BUS303: Strategic Information Technology

Each time a customer visits Netflix after sending back a DVD, the service essentially asks "so, how did you like the movie?" With a single click, each film can be rated on a scale of one to five stars. If you're new to Netflix, the service can prompt you with a list of movies (or you can search out and rate titles on your own). Love Rushmore but hate The Life Aquatic? Netflix wants to know.

The magic of Cinematch happens not by offering a gross average user rating - user tastes are too varied and that data's too coarse to be of significant value. Instead, Cinematch develops a map of user ratings and steers you toward titles preferred by people with tastes that are most like yours. Techies and marketers call this trick collaborative filtering. The term refers to a classification of software that monitors trends among customers and uses this data to personalize an individual customer's experience. Input from collaborative filtering software can be used to customize the display of a Web page for each user so that an individual is greeted only with those items the software predicts they'll most likely be interested in. The kind of data mining done by collaborative filtering isn't just used by Netflix; other sites use similar systems to recommend music, books, even news stories. While other firms also employ collaborative filtering, Netflix has been at this game for years, and is constantly tweaking its efforts. The results are considered the industry gold standard.

Collaborative filtering software is powerful stuff, but is it a source of competitive advantage? Ultimately it's just math. Difficult math, to be sure, but nothing prevents other firms from working hard in the lab, running and refining tests, and coming up with software that's as good, or perhaps one day even better than Netflix's offering. But what the software has created for the early-moving Netflix is an enormous data advantage that is valuable, results yielding, and impossible for rivals to match. Even if Netflix gave Cinematch to its competitors, they'd be without the over-two-billion ratings that the firm has amassed (according to the firm, users add about a million new ratings to the system each day). More ratings make the system seem smarter, and with more info to go on, Cinematch can make more accurate recommendations than rivals.

Evidence suggests that users trust and value Cinematch. Recommended titles make up over 60 percent of the content users place in their queues - an astonishing penetration rate. Compare that to how often you've received a great recommendation from the sullen teen behind the video store counter. While data and algorithms improve the service and further strengthen the firm's brand, this data is also a switching cost. Drop Netflix for Blockbuster and the average user abandons the two hundred or more films they've rated. Even if one is willing to invest the time in recreating their ratings on Blockbuster's site, the rival will still make less accurate recommendations because there are fewer users and less data to narrow in on similarities across customers.

One way to see how strong these switching costs are is to examine the Netflix churn rate. Churn is a marketing term referring to the rate at which customers leave a product or service. A low churn is usually key to profitability because it costs more to acquire a customer than to keep one. And the longer a customer stays with the firm, the more profitable they become and the less likely they are to leave. If customers weren't completely satisfied with the Netflix experience, many would be willing to churn out and experiment with rivals offering cheaper service. However, the year after Blockbuster and Wal-Mart launched with copycat efforts, the rate at which customers left Netflix actually fell below 4 percent, an all-time low. And the firm's churn rates have continued to fall over time. By the middle of 2008, rates for customers in Netflix most active regions of the country were below 3 percent, meaning fewer than three in one hundred Netflix customers canceled their subscriptions each year. To get an idea of how enviable the Netflix churn rates are, consider that in 2007 the mobile phone industry had a churn rate of 38.6 percent, while roughly one in four U.S. banking customers defected that year.

All of this impacts marketing costs, too. Happy customers refer friends (free marketing from a source consumers trust more than a TV commercial). Ninety-four percent of Netflix subscribers say they have recommended the service to someone else, and 71 percent of new subscribers say an existing subscriber has encouraged them to sign up. It's no wonder subscriber acquisition costs have been steadily falling, further contributing to the firm's overall profitability.

The Netflix Prize

Netflix isn't content to stand still with its recommendation engine. Recognizing that there may be useful expertise outside its Los Gatos, California headquarters, the firm launched a crowdsourcing effort known as The Netflix Prize.

The goal was simple: Offer one million dollars to the first group or individual who can improve Cinematch's ratings accuracy by 10 percent. In order to give developers something to work with, the firm turned over a large ratings database (with customer-identifying information masked, of course). The effort has attracted over 30,000 teams from 170 countries. Not bad when you consider that one million dollars would otherwise fund just four senior Silicon Valley engineers for about a year. And the effort earned Netflix a huge amount of PR, as newspapers, magazines, and bloggers chatted up the effort.

While Netflix gains access to any of the code submitted as part of the prize, it isn't exclusive access. The Prize underscores the value of the data asset. Even if others incorporate the same technology as Netflix, the firm still has user data (and attendant customer switching costs) that prevent rivals with equal technology from posing any real threat. Results incorporating many innovations offered by contest participants were incorporated into Cinematch, even before the prize was won.

As the contest dragged on, many participants wondered if the 10 percent threshold could ever be reached. While many teams grew within striking distance, a handful of particularly vexing titles thwarted all algorithms. Perhaps the most notorious title was Napoleon Dynamite. The film is so quirky, and Netflix customers so polarized, that there's little prior indicator to suggest if you're in the love it or hate it camp. One contestant claimed that single film was responsible for 15 percent of the gap between his team's effort and the million dollars.

The eventual winner turned out to be a coalition of four teams from four countries - prior rivals who sought to pool their noggins and grab fame and glory (even if their individual prize split was less). BellKor's Pragmatic Chaos, the first team to cross the 10 percent threshold, included a pair of coders from Montreal; two U.S. researchers from AT&T Labs; a scientist from Yahoo! Research, Israel; and a couple of Austrian consultants. It's safe to say that without the Netflix Prize, these folks would likely never have met, let alone collaborated.

Patron Saint of the Independent Film Crowd

Many critically acclaimed films that failed to be box office hits have gained a second life on Netflix, netting significant revenue for the studios, with no additional studio marketing. Babel, The Queen, and The Last King of Scotland are among the films that failed to crack the top twenty in the box office, but ranked among the most requested titles on Netflix during the year after their release. Netflix actually delivered more revenue to Fox from The Last King of Scotland than it did from the final X-Men film.

In the true spirit of the long tail, Netflix has begun acquiring small market titles for exclusive distribution. One of its first efforts involved the Oscar-nominated PBS documentary, Daughters from Danang. PBS hadn't planned to distribute the disc after the Academy Awards; it was simply too costly to justify producing a run of DVDs that almost no retailer would carry. But in a deal with PBS, Netflix assumed all production costs in exchange for exclusive distribution rights. For months after, the film repeatedly ranked in the Top 15 most requested titles in the documentary category. Cost to PBS - nothing.