BOOK SPECIAL...... BOOK EXCERPT: Lead and Disrupt:

 BOOK EXCERPT: 

 Lead and Disrupt:

How Netflix Disrupted Blockbuster—Twice

from: Lead and Disrupt: How to Solve the Innovator’s Dilemma

by Charles A. O’Reilly III and Michael L. Tushman

Consider Netflix and Blockbuster. In 2012, Fortune magazine featured Reed Hastings, Netflix founder and CEO, as its businessperson of the year. Founded in 1999, Netflix is now the world’s largest online DVD rental services and video streaming firm, with more than 100,000 titles in its library, 60 million subscribers, and annual revenues of more than $4 billion. In 2002, the year Netflix went public, prime competitor Blockbuster had revenues of $5.5 billion, 40 million customers, and 6,000 stores. Yet only eight years later, on September 23, 2010, Blockbuster filed for bankruptcy; in a supreme irony, Netflix was added to the S&P 500 shortly after, replacing Eastman Kodak, another failed corporate icon.

When Netflix went public in 2002, a Blockbuster spokesperson said it was “serving a niche market. We don’t believe that there is enough demand for mail order—it’s not a sustainable business model.” In 2005, as Netflix began moving into the streaming of videos over the Internet, the chief financial officer of Blockbuster said, “We don’t think the economics (of streaming) works well right now.”

But before these public dismissals, there was a private one. In 2000, Reed Hastings flew to Dallas to meet with the senior executives at Blockbuster. He proposed that they purchase a 49 percent stake in Netflix, which would then become the online service provider for Blockbuster.com. Blockbuster wasn’t interested. Blockbuster didn’t have to buy Netflix—though it could have—to rent videos by mail. It had all the resources needed to crush a freshman firm that had revenues of only $270,000 and was a fraction of Blockbuster’s size when it went public. But by the time Blockbuster got around to renting videos by mail in 2004, it was too late.

Why did Blockbuster fail and Netflix succeed? The difference boils down to how their leaders thought about change. Blockbuster leaders were focused on growing and running today’s business: video rentals through conveniently located stores. And they were good at this. Their strategy focused on growth in new markets, increasing penetration in existing ones, and maximizing the number of movies rented. In 2003 Blockbuster had a 45 percent market share and was three times the size of its closest competitor. In 2004, as Netflix was becoming an even bigger threat, Blockbuster revenues still increased 6 percent and senior executives talked proudly about “the experience of a Blockbuster store.” In addition to extracting revenues for their existing business, the company saw opportunities for expansion through acquisitions (e.g., Hollywood Video), methods for boosting rentals, and the creation of a DVD trade-in program. Their decision to enter into the mail order and online rental business was reactive and defensive, not proactive and transformational. In hindsight, we can see that they focused on winning a game that was soon to be irrelevant.

In contrast, leaders at Netflix didn’t think of themselves as being in the DVD rental business; rather, they identified their offering as an online movie service. In Hastings’s words, “I was obsessed with not getting trapped by DVDs the way AOL got trapped, the way Kodak did, the way Blockbuster did … Every business we could think of died because they were too cautious.” Even though their mail-in rentals caught on first, they’ve been focused from day one on how to be a broadband delivery company. “It was why we originally named the company Netflix, not DVD-by-mail.” The Netflix strategy emphasizes value, convenience, and selection. To deliver on these, they have been willing to cut prices and invest aggressively in new technologies ($50 million in 2006-2007 in video on demand). More important, they have been willing to cannibalize their old business to succeed in the new.

Video streaming puts Netflix revenue from DVD rentals at risk. Yet its leaders needn’t fear because they have been aggressive in moving into streaming; today more than 66 percent of Netflix subscribers use streaming, and the company has retained customers who might have otherwise moved to Hulu, HBO, or another of their many competitors. In Hastings’s view, DVD rental by mail is just one phase of the business. His goal is to have every Internet-connected device capable of streaming Netflix videos. To accomplish this, Netflix gives away the enabling software and is now on more than two hundred devices. In making this transition, Netflix is beginning to close some of its fifty-eight regional mail order distribution centers. While subscription rates for online service are lower than for DVD rentals, Netflix is beginning to save some of the $700 million that it spends for mailing DVDs. In the process, it is still growing its customer base by close to 50 percent every year.

More recently, in order to attract and maintain customers, Netflix has moved into video production and in 2015 will spend $6 billion in producing hit shows like Arrested Development and Orange Is the New Black. In producing original programming, Netflix is not seeking short-term profits but playing a game for the long haul. In the words of chief content officer Ted Sarandos, Netflix wants “to become HBO faster than HBO can become Netflix.

What was it about Netflix and its leadership that helped the firm transition from DVD rentals to video streaming, while Blockbuster and its management struggled and failed? This is the puzzle that is at the heart of our book.

(c) 2016 by the Board of Trustees of the Leland Stanford Jr. University. All rights reserved. Published by Stanford University Press in hardback and digital formats. By permission of the publisher, sup.org. No reproduction is allowed without the publisher's prior permission.