Threadlines: Netflix's Last Red Envelopes

Netflix is shuttering DVD rentals

Earlier this fall, Netflix announced they were shuttering the service that started it all, their DVD rental subscription service. This announcement marks the completion of a journey that took the company from its beginnings in DVDs to now defining and leading the world of video streaming, the format that dominates modern media.

In modern business, companies rarely complete successful transformations of their product offering, especially not to the scale of Netflix. Some stories include Amazon moving from being an online bookseller to being an online everything-seller, Marvel shifting from focusing on comics to focusing on the silver screen, and in late 2021 Facebook rebranded as Meta, a brand focused on the metaverse, trying to remain relevant in a modern technological landscape.

Among those, Netflix's transformation from DVDs to streaming remains one of the most notable and high-profile transformations in modern business.

This article is going to look back at the history of Netflix, some of the milestones of their DVD service, and examine how the company transitioned to becoming the streaming giant it is today.

Netflix’s Origins

Netflix began in the late 20th century, right in the middle of the dot-com era. Reed Hastings and Marc Randolph joined in the excitement of the fledgling internet by founding Netflix, a service where people could rent movies online and have them delivered directly to their house via USPS.

The online component of the business differentiated them from other DVD retailers such as Blockbuster.
As the story goes, Hastings was spurred on by a negative experience he had renting with Blockbuster, "In 1997, a man named Reed Hastings returned a late copy of Apollo 13 to his local Blockbuster. He was assessed a $40 fee.
Two years later, he founded Netflix."

Moreover, Blockbuster "could have bought Netflix that day for $50 million, but its CEO didn't even bother to consider the possibility. He seemed to see it as a great big joke."
I'm sure former Blockbuster executives cringe at both of those stories.

After the dot-com bubble burst, Netflix suffered a downturn alongside all similarly-positioned online companies, but they did survive, and over the years in the early 2000s, they would begin to thrive.

One of the most important decisions that propelled Netflix's success was to implement a subscription-based business model. Neil Hunt, former VP of Internet Engineering at Netflix recalled that "At that point, it was a service offering transactions a la carte, rentals of DVDs for a period of a week or so. And we found it pretty difficult to get consumers to come back and have a second try. You know, shipping delay is a pretty serious impediment when you’re taking a day to four days to ship a disc each way. And so at that stage, the business was not tremendously successful."

So, CEO Reed Hastings decided to make a change.

Former CFO Barry McCarthy recalled that "It was Reed's insight that the subscription model would resonate with consumers in a compelling way... He re-engineered the Website and software to support a subscription model...we began to grow exponentially overnight."

Yes, a Subscription Service was Innovative

In 2023, it's easy to be unimpressed by the subscription model. It feels like everywhere you turn, there's a company trying to force you to sign up for their subscription, whether it's socks, beauty products, or video games. But, at the turn of the century, Hastings was a pioneer here. He realized that Netflix needed to be different than the host of video retailers where you paid per DVD you rented.

The subscription service "improved second-time movie rental rates considerably. Customers were locked into the platform, and were therefore much more likely to try rentals again."

This move was a massive success, with McCarthy again recalling that "In 1998, I think the business did $1 million in revenue. In 1999, we did $5 million, then $35 million and then $75 million and $150 million and then almost $300 million...
We were I think five years to $500 million and another three years to $1 billion, all because of the subscription model."

Queues and Algorithims

There were two other innovations that Netflix introduced to set themselves apart from the competition in those critical early years.

First, the Netflix team created a DVD queue system, where users would put movies they wanted to watch next onto a list of what they wanted to watch next. Then, whenever a customer returned a DVD to Netflix, it would automatically send them the next movie up on their queue.
This was successful in getting users to consistently send their DVDs back as they were motivated to send them back so they could get their next one on the queue.

This queue also increased customer retention by keeping the DVDs flowing smoothly. The less friction for customers to get their next movie, the less chance they would unsubscribe from Netflix.

Second, Netflix introduced a movie-matching system that recommended users new movies to rent based on ones they had chosen in the past. This algorithm came to be wildly popular with users and transformed the way that they experienced the platform.
Customers now could count on Netflix not just to watch movies they already love, but also to discover new ones.

Over the decades, this matching system has only become more and more sophisticated and more and more advanced.

Robots and Red Envelopes

Driven by these innovations, Netflix over the years shipped billions of discs to its subscribers over the decades. This was a difficult undertaking, backed by a complex, sophisticated supply chain.

Janko Roettgers reported in The Verge that Netflix worked with a contractor to "custom-design a massive disc robot called the 'automated rental return machine,' or ARRM 3660. The ARRM, as Netflix employees simply called it, was an assembly-line-sized machine consisting of 6,500 parts total. At its center were two carousels, housed behind glass doors, that were loaded up with incoming mail and then used pneumatic arms to perform all of the things people had done before: slice open returned envelopes, unpack discs, inspect them, clean them, add them to a facility’s inventory system, and get them ready to go out of the door again — basically, every job short of sorting discs and stuffing envelopes for the next customer."

These robots served as the drivers for hubs around the United States that were basically fully automated DVD-packing facilities.
These robots saved thousands of man-hours as well as millions, if not billions of dollars in costs.

Moreover, Netflix DVD director of engineering Paul Johnson noted that these machines were also a lot better at jobs like quality control, which was critical to limiting customer frustration. When customers sent back their DVDs, they were supposed to be sure they put them in the right sleeves, but inevitably, not everyone did that. "Netflix hub employees were supposed to catch those mix-ups and make sure that the next customer didn’t accidentally receive the wrong disc. But humans aren’t very good at that,” Johnson said.

But... machines are excellent at finding deviations like that, and would consistently resolve disc mismatches.

Netflix's complex infrastructure also addressed issues like old discs that couldn't play anymore and product availability as it optimized the discs that were on the shelves of each shipping center. This infrastructure enabled Netflix's DVD subscription rental service to dominate - not just the video business, but the world.

"There was a point in the late 2000s when it seemed like every mailbox was stuffed with red envelopes."

Anecdotally, I remember working with my mom to figure out our family's Netflix queue order so that all of us could get the movies we wanted. It was a sophisticated operation to get the DVD shipping and return cycle timing exactly right so we were all satisfied.
At one point, we decided to sign up for the upgraded plan so we could rent multiple DVDs at the same time. It was a revolving door of red Netflix envelopes at our house. And we weren't alone in this as, "Netflix shipped a billion DVDs by mail between 2007 and 2009 alone, with its loyal fans overwhelming the US Postal Service by returning 1.6 million discs every single day.”

Netflix turns to streaming

As Netflix grew out of the dot-com bubble, the company began to earn more and more market share in the video business. In 2002, Netflix went public on the stock market at a valuation of $82.5 million as one of the first tech companies to IPO after the dot-com crash.
By 2004, (just 4 years after the Blockbuster executives rejected buying Netflix), Blockbuster introduced Blockbuster Online to compete with Netflix. And by the start of the next decade, Netflix had grown so much that it launched the streaming service that would soon come to define the company.

The DVD segment was still important though, as it laid the groundwork for the streaming service.

For instance, the movie recommendation system Netflix used to recommend new DVDs became the foundation for suggesting streaming recommendations, and the queue customers used to order DVDs became the streaming watchlist.

On top of this, "Between 2012 and 2019, when Netflix stopped breaking out revenue for the segment, DVDs generated more than $2.6 billion in profits. Streaming, on the other hand, was hugely capital-intensive, especially for a company aiming to be a global player. Netflix’s international streaming segment wasn’t profitable until 2018."

The DVD business was the cash cow that directly enabled Netflix to sink billions into standing up its streaming business.

And now... we know Netflix as the streaming giant that helped usher in a new era of video where we have millions of hours of content available a few clicks away.

But before this... these red envelope DVDs were it. They were the way to enjoy popular media at home. And as Netflix closes the door on its DVDs, we say goodbye to a service that redefined how movies and TV would be watched.

I couldn't put it better than the current CEO Ted Sarandos, "To everyone who ever added a DVD to their queue or waited by the mailbox for a red envelope to arrive: thank you."