Combined with the queue system, the recommendation engine goes a long way toward eliminating one of the most frustrating hassles of traditional movie rental—the fruitless Friday night ramble through the video store aisles. Once you’ve created your Netflix queue—aided by Cinematch’s personalized recommendations—you have a standing list of ten, twenty, or more preselected movies you’re likely to enjoy, the next one ready to land in your mailbox the moment you request it.
Over time, Hastings and his team honed and refined their product, continually learning from mistakes and searching for opportunities to improve the customer’s hassle map even more.
For example, Netflix once employed staffers to watch a dozen video monitors as DVDs returned by members were played back at high speed, in search of scratches and other imperfections that might spoil viewing. Eventually they discovered an electronic scanning device that performed the same task automatically with much greater accuracy, making the monitor system obsolete.
As circumstances change, the product may need to be modified to meet ever-rising expectations. Reed Hastings and his team have developed a deep, instinctive understanding of this reality. Combined with their analytic mind-set, it drives them to study the ever-changing customer with manic intensity. On any given day, Netflix conducts, on average, around two hundred separate surveys—online, by phone, through the mail, and via in-home research by live interviewers. (Taking on the role of “media anthropologists,” Netflix employees actually sit with customers as they watch movies and TV shows, observing their behaviors—how and when they hit the pause button, where they put the remote control, when and why they stop watching altogether.) And then there are the customer focus groups constantly being held at Netflix facilities around the country, attended not just by marketing specialists but by the engineers who will later write the software code to address the customer issues they learn about, along with such purely routine inquiries as the e-mails asking members how long it took to receive their last movie (Netflix sends out hundreds of thousands of those every day). When an urgent issue demands it, Netflix can run a survey in twenty-four hours, yielding an instant snapshot of the mood of its members.
People at Netflix like to draw a connection between Reed Hastings’s engineering background and his company’s obsessive attention to tiny details. “Pure Software’s product was software that found bugs in other people’s software,” one of them reminded us. “That’s Reed’s whole orientation—to find something wrong where other people think everything’s fine.” This is the mind-set that helps a company drive error rates—like deliveries of scratched or inaccurately labeled DVDs—below 1 percent and then below one-tenth of 1 percent and ultimately below one-hundredth of 1 percent … each downward tick representing a customer hassle eliminated.
MEANWHILE, AS HASTINGS and his team were launching, building, and improving their business, what were their potential rivals doing?
The answer, shockingly, was nothing. Months went by. Then years. Netflix kept growing—slowly at first, then, especially after the discovery of the delivery-speed trigger, faster and faster. Blockbuster didn’t respond. Neither did Walmart, Apple, the movie studios, or any other big media player. The new demand Netflix had discovered was seemingly invisible to the most likely competitors.
Neither Blockbuster nor any other major incumbent responded until 2003, four years after Netflix’s launch, when Walmart finally launched its own Web-based movie rental service. Netflix’s stock price tumbled: A mere press release from the world’s largest corporation was enough to send shivers down competitive spines. But by 2005, Walmart was out of the online movie rental business, having sold its modest subscriber list to Netflix.
That same year, after a fifty-eight-month delay, Blockbuster entered the fray, and in a big way. Blockbuster by Mail boasted lower prices and many more movie titles than Netflix (25,000 versus 20,000). Again, Netflix’s stock fell sharply. Surely David was in big trouble now that the sleeping Goliath had finally wakened.
But Netflix responded swiftly and decisively, as if it had been preparing to do so for years. It cut prices to match Blockbuster’s. It rapidly expanded its movie catalog. By the end of 2005, Netflix boasted a far larger library than Blockbuster, an advantage it has maintained ever since. It accelerated the improvement of its recommendations engine. David kept loading and reloading his slingshot and firing in the direction of a bewildered Goliath.
Nevertheless, Blockbuster fought back. The company invested some $500 million into developing and promoting the online business. At first Blockbuster kept its two services completely separate—a slightly odd strategy, since it failed to capitalize on the company’s biggest potential advantage, its vast chain of physical stores. But in early 2007, Blockbuster shifted gears. It announced a new program called Total Access, which powerfully linked its online service with its physical outlets. Blockbuster by Mail customers would now be permitted to return discs to any Blockbuster store, exchange them for a free movie, and also get their next regular movie delivery by mail.
It was an attractive package—the first magnetic new product Blockbuster had offered in years. The second quarter of 2007 was the only period in Netflix’s history when its subscriber base actually shrank. Defections to Blockbuster were the reason. For a moment, it appeared that Reed Hastings’s worst nightmare—an aroused and effective Blockbuster—was coming true.
But Total Access created two big headaches for Blockbuster. One was that many of the chain’s franchised store owners refused to participate in the program. The other was that Total Access involved so many free giveaways that Blockbuster actually lost money with each membership.
Hastings and his team studied the numbers and quickly realized that Blockbuster’s gambit was unsustainable. They resolved to stay the course, continue to ratchet up the quality of their own product, and hope (fingers crossed) that Blockbuster would throw in the towel sooner rather than later.
Within a few months, the other shoe dropped.
By mid-2007, Blockbuster yielded to financial pressure and complaints from its franchisees by dramatically altering the Total Access plan. It raised prices, sharply limited the number of free disc exchanges, and instituted charges for in-store movie returns thereafter. The new Total Access presented a cacophony of choices, ranging from a one-DVD-at-a-time, $8.99-per-month, through-the-mail-only plan to a $17.99 mail-and-store plan that included three DVDs at a time and up to five in-store exchanges per month—with several other options in between. Many customers found the new program more confusing than empowering.
The consumer review website Gizmodo analyzed the changes and concluded, “Thanks, Blockbuster, for making it that much easier to recommend Netflix.”
When the dust cleared, Netflix’s lead over Blockbuster in online movie rental had only grown. The upward march of Netflix’s subscriber numbers resumed. By the end of 2008, Netflix’s corporate value (as measured by the total value of outstanding shares of stock) was ten times greater than Blockbuster’s. By 2010, Blockbuster was in bankruptcy, and in 2011, Blockbuster’s business assets were up for auction.
TODAY’S NETFLIX BUSINESS DESIGN is magnificent—a well-oiled machine that supplies more than 20 million members with a hypermagnetic product they can’t stop telling their friends about.
But the attention of Reed Hastings and his team is already focused on the next issue.
DVD technology, like VHS before it, has a limited shelf life. Movie downloads and streaming video are the key to the next generation of movie distribution. Over time, Netflix’s incredibly efficient delivery machine that piggybacks on the U.S. postal system will become increasingly irrelevant. As the rules of the game change, will Netflix be agile enough to stay one step ahead of its customers and two steps ahead of the competition?
The answer is taking shape today.
As early as 2008, Netflix quietly began infiltrating the infrastructure of the streaming video revolution. By mid-2009, streaming video from Netflix had already b
een made available in 3 million homes via PCs, Xbox 360 and Sony PlayStation 3 game players, Blu-ray disc players from Samsung and LG, and dedicated video gadgets like TiVo and Roku (the last-named a Netflix spin-off). In 2010, many more devices were added to the list, including the Nintendo Wii, Apple’s iPhone, iPod touch, and iPad, and Apple TV. By the end of 2010, Netflix anticipated serving more than 10 million members through more than 200 devices.
Hastings and his team aren’t ready to abandon the DVD or mail deliveries. Instead they are negotiating a gradual transition that they expect to take several years. “Netflix is a three-act play,” says company spokesman Steve Swasey:
Act one was strictly DVDs by mail. In 2010, we’re in act two, which is DVDs by mail and streaming service to your TV and your computer. And act three, which will be streaming only, no DVDs, is coming faster than any of us imagined. In fact, we launched a pure streaming service in Canada in September 2010—no DVDs!
We’ll continue to send DVDs to Netflix members in the U.S. for several more years. But as Netflix expands internationally, with a second region anticipated in 2011, it will be pure streaming.
The precise timing of the transition is unpredictable, though it appears to be moving more quickly than most experts anticipated. (A streaming-only plan was introduced in the U.S. in November 2010.) But whenever it happens, Netflix will be ready.
Streaming video requires a new business model. Under the copyright law’s “first sale” doctrine, anyone who buys a DVD can sell or rent it with virtually no restrictions. (For the same reason, you can sell a used book without paying royalties to author or publisher.) But selling streaming content demands a contract with the owner/creator that provides for long-term revenue sharing.
Will this change gum up the financial works of Netflix’s finely tuned business model? Not necessarily. As DVD mailing decreases, a growing fraction of Netflix’s annual $500 million postage bill will be freed up to pay for the new streaming business. “Once we cut our physical distribution costs in half,” Swasey observes, “we’ll have $250 million extra to spend with the movie studios—and those are Walmart numbers, big enough to make us one of their biggest customers.”
Thinking ahead, Hastings and his team have been working that side of the field for years, cultivating relationships with the movie studios, TV networks, production companies, and other content suppliers. “Our strategy,” Hastings has observed with a wry smile, “is to write them big checks.” Today Netflix has deals with dozens of them, from the Disney Channel, NBC Universal, Warner Bros., MGM, and CBS to Twentieth Century Fox, Lionsgate, New Line Cinema, and Epix, yielding a catalog with thousands of movies and TV programs available for instant streaming.
This new world means new competitors for Netflix—ad-supported video streaming companies like Hulu and YouTube, pay-per-view download companies like Apple and Amazon, and pay-per-view services offered by cable companies like Comcast On Demand. Netflix represents a different business model—subscription-based streaming. At the moment, all these models are growing, and Hastings expects this to continue as video streaming penetrates more and more American households.
Netflix is in a leading position as the next phase of this multiplayer chess game begins. But what will the consumer’s new hassle map look like, and what will be the key demand trigger? Will it be ubiquity of access? (If so, Netflix has a huge head start with its presence on hundreds of devices from almost every major electronics manufacturer.) Will it be highly prized exclusive content? Will it be some technological leap that brilliantly enhances the viewing experience, like in-home 3-D? Will it be a blend of entertainment and social networking, with world-spanning groups of people sharing live events featuring beloved performers?
No one today knows the answer—not even Reed Hastings. But we wouldn’t bet against him being among the first to discover it.
NESPRESSO AND THE DEMAND
THAT ALMOST WASN’T
No two demand creation stories are the same. Netflix is a classic David-and-Goliath tale: Entrepreneur Reed Hastings and his team of upstarts created a vast new stream of demand under the very noses of a giant industry leader.
Now we look through the other end of the telescope, at the tale of a huge, very successful company struggling to nurture the tiny flame of a new demand creation idea that didn’t fit comfortably into its existing business model. It’s a story with very different challenges, but with even more surprising twists and turns.
Our story begins in the early 1970s at the Battelle Research Institute in Geneva, Switzerland, where scientists had developed the basic design for a new kind of single-serve espresso brewing system. In 1974, the right to commercialize this design was purchased by Nestlé, the Swiss-based corporation that is the world’s largest marketer of consumer packaged goods. Nestlé then invested more than a decade in further technical development under a team led by engineer Eric Favre.
By the mid-eighties, the new system—dubbed Nespresso—was perfected. Through a three-step prewetting, aeration, and extraction process, the Nespresso brewer expanded, irrigated, and drew flavor from coffee pods at optimal pressure and heat, thereby producing delicious coffee with greater ease and cleanliness than any other system. Unlike traditional espresso makers, which were bulky, breakdown-prone, and demanded the practiced touch of a skilled barista, it was compact, reliable, and simple to operate. The unique technology was protected by thirty separate collections of patents.
The Nespresso system offered coffee lovers a host of advantages. Its one-cup-at-a-time brewing capacity made espresso an easily personalizable treat. Nespresso developed a selection of different flavor varieties, each available in a different-hued gleaming aluminum pod. Thus a hostess and her dinner guests could enjoy several different coffees—Ristretto for one (“Composed of pure Arabica beans from Latin America for its finesse and a touch of Robusta for its intensity”), Capriccio for a second (“A satisfying smooth espresso”), and Volluto for a third (“The mellow richness of early Latin American beans gives this blend a distinct elegant, subtle bouquet”). Responding to the varied demands of individual customers can be a powerful demand multiplier: Make the product perfect for me, and I will want it that much more.
Thanks to features like these, even the most demanding espresso aficionados found the Nespresso system impressive, making comments like “It’s the first time I’ve been exposed to such a range of espresso tastes.… You can produce good espresso every time.… It’s such a neat, intuitive way of producing coffee of professional quality.”
Here, then, was a seemingly magnificent demand creation opportunity for Nestlé: a convenient new technology for preparing the world’s most popular beverage, boasting innovative features that millions of consumers were likely to enjoy. Yet in the early years of Nespresso, demand lagged. On more than one occasion, the business came close to extinction.
What was the problem? It was the lack of a trigger—or, better still, a series of triggers—that could overcome consumer inertia and convert potential demand into real demand. The quest for those triggers turned out to be the central drama in the saga of Nespresso.
ONE KEY TO UNDERSTANDING the Nespresso story is the special challenges involved in building a groundbreaking new business inside a very large, successful organization.
When the Nespresso opportunity came its way, Nestlé was already one of the world’s great companies, with revenues in the tens of billions and hundreds of thousands of workers in eighty countries producing profits “year after year like a Swiss clock,” as one observer has put it. For this giant corporation, the opportunity to commercialize the Nespresso brewing system offered a portal into the world of roast and ground (R&G) coffee, where Nestlé lagged in fourth place. (Nestlé already dominated instant coffee through its Nescafé brand.) Since R&G made up fully 70 percent of the world’s coffee business, the leaders of Nestlé had long wondered how they could profitably serve those hundreds of millions of customers. Nespresso seemed to be the answer.
But there was a complication. The idea of building a brand around a machine rather than around packaged food ran contrary to the instincts of most executives at Nestlé—a company with no experience in the appliance industry. And when it came to launching a brand-new product that didn’t fit neatly into its existing business model, Nestlé’s size and its enviable track record were a two-edged sword. The company’s rigorous management systems and its conservative style were better suited to protecting and expanding its existing businesses than to experimenting in a radically different market.
Helmut Maucher, Nestlé’s CEO, had long understood the difficulties of demand innovation at big companies like his. An out-of-the-box thinker, Maucher had been among the first to see the enormous potential of bottled water and pushed the company to acquire brands like Perrier and Vittel at the start of that trend. He’d come to believe that creating new streams of demand in mature markets was the key competitive challenge Nestlé faced, and he understood that Nestlé’s size, history, and culture might prove to be both assets and obstacles in this quest.
New additions to Nestlé’s packaged goods lineup, like bottled water, fit comfortably within its traditional way of doing business. But the Nespresso brewing technology was an outlier. So in 1986, when the Nespresso system was finally ready for the marketplace, Maucher took steps to insulate the start-up from the rest of Nestlé.
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