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Dissecting Netflix's Reel Strategy

|About:Netflix, Inc. (NFLX) Includes:Apple Inc. (AAPL), AMZN, CMCSA, TWX

I find Netflix (NASDAQ:NFLX) one of the most interesting companies of the 21st century. From its early beginnings, Netflix was a disruptive innovation with its DVD by-mail service and no late fees. This Los Gatos based company was truly a force to be reckoned with. Not only did Netflix quickly unseat the market leaders in the DVD rental industry, the company was integral in shifting the way we rent movies, which quickly lead to the eventual bankruptcies of both, Blockbuster and Movie Gallery. This all within eight years of its IPO. However, Netflix wasn't quite finished with disruptive innovations.

Netflix was aware that there needed to be a continued focus on innovation and the changing markets so as to not fall in the footsteps of past competitors, where they fell victim to a lack of focus and adaptability to the quickly changing technologies of today. This is one of the reasons Netflix attracts, what they identify as high performance individuals, by paying them top of the market rates, and only seeking the best employees. A quote from a company presentation sums it up well; "Adequate performance gets a generous severance package". Netflix seeks out the best performers, and expects the best performance. They also do this by limiting company rules and restrictions, providing their employees with more freedoms, to help promote innovation and creativity, and relying on the responsibility common with high performers. Netflix looks to straddle the line between creation and chaos, and so far it has seemed to have worked, particularly that the company completed switched its focus to an entirely new business plan within 10 years.

Netflix quickly identified that video streaming was the future medium for video rentals, and quickly became one of the first movers of providing this service. I think it is interesting to note that Netflix was able to quickly gain a large consumer base, literally jumping Geoffrey Moore' user base chasm which has become a difficult task for many companies introducing new products or technologies. For example, Microsoft (NASDAQ:MSFT) has lost products such as their ultra-mobile Tablet PC that they introduced back in 2005, as it showed very little consumer interest. Even today they are having difficulty with the introduction of their Surface Tablet, selling a paltry 1 million since its introduction, nearly 1/20th of what Apple (NASDAQ:AAPL) sold in the last quarter. Apple was successful with their iPad launch due to a significant (almost fanatic) Apple fan user base, which was willing to line up in droves to purchase tablets before the products were even available.

Netflix used a similar approach in quickly compiling a strong user base of video streaming customers, by providing it as a free service to their current DVD by mail customers. This was a brilliant move to quickly introduce their service, and quickly develop a fast customer base. It is interesting as well that many Netflix critics view Reed Hasting's separation of these two services as a significant misstep, however, it was an essential part of moving their streaming service to the next stage. And with a shrinking DVD by mail customer base, Netflix needed to focus solely on a video streaming business plan. The partitioning of products produced some short term stomach pains, but in the end, did not deter customers from continually flocking to the service, thus allowing the company to focus on video streaming as a core product.

Many believe that Netflix low cost, unlimited video streaming model is not sustainable, however, I believe that this strategy is a means to an end, in that Netflix is utilizing this affordable service to introduce themselves into every home in America, and even abroad. At a cost of $8 a month, it is difficult to argue that it is not a great deal for all households, and in particular, parents who are able to take full advantage of the animated library for their little ones. With the introduction of original content, the company has been able to leverage their streaming service and audience base to build on their business model. By investing in their own branded shows, Netflix lowers licensing costs by providing their own content while diversifying its business model to eventually include revenue from that programming. Now here is the kicker, Netflix understands that the operating margins on their video streaming revenue is fairly tight at 18.1%, particularly compared to ~50% for their DVD by mail service. However, Netflix also understands that to compete with cable companies, not to mention the cable giants, Comcast (NASDAQ:CMCSA) and Time Warner (NYSE:TWX), it needs to gain viewership first and foremost.

By offering an affordable alternative to pricey cable packages, Netflix is moving itself into every living room in North America. And, it may be too little too late for cable companies to counteract, as they are already beginning to see the trend with the evolution of the Zero TV Segment jumping up to 5 million residences this last year. It no longer seems incredible that the 2016 Super Bowl on CBS could just be streamed live on Netflix. I am not insinuating that is in the works, I am merely stating that it is not as far-fetched as it may have once seemed. Once Netflix has cemented itself with enough viewers, it then has the bargaining power to go after the content that it wants. Providing unlimited movies may just be the company's lower end package, with the possibility of higher end packages providing up to date program content, live sports broadcasts and potentially even an a la carte menu of sports from all around the world thru video streaming. By expanding their customer base, Netflix by default, becomes the cable providers greatest threat. As a consumer, I would much rather spend $50 on internet and video streaming TV then $150 plus on cable and internet services.

Now, one cannot write an article on Netflix and not mention their current competitors, Hulu and Amazon. Though Amazon (NASDAQ:AMZN) does offer an unlimited movie service, Prime, however the library content is considerable less than that of Netflix, and their focus seems to be more on the pay per movie model, which targets more the casual viewer. Amazon has recently pushed for original content programming, however, they are still lagging Netflix quite a bit. In terms of viewership, though Amazon has not disclosed their actual streaming customer base, it is considering in the millions, considerably less than that of Netflix nearing the 30 million customer mark.

Hulu on the other hand, does provide some of the benefits of a cable package by providing up to date content, and has as of recently attempted to become much more aggressive at gaining viewership by announcing several new original programming content for 2013. Yet, Hulu seems to be playing more of a reactionary role with Netflix paving the way for video streaming, at revenues nearly five times that of Hulu, and viewership at 10% that of Netflix. Being a disruptive innovative presence is nothing new to Netflix, and with video streaming quickly moving into every household in America, cable companies are beginning to realize that there may have been much more to the $8 a month all you can watch TV model than just a Saturday night movie alternative.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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