How Does Netflix Work?

By Markets Fool.com

Source: Netflix.

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Netflix is nothing more than a simple entertainment service, if you ask the average consumer. In a couple of clicks on the TV remote, Netflix serves up a plethora of movies and TV shows, some of which can't be found anywhere else. To others, Netflix is that red envelope that arrives in the mail with a DVD inside, just after you've returned the last one.

But a glance behind the curtain reveals that Netflix is much more complex. How does the company deliver those digital video streams and DVD mailers? And how exactly does Netflix make money for its investors?

Dodging bullets in the DVD age
Let's start with the nuts and bolts. Or at least with the plastic disks and a long history of very tough competition.

Blockbuster once thought the DVD mailing business looked simple. You might also recall Wal-Mart trying its hand at DVD rentals by mail. The retail titan's sheer size ought to have smothered the tiny upstart that Netflix was back in those days.

But Blockbuster emptied its store shelves and its coffers by treating its mail-order service as a marketing afterthought. Massive customer demand for it caught management unprepared, and Blockbuster never recovered from its Total Access blunder.

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Meanwhile, Wal-Mart's DVD service became known for ploddingly slow delivery. When the Walton empire bowed out and handed its entire customer list over to Netflixnearly a decade ago, it had only collected about 100,000 names. Too big to fail? Not this time.

Blockbuster and Wal-Mart failed to kill Netflix because this DVD mailing thing was just a hobby for them.

But Netflix remained laser-focused on creating the best DVD mailer service possible, which is harder than it sounds. Shipping centers were set up in every major city and plenty of smaller ones, too. Then they were automated to the hilt, managed by a highly trained skeleton crew of humans, and scaled to handle millions of incoming and outgoing disks every day. Next, Netflix patented its DVD-mailing business model andsuccessfully sued Blockbuster for infringement.

And while many businesses would be tempted to rest on their laurels after developing a success story like the Netflix DVD business, Netflix refused to fall victim to the innovator's dilemmaandstarted killing its own golden goose.

The streaming era
Just in case you've been living under a very large rock with a strictly enforced 24/7 curfew, streaming delivers video content directly to your favorite screens through a high-speed Internet connection.

Instead of managing a DVD queue to send out some hard-copy entertainment, you simply fire up Netflix on your TV, in a Web browser, or on your mobile device. The lead time is cut from several days to several seconds.

Netflix CEO, Reed Hastings. Source: Netflix.

Whereas the "first sale doctrine" allows anyone to buy a DVD at retail and then sell or rent out that particular copy, there are no such rights for digital media files. So while Netflix can add any DVD to its mailing warehouses, it must negotiate licensing rights for each digital movie or TV show it wants to offer. Hence, the streaming content selection is smaller than the mailing catalog, and often more dated.

Despite these limitations, streaming has proven quite popular with Netflix subscribers. Today, the company offers DVD services only in the U.S., where it has 5.8 million customers. Meanwhile, Netflix boasts 39 million domestic streaming customers and 57.4 million accounts worldwide. In other words, the formerly be-all, end-all DVD business now accounts for just around 9% of Netflix's total subscriber base.

Given the "Net" in this company's name, it was no surprise when Netflix launched its first online video-streaming service. After all, management never made a big secret out of its long-term plans.

When The Fool interviewed Netflix CEO Reed Hastings in 2005, digital conversion was already on the horizon:

In terms of downloading, we see it evolving slowly but steadily over the next 10 years. We will launch an initial version of Internet delivery of movies this year, 2005, and we will continue to fund and subsidize that work at 1 to 2% of revenues every year. It will grow in significance year over year.

Eventually five or 10 years from now, as there are more and more homes with large-scale broadband, more and more content availability, Internet delivery will be a very substantial business.

Hastings even put a deadline on the DVD market -- and a much longer window of opportunity on the next generation of digital streaming:"Let's separate the market into two phases. One is the phase of DVD, which peaks in five to 10 years and lasts for 20 to 30 years. Then there is the phase of Internet delivery, which peaks 20 or 30 years from now and lasts for 100 years."

He followed through on those estimates in 2011. Six years into that "five to 10 years" projection of the DVD market's best-before date, Netflix was ready to separate its streaming service into an entirely separate business. DVD mailing would operate under the new Qwikster name and be managed entirely separate from the Netflix-branded streaming service.

The hue and cry was enormous.Up to that point, digital streams had simply been thrown in as a freebie when you paid for the DVD mailer product. Some saw the new pricing structure as a doubling of the monthly service fee. Others picked just one service and paid the same amount as before, but with a less generous service offering. A 3.2% minority dropped their Netflix subscriptions altogether.Hastings quickly apologized and scuttled the Qwikster brand, but insisted on separating streaming from DVD.

Since then, customers have voted with their wallets: The age of DVD mailers is over and streaming is the new standard method for entertainment delivery.

If anything, Netflix may have made this move a little bit too fast. The Qwikster idea wouldn't seem silly today, but it was ahead of its time in 2011.

Let's get technical!
But now as streaming reigns supreme, investors should understand how its business model differs from the DVD business.

From a consumer's point of view, Netflix video streams are very simple. Click, click, and there's your movie. But it's a bit more involved on Netflix's side of the action, of course, especially with content licensing.

Netflix's Chief Content Officer, Ted Sarandos. Source: Netflix.

In short, Netflix is trying to get away from buying separate content licenses for each geographic market it serves. Netflix content guru Ted Sarandos is pushing for global rights whenever he can get them at a reasonable price. It's the only way to build a global video service with a two-year deadline.

License in hand, Netflix can then procure or produce a digital master copy of the licensed content, converted to many different quality levels and specific media formats, uniquely built to support various file formats. (In this case, one size does not fit all, and Netflix quickly learned this lesson when Apple's first iPad launch didn't support Netflix's video file formats.)

Finally, the correct file is ready to hit your TV screen, or your smartphone, or whatever device you prefer, but only after getting chopped up into thousands of snippets, each a few seconds long. It's a powerful and flexible system.

But that data architecture can't handle the viewing traffic generated by the company's worldwide expansion plans. So Netflix is rewriting this process from scratch, redesigned to handle many billions of viewing actions per day.

Netflix is happy to rip up a good design when it needs a great one. The streaming platform works today, but won't tomorrow. So let's start over. The DVD business made sense in 2010, but it won't be around forever. So let's smother it under a much better streaming service. If and when Internet delivery becomes old hat, I fully expect Netflix to be first in line to kill its darlings, only to replace that with something better.

The takeaway for investors
Netflix is in the midst of a dramatic global expansion project. Hastings expects the company to complete this stage by the end of 2016 and will trade in his accelerator pedal for higher profits in 2017. As a Netflix shareholder, I'm looking forward to this moment with bated breath, since it will be a turning point in the stock's wealth-building history.

Netflix has already made many investors lots of money. Here's how the stock compared against Apple, the ultimate growth stock, over the last decade:

NFLX Chart

NFLX data by YCharts.

The next few years will build on this rich legacy as Netflix completes its global build out, and then starts paying closer attention to bottom-line profits. Right now, the only purposes of additional cash are to grow the company's international footprint faster and to build a better library of exclusive content.

I think we're still looking at the mere beginnings of a global media powerhouse. Come back in five or 10 years, and Netflix should be worth many times what it is today, standing shoulder to shoulder with Apple and other giants.

The article How Does Netflix Work? originally appeared on Fool.com.

Anders Bylund owns shares of Netflix. The Motley Fool recommends Apple and Netflix, and also owns shares of both companies. Try any of our Foolish newsletter services free for 30 days.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.