $300 Q. Supplier’s Profit $500 $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

Figure 4. The logistics of Netflix. (Business 2.0 “How Netflix is Fixing Hollywood”)

With their current system, each facility fills approximately 98 percent of customer

orders. Orders that cannot be met by the nearest facility are passed on through time zones until they can be filled. An estimated 84 percent of its rental library is available within a few days, making turn-around on titles very quick.11 Logistics are clearly an important factor in a model such as this. Originally, all returns were checked-in and shelved before the new demands were met, making the first half of the day returns, the afternoon fulfillment. However, by changing the procedure to simultaneously check in a movie and then match it to a new demand the process has streamlined substantially. This system modification reduces shelf time on inventory has slowed hiring and reduced labor costs by about 15 percent.9 On average about 300 DVDs are unshipped from each facility at the end of the day, about 2 percent of the volume that flows through the center on an average day, and are stored in a small box at the facility. Each week, any consistently unused inventory is returned to the main distribution center in San Jose for longer-term storage.4

Operational Comparisons

No. of locations

No. of employees

No. of titles available

No. of DVDs available

Blockbuster, Inc.

8000+; 1 distribution center

89,000 About 1000 per location, up to 8,000

Hundreds Per Location

Netflix 16 distribution centers

381 13,500 3.3 Million

Walmart.com 6 distribution center

Not available 12,000 Not available

Table 2: Operational comparisons for the top three competitive DVD subscription services.

Competition

As with any successful business idea, Netflix has its imitators. While there are many small online companies with a similar product, the two largest direct competitors are well known: Wal-Mart and Blockbuster (Table 3).

In October of 2002 Wal-Mart announced a test program through walmart.com in

which customers could rent up to 3 movies for $18.86 per month. Films are delivered via the postal service and new selections are sent out as prior selections are returned. Wal-Mart currently offers a selection of over 12,000 titles, shipped from its six distribution centers.

Blockbuster is following suit with its filmcaddy.com site, allowing up to four

DVDs at a time for a $19.95 monthly subscription. Titles are limited and all films ship from its Arizona distribution center. However, expansion to more distribution centers is under consideration. In addition, in July of 2002 Blockbuster started a test market for its DVD Subscription Pass program that would allow for members to rent up to two DVDs for $19.99/month or 3 for $24.99/month. Members prepay for the service and choose from DVDs available at their local Blockbuster store. While this service does not provide any benefits in selection or convenience, it does allow for unlimited viewing of a DVD. With the enhanced content of DVDs many movie viewers appreciate extra time to view the bonus features such as deleted scenes, cast interviews, and behind the scenes footage without the late fees. In addition, while Netflix, Wal-Mart, and FilmCaddy require at least a day to ship the DVD, Subscription Pass caters to the instant gratification market in that members can choose their movie the day that they wish to see it and exchange it for a new selection in one transaction. Blockbuster reports that 90% of its customers decide on their movie less than 4 hours before making a rental2.

DVD Subscription Services

Monthly Cost

Discs at a time

Number of Titles Available

Delivery Delivery

Time

Blockbuster DVD Subscription Pass aka DVD Freedom Pass

19.99

24.99

2

3

In Store selection

Customer picks up/drops off

Instant

Blockbuster’s

www.filmcaddy.com

$19.95 4 8000 Postal 2-4 days

Netflix 19.95 for basic

3 13,500 Postal 1-4 days

Wal-Mart DVD Rentals 18.86 3 12,000 + Postal 2-4 days Rent My DVD

www.rentmydvd.com

$23.95 4 12,000 + Postal 1-4 days

Number Slate

www.numberslate.com

$19.95 3 13,000+ Postal 2-4 days

Table 3. Comparable subscription packages offered by the main competitors.

However, Netflix may be able to defray this direct competition. In June of 2003, Netflix was granted a patent on their business model for DVD rental. Wal-Mart, Blockbuster, and any other potential competitors will have to design a model substantially different from the Netflix model unless Netflix decides to license out the patent rights. Among over 100 elements of the business model, the patent gives Netflix intellectual property protection over the way that a customer sets up his or her rental list and the way the company sends the DVD's.

However, imitators are not the only competition. Pay-per-view, premium cable,

and Video on Demand seek to serve the in-home on-demand movie market. These services also serve to the “stay-in” crowd by allowing entertainment selection without having to leave the house. Pay-per-view and premium cable are available to anyone with cable, satellite, or digital service; as of 2000 about 75% of households that owned televisions subscribed to a cable service8. However, cable and pay-per-view are constrained in their selection to viewers, and the selections are not interactive: they cannot be paused or replayed and do not offer the bonus features of a DVD. On-line video rental services, such as Movielink, offer a limited number of films for download to home computer. Critics of such services say that they are too slow to download and argue that most people will not want to watch a movie on their computer. Forward-thinking proponents argue that as the line between home entertainment and computers continues to blur, and as more homes get broadband, the online video rental services will gain popularity. Video-on-Demand has attracted a lot of attention, offering a wide selection of films that can be downloaded to a television set via a set-top box. However, the technology required for this service is costly and not widely available, limiting the market. As broadband becomes more prevalent and the cost of set-top boxes decreases, video on demand is expected to gain ground in the on-demand entertainment market. Netflix’s Reed Hastings acknowledges the appeal of going digital, but notes that while every household has postal service, very few have broadband. Also, delivery costs on downloadable DVD-quality movies can be more than $30, as compared to the 72-cent roundtrip cost of the current model. But as the costs of digital delivery drop, Hastings says, “in five to ten years, we’ll have some downloadables as well as DVDs. By having both, we’ll offer a full service.”10

Customer Relationships

Anyone that has used traditional video rental agencies knows that the system has problems. With a strategy known as “managed dissatisfaction”, video stores choose to stock fewer copies of films than projected demand in the first few weeks following release. Stocking to meet projected demand would result in huge volumes of excess inventory after the initial rush. Customers unsuccessfully seeking a specific title generally leave with a second or third choice, with the stores gambling that the customer will be disappointed but still willing to come back the next weekend. If a customer does not have a second choice in mind when he comes in, he is left walking the aisles, an often frustrating and very time consuming part of the evening.

Now consider Netflix. With the online personal profile, movie rental history as well as the member’s personal ratings of movies is fed into the CineMatch software, available free to all subscribing members. A list of recommended movies can be pulled up and added to the rental queue with a mouse click. When the time comes to send out a new selection, if a particular movie is out of stock, the next movie in the member’s rental queue is substituted. This guarantees that while it may not be the top movie on his list, he is not settling for just any movie in stock. Netflix claims that they ship more than 90 percent of all titles from the first three spots of members’ rental queues. However, the method by which the high demand movies are allocated is under question. A dissatisfied customer, frustrated because most of the movies on his queue were of “long wait” status, investigated the process using several accounts13. He tested the same set of 43 movies across two types of accounts (3-out and 5-out) and varied the rental rates in the accounts. Despite the fact that each account had the same movies in queue, those with lower rental volume and thus a higher per-disc revenue for Netflix, consistently had a lower queue availability score, meaning more movies were made available to them. In general, he found that customers with very high rental rates in recent history are given lower priority on high demand movies. (Figure 5) This means that new customers, trial basis customers, and those customers who tend to hold onto movies longer and thus rent fewer per month are given better customer service. Netflix does not reveal how allocations are made. See the appendix for excerpts of his analysis.

1. Figure 5. Account A paid $30 per month for a 5-out plan, Account B paid $20 per month for a 3-out plan. Lower scores indicate less

waiting time. For account A in the first shown billing period, the price-per-disc the previous month was about $2, resulting in an average availability score of 42 (most movies had at least a short wait). In the second billing cycle, the price per disc history had increased to $5 per disc and the score improved to 25, meaning about half of the movies had status “available now”. Notice that when account B’s average price-per-disc changed from $4 to less than $2 on 4/14 the availability score drastically jumped from an average of 13 to an average of 40. Source: http://dvd-rent-test.dreamhost.com

The CineMatch software also aids in inventory control. Traditional video stores rarely take the time and money to market smaller films, instead deriving about 80 percent of rental activity from 200 titles10. Using CineMatch, Netflix can recommend titles based on a member’s rental history and ratings, regardless of how the film did at the box office. As a result, 80 percent of rental activity is generated by 2,000 titles, and 97 percent of Netflix’s titles are rented in a month12. With the decrease in demand on popular new releases, Netflix can better meet customer demand and saves on payouts for revenue sharing agreements. The whole experience is catered to a member’s personal tastes and preferences, making an online transaction seem more personalized than an actual trip to a video store. One customer service drawback to the Netflix arrangement that similar models will also face is the involvement of a third party, namely the US Postal Service (USPS). Discs lost en route to the member or back to the distribution center reflect poorly on both the customer and the service, with both parties likely to blame the USPS for the loss. Customers with chronic problems have their accounts put on hold, which is frustrating to a customer that has done everything correctly. Members must file a complaint with the postal service in order to have their accounts reinstated, a time consuming process during which they are paying for services that are not active.

Conclusion

The advent of digital entertainment has changed the face of video rental, and as technology improves the industry will continue to utilize new developments to better serve customers seeking convenience, ease of use, and variety all at a low cost. In the meantime, current models seek a competitive advantage among similar services and attempt to streamline current operations to make the systems profitable.

Discussion Questions

1. At what rate should a Netflix customer rent in order to enjoy the value of the

subscription rather than renting from Blockbuster? How are you going to account for the “late rental return” behavior of the customer in your estimate? How should the rate be different for different types of movies, new releases, old movies, kid’s movies?

2. Based on your answer to the above question, how would you estimate the variable

costs incurred by a customer who enjoys the value of the subscription? Can you describe two or three customer segments that affect Netflix's margin differently?

3. In a recent article about the Netflix business model, the following statement was

made: “Boutique movie studios like IFC films, which released last year’s critical hit Y Tu Mama Tambien love Netflix because it provides a huge market for movies that can’t muster a widespread theatrical release, as well as for those that last only a few weeks on the big screen.” Why do you think it is so? Is after all Netflix just a niche market player? Should it become one? Justify your answer.

4. It looks like success could breed failure. According to a recent story: “But the

[Netflix’s] spectacular growth is creating unforeseen problems… Customers are renting an average of 5.5 movies per month, compared with 4.5 two years ago.” Why is this a problem for Netflix? In what ways could Netflix handle the operational and revenue sides of this observed trend?

5. Netflix uses multiple regional DCs while Wal-Mart until recently used one central

DC for its DVD rental program. Compare the pros and cons of these two distribution strategies. What inventory allocation strategy should Netflix employ to achieve better usage of inventory? What are the logistics challenges Netflix faces at each one of its distribution centers? How should the information on inventory be exploited to manage the material flow in Netflix's distribution system? What shipping priority to customer rules should Netflix use for limited availability movies?

6. How should Netflix and Blockbuster estimate the life-time value of customers?

Compare the strategies that Netflix and Blockbuster should use to attract customers. How do strategies affect decisions on metrics for customer service levels?

7. What are the pros and cons of the revenue-sharing contract used by Blockbuster

on VHS tapes versus its earlier practice? How comfortable do you feel with the assumptions in Table 1 in attempting to extrapolate revenue sharing benefits of VHS rentals to DVDs and subsequently compare Blockbuster’s and Netflix’s

benefits? Which assumptions would you challenge? From the Netflix perspective, how should the revenue-sharing agreement be structured? Does it make sense for Netflix to use revenue sharing arrangements for DVDs in the first place? Explain.

8. In a recent article the following information was repeated: Netflix acquired 500

copies of the Nice Guys Sleep Alone film. They paid only $1 per copy and offered a cut of each rental for the first year. The 10,000 rentals of the movie in the year allowed the producer to collect $12,000 in rental income. Using this information, what changes would you make to your revenue sharing calculations for DVDs in Table 1? Explain.

9. Netflix's system collects a lot of information from customers. When ordering

DVDs for a new release, how can Netflix take advantages of the information in making the ordering decision? Is that information valuable to the film studios? In what way? What would you suggest to Netflix on using information to manage its customer relationship, as well as studio relationship?

10. How do you anticipate the Netflix-Wal-Mart competition to evolve? What is your

advice to Netflix on what to do with its new patent on DVD subscription services? Should they enter licensing agreements with its major competitors? How likely do you consider for the implied event in the recent journal article entitled “Netflix, a Division of Wal-Mart?” to happen?

11. What aspects and observations of the insightful Michael Porter HBR article

“Strategy and the Internet” do you see applicable in the video rental setting as of today. Mostly Comment on Netflix, Blockbuster, and Wal-Mart supply chain models. Is the Netflix business model “disruptive”? What should be the future business model for video rental?

12. Blockbuster offers video game rentals. Based on the above analysis, should

Netflix expand its product offering to game rental? Are there any other product categories you might consider appropriate for a “Netflix-like” model? What are the product and currently used supply chain features that make them amenable to this business model?

Citations

1. Cachon, Gerard P. and Martin A. Lariviere “Turning the Supply Chain into a Revenue Chain” Harvard Business Review March 2001

2. Cohen, Alan “The Great Race” www.fortune.com 1 December, 2002 3. Hyman, Gretchen “Netflix Flicks Switch on DVD Rental Centers”

www.internetnews.com 20 June 2002 4. Mason, Sarah “Movies on Demand” IIE Solutions, October 2002, p.25-31 5. Narayanan, V. G. and Lisa Brem. “That’s a Wrap: The Dynamics of the Video

Rental Industry” Harvard Business School 6. “Netflix Opens New Shipping Center” www.etrade.com 26 February 2003 7. “Netflix Opens Tempe Distribution Center” The Business Journal of Phoenix 24

February 2003 8. “Networks, Party Chairs Differ Sharply on Obligation of TV Networks to Cover

Conventions” www.vanishingvoter.org 31 July 2000 9. Null, Christopher “How Netflix is Fixing Hollywood” www.business2.0.com July

2003 10. O’Brian, Jeffrey M. “The Netflix Effect” www.wired.com December 2002 11. Ostrom, Mary A “With Newer Releases, Netflix Users Can Anticipate a ‘Very

Long Wait’” The Mercury News 7 July, 2002 12. www.netflix.com (SEC: Netflix, Inc. Form S-1, March 6, 2002, page 36) 13. http://dvd-rent-test.dreamhost.com 14. Blockbuster Annual Report 2000

Exhibit 1: Comparison Of Financial Statements Fiscal Year 2002

Blockbuster Netflix Industry S&P 500

Sales Growth (Qtr vs Year ago Qtr) % 7.9 101.30 7.10 -2.80

Income (Qtr Vs Year ago Qtr) % NA NA NA 6.00

Gross Profit Margin % 76.0 66.2 70.8 47.5

Pre-Tax Margin % 5.3 -14.3 5.3 7.3

Net Profit Margin % 3.4 -14.3 4.9 3.7

5 Yr Gross Margin (5-Yr Average) % 74.7 NA 67.8 47.5

5 Yr Pre-Tax Margin (5-Yr Average) % -1.8 NA -1.4 9.0

5 Yr Net Profit Margin (5-Yr Average) % -2.2 NA -1.8 5.5

Return on Equity % 4.5 NA 8.6 7.7

Return on Assets % 3.0 -16.8 5.1 7.2

Return on Capital % 4.1 NA 7.5 3.6

Income/Employee $ 4,000 -57,000 6,000 11,000

Revenue/Employee $ 117,000 401,000 114,000 287,000

Receivable Turnover % 33.2 NA 43.2 5.7

Inventory Turnover % 4.1 NA 3.2 7.9

Asset Turnover % 0.8 1.8 1.0 0.3

Exhibit 2: Balance Sheet Comparisons: FY 2002 (in millions)

BBI FY2002

NFLX FY2002

Assets Cash and equivalent 152.5 59.8

Receivables 184.8 0.0 Inventories 452.1 0.0

Other current assets 169.5 47.3 Total Current Assets 958.9 107.1 Total Non-Current Assets 5284.9 23.4 Total Assets 6243.8 130.5

Liabilities

Accounts Payable 757.0 20.4 Short-Term Debt 132.8 1.2

Other Current Liabilities 587.8 18.8 Total Current Liabilities 1477.6 40.4 Total Liabilities 2076.8 41.2 Total Equity 4167.0 89.4 Total Liabilities and Equity 6243.8 130.6 Cash Flow

From Operating Activities 1451.2 40.1 From Financing Activities -199.2 70.9 From Investing Activities -1303.5 -67.3

Free Cash Flow 129.4 13.2

Excerpts from “An Analysis of Netflix's DVD Allocation System” For the original full version see: http://dvd-rent-test.dreamhost.com/

Introduction

Around January 2003 I started seeing "wait times" on numerous movies in my queue skyrocket. In particular some movies which were recent, mainstream, and well advertised releases were impossible to get. About a Boy was one such example. Thus I began a quest to determine what was going on. It just did not make sense that some of the popular movies in my queue were so hard to get. I searched USENET but came up empty.

Test Overview

I created a list of 45 movies in my queue that did not have an availability of "Now." Initially I only added these movies to account "B." I later added these same 45 movies to three other pre-existing friend and family accounts, which will be referred to as accounts "C", "D", and "E". Three of these movies eventually shipped to account "A" or "B" during the period I was collecting data, so in the end there were only 43 movies that were in common to all five accounts during the entire test period.

Keep in mind that most movies in my queue had a "Now" availability. The following table summarizes the state of my queue before testing. Future releases have been excluded.

Availability Number of Movies

Percentageof Total

Now 214 73% Short Wait 48 16% Long Wait 19 6% Very Long Wait 12 4% 293

This report does not attempt to determine what percentage or class of movies Netflix has availability problems for. It focuses solely on how movies are allocated when there are availability problems.

The five test accounts used three different Netflix service centers. A service center is the place where you are most likely to receive a DVD from and where you return your DVDs to. Two of the accounts were in the 5 movie out plan ("A" and "C") while the rest were in the 3 movie out plan ("B", "D", and "E").

An overview of the test accounts:

The Results

To aid in comparing the availability of movies in one queue to another, I created an "availability score" for each queue. I assigned a weighting to the different levels of availability

Availability Weighting Now 0 Short Wait 1 Long Wait 2 Very Long Wait 3

A queue was then assigned an overall "availability score" by adding up the weighting of each movie. So lower availability scores mean more movies are available, higher scores mean more movies are unavailable. To put it another way: low score good, high score bad!

The following table summarizes the availability stats for each test account:

The number of rentals in the previous billing period is charted against average availability score for the current billing period below. Accounts in the 3 movie plan are shown in orange while those in the 5 movie plan are shown in blue.

In version 1.0 of this report I indicated that I thought the rental plan you are in is not affecting the availability score. I.e. if customer A who is on a 5 disc plan and customer B who is on a 3 disc plan had the same rental habits over a period of time, they would have the same availability rating.

A slashdot poster suggested average rental price was in fact what is affecting availability, and this it would take into account the various rental plans. Or at least in the unlimited plans. The following chart shows per-disc rental cost charted against availability score. I have charted two data sets: the previous billing period average disc cost and the average disc cost over the last two billing periods.

The points stuck on the X axis are for "B" during the trial and 1st month. The clustering of both 3 and 5 disc plan samples in the same area does indicate that your rental plan is part of the equation! This is great news.

Given the very small data set, it is difficult to tell whether Netflix simply places renters into different priority "buckets" or fine tunes the algorithm on a per-customer basis. Note that as of the 1st quarter of 2003, on average each customer rents 5.5 discs per month. I do not know whether this is an average across all plans or only the $19.95 plan. Assuming a $19.95 plan, this translates to $3.63 per disc. This would put the average customer in the second cluster from the top above.