2011

Untapped Markets of China

Business Intelligence Research: NetFlix
Comprehensive business intelligence providing an informational competitive advantage for accessing untapped market potential within China. Specifically in regards to the development of online service subscriptions for streaming high definition internet video media.

By: Montana Penton International Business 4/28/2011

Table of Contents

Country Review of The Market

Page 3

Business Review

Page 4

Entry Decision and Factors

Page 6

Bibliography

Page 7

Country Review of The Market The business sector of interest for Netflix is the recreational sector, specifically the online streaming of high definition video media as well as mail order video rental. There really is no traditional method for gaining an inroad to the is sector of China's economy since online services within China and throughout much of the world remains a digital version of the wild, wild west. Currently the largest internet firm operating in China is Baidu, which has already attempted to emulate the Netflix internet media distribution model with a small internet media firm called Qiyi, but has faced many failures and setbacks, mainly due to the reluctance of U.S. video producers and distributors to trust Baidu to protect their media from copyright infringement and piracy. In addition to Qiyi, Youku has also tried to establish itself as an online video media content provider, but has run into similar problems as Qiyi, with licensing agreements. Youku has settled into a role more in line with that of YouTube. Baidu is a well established internet search provider within the Chinese market with 54% of internet searches being performed through Baidu. Baidu is also well known for working within the confines of Chinese government censorship regarding the content Baidu allows users to view on their servers. Both of these strengths in Baidu make them a possible target for partnership to ease Netflix's entry into the Chinese marketplace. The two main distribution channels for Netflix products is by mail order or by internet connection. The State Post Bureau of The People's Republic of China is the official postal service. Postal efficiency of the State Post Bureau has been improving over the years, not long ago large volume mailers would complain that up to 35% of materials were not being delivered. Efficiency rates for "in-city" addresses are much higher than "out-city" rates. This discrepancy between inner and outer city, and overall poor efficiency, I believe rules out the use of the State Post Bureau to generate mail order subscriptions using the public system, similar to how Netflix utilizes the U.S. Postal Service. It is possible that a private carrier such as FedEx, UPS, or DHL could perform this service for Netflix, however private carriers are expensive. Online distribution of content is the cheapest, most efficient method for reaching the greatest amount of customers without sacrificing brand image to unreliable distribution channels such as the public mail system. The number of Chinese internet users hit 420 million, with 277 million accessing the internet via cell phones, according to a report published by China Internet Network Information Center (CNNIC). The Chinese market for e-commerce, particularly for high quality streaming video media is massive, larger than the population of the United States. The penetration rate of Internet users rose 2.9% to 31.8% by the end of 2009, with 98.1% of internet users choosing broadband, by far the largest population of broadband internet users in the world. The CNNIC report also found the average time Chinese internet users spend online grew to 19.8 hours per week, with 41% of internet users are over the age of 30. More traditional entry into the Chinese market place has meant long distribution channels, with many intermediaries that must be persuaded to carry the product or service. Companies seeking to launch a new product into the Chinese domestic market have had to rely on a push strategy to force their product through to the customers. This strategy is expensive because of the emphasis on direct selling, which requires financing and training a competent

sales force. Additionally, the direct selling approach means having to deal with a large fragmented rural population as well as the concentrated population of inner-city consumers in order to achieve optimal market penetration. These traditional inroads for firms launching a product or service in China are non-existent obstacles for Netflix's entry. An internet distribution model concentrates consumers into one location, no matter their physical, geographic location, which makes for a very short distribution channel. A pull strategy using targeted online advertising would also be the best route for a internet service provider to reach its target demographic, which is far more cost effective than the traditional push strategy. Netflix will also have to engage in a predatory pricing policy not only to flush out competition like Qiyi and Youku, but to also incentivize customers to use Netflix's services rather than pirated media. Business Review Netflix is the world's leading Internet subscription service for enjoying TV shows and movies, and boasts over 20 million subscribers as of December 31, 2010. The company was established by Reed Hastings in 1997 and is headquartered in Los Gatos, California. In September 1999 Netflix introduced the monthly subscription concept and dropped the singlerental model. Netflix has built a reputation on the business model of flat-fee unlimited rentals without due dates, late fees, shipping or handling fees, or per-title rental fees. Netflix has also played a prominent role in expanding the audience of the independent film industry, both through exclusive licensing and distribution agreements as well developing original content through a division called Red Envelope Entertainment. On May 29, 2002, Netflix initiated an initial public offering, originally selling 5.5 million shares of common stock at a price of $15 per share. In 2003 Netflix posted positive earnings after having posted losses during its first few years. Netflix has continued its earnings growth, posting an 88% growth in earnings during the first quarter of 2011. Netflix common stock is currently selling for $236.91 per share, and has a $12.4 billion market cap. The increase in total subscribers, as well as the acceleration in net subscriber additions, has fueled significant growth in Netflix revenue. Netflix passed a significant milestone in 2010 with the majority of subscribers viewing their TV shows and movies via streaming than by DVD. Hours consumer spend using streaming content has grown at a much faster rate than DVD hours, Netflix feels DVD shipments will be flat, and possibly declining in future periods. The following table represents performance highlights for 2010, 2009, and 2008 fiscal years for Netflix. 2010 2009 2008 (in thousands, except per share data) Revenues-------------------------------------------------$2,162,625 $1,670,269 $1,364,661 Operating income--------------------------------------283,641 191,939 121,506 Net income-----------------------------------------------160,853 115,860 83,026 Net income per share - diluted----------------------$2.96 $1.98 $1.32 Total subscribers at end of period-----------------20,010 12,268 9,390 Net subscriber additions------------------------------7,742 2,878 1,911

Netflix currently generates revenue from two marketing strategies, online content and mail order video rental. Netflix offers internet video streaming of selected titles to computers

running Windows or Mac OS X and to compatible devices, such as the Playstation 3, through their regular subscription service with no additional charges. A fixed monthly rate of $8.99 a month purchases unlimited access to Netflix's streaming content, however only a portion of Netflix's content is available for instant play, the remaining content must be viewed on DVD and ordered through the mail order subscription service. Netflix instant watch is supported by a number of devices, which helps Netflix build its subscription base. A number of Apple products, such as the iPad and iPhone support Netflix, additional devices such as home theatre systems, flat panel televisions, Logitech Revue Buddy Box, gaming consoles, and DVR's, all offer Netflix support systems so customers can use the instant watch system. In addition to the Internet streaming services, Netflix provides a monthly flat-fee service for the rental of DVD and Blu-ray movies. The subscriber creates an ordered list, called a rental queue, then movies are delivered individually via the U.S. Postal Service from a network of warehouses. There is no limit on the amount of time the subscriber may keep the movie, however the subscriber will not receive the net movie in their queue until the last movie is returned via mail. Limitations as to how many movies a subscriber may have out simultaneously are based on the subscription level. Competition within the entertainment video industry is fierce, and subject to rapid change in strategy, infrastructure and technology. The online market place has drastically reduced barriers to entry for competition, fostering an environment where consumers can easily shift from one entertainment video provider to the next, while easily maintaining simultaneous relationships with multiple providers. Netflix's direct competitors are internet movie and TV content providers, such as YouTube, Hulu.com, Amazon.com, and Apple's iTunes. Additional direct competitive pressure comes from DVD rental outlets and kiosk services, such as Blockbuster and Redbox, as well as independent, local "brick and mortar" video rental stores. Netflix is also focused on competition from multichannel video programming distributors with free television broadcasting, as well as video on demand content and pay-per-view programming from cable and satellite providers. Telecommunication devices have also become outlets for streaming video media, making telecommunication providers such as Verizon and AT&T competitors. The rapid pace of technological advancement also poses a threat to Netflix should they choose to not stay abreast of changing technological trends. The way in which consumers view video content has changed drastically in just the last decade, Netflix must continually explore ways to utilize new technology to their advantage. Currently the only other country Netflix operates in is Canada, with operations beginning in September 2010. Netflix began its international operations by offering an unlimited streaming plan without DVD's in Canada, and thus far has no plans to implement DVD subscription services. Majority of revenue still comes from operating income generated in the U.S., however Netflix has had a positive initial result from their expansion into Canada. This early success has wet Netflix's appetite for further international expansion, and implementation of two divisions or segments for Netflix; U.S. division, and International division. Additionally Netflix has taken initiatives to finance its international expansion by issuing $200 million in a debt offering of 8.5% senior notes, bringing the debt to equity ratio to an easily manageable 0.85. Using a debt offering instead of issuing stock is a sign of managements interest in building wealth for the stakeholder by not diluting their ownership of future net income. Because of the nature of

Netflix's subscriber based revenue, servicing future short term liabilities while expanding into international markets should not pose a significant financial risk. Given Netflix's financial stability, they are in a terrific position to expand internationally, particularly into the Chinese market to capitalize on a population of 412 million broadband internet users. Entry Decision and Factors Thus far this report has established a favorable outlook for entry into the Chinese marketplace. There are a multitude of strategy's that would likely result in varying degrees of success for Netflix, strategies such as Foreign Direct Investment, franchising, licensing or joint venture. Each strategy offers advantages and disadvantages that would result in varying levels of financial risk, and success, however I believe it would be in Netflix's best interest to participate in a joint venture. A joint venture between Netflix and China's number one internet search provider would ensure a quick turnaround from net income losses to earning positive net income. The advantages of a joint-venture are numerous. First, Netflix would benefit from Baidu's local knowledge of China's market conditions, cultural norms, language, and most daunting of all, the intrusiveness of the Chinese regulations regarding censorship. In exchange Netflix can provide it's proprietary internet streaming software which has thus far made for the most seamless viewing experience on the internet of high quality video media. Second, Netflix would be able to maintain low development costs by sharing a portion of these costs with Baidu. The existing internet infrastructure that Baidu has created would also offer Netflix instant access to a massive concentration of customers. Third, political risk for outside internet content providers in China has proven tricky, with Google, Microsoft, and Yahoo all facing major setbacks or outright failure largely because of intrusive government regulations regarding the content that Chinese citizens are allowed to view. A joint venture with Baidu ensures Netflix content will not infringe upon government regulations regarding censorship and will help Netflix avoid the same failure brought on by political risk these previous U.S. internet content providers faced. Despite all of the advantages of a joint-venture with Baidu, Netflix will be taking a risk that Baidu may gain control of Netflix's proprietary software. Chinese firms have been notorious in the past for outright stealing patented technology with no recourse. However China has made great improvements over the years in improving its protection of patented technology, and Netflix should take great care when constructing the joint-venture agreement to protect its proprietary software and ensure greater control over the use of its technology. A second disadvantage would be the possibility of conflicting goals between Baidu and Netflix when seeking to engage in further global expansion, or expansion throughout Asia. Netflix will have to outline an agreement with Baidu which establishes a controlling interest on Netflix's part. Should a conflict arise in the future that results in the dissolution of the venture Netflix will likely have gained a tremendous amount of operational experience as well as an established brand presence with consumers within the Chinese market and could opt for a wholly owned subsidiary strategy.

Bibliography

"2010 Annual Report." Netflix Investor Relations. 31 Jan. 2011. Web. 28 Apr. 2011. <http://ir.netflix.com/annuals.cfm>. (chinadaily.com.cn), Gao Qihui. "China Internet Population Hits 420m." Chinadaily US Edition. 15 July 2010. Web. 02 May 2011. <http://www.chinadaily.com.cn/china/201007/15/content_10112957.htm>. "State Post Bureau." Gov.cn: The Chinese Central Government's Official Web Portal. Web. 02 May 2011. <http://english.gov.cn/2005-10/03/content_74308.htm>. Thornton, James. "Postal Efficiency in China Is Improving | Post & Parcel." Post & Parcel News, Views and Jobs for the Global Mail & Express Community. 18 Sept. 2009. Web. 02 May 2011. <http://postandparcel.info/28157/in-depth/postal-efficiency-in-china-isimproving/>.