With all due respect to Reed Hastings, the Netflix-Qwikster split sucks for customers

September 19, 2011

This post originally appeared at Business Insider.

We have nothing but respect for Netflix CEO Reed Hastings, who has demonstrated again and again a willingness to take the long view instead of an easier short-term one — making tough decisions that cause near-term pain in order to improve the company long-term.

In the middle of last decade, for example, Reed decided to cut Netflix’s pricing to neutralize a competitive threat from Blockbuster. Hastings and Netflix were scorned at the time for this decision — Netflix would obviously go broke — and Netflix’s stock collapsed.

Well, we know how that one turned out: Netflix won the battle, and its stock blasted off for the moon. Blockbuster, meanwhile, went bust.

And now Hastings has gone and made another earth-shaking decision — enacting a major price increase for DVDs-by-mail and splitting Netflix into two companies. And the market has responded by chopping Netflix’s stock price in half.

We suspect, eventually, that Reed Hastings will once again be proven right about the price increase and that those who have written the company off for dead will once again have to hang their heads in shame.

And we can also certainly understand why, from the company’s perspective, it makes sense to split the DVD and streaming businesses into two separate companies: They’re different businesses, with different cost structures and different delivery, marketing, licensing, and management challenges, and they will be easier to run better if they’re managed separately.

But what’s better for the company, in this case, is worse for most of the company’s customers.

One of the big advantages of Netflix’s current service is that it’s a one-stop shop. Subscribe to Netflix, and you know that you’ll be able to watch basically any movie or TV show ever made. You may not be able to watch it instantly, via streaming, but if you can’t watch it instantly, then you can order the DVDs.  And you can go to a single web site, Netflix, to figure out what your options are.

This is very different offering than most of Netflix competitors have, which is access to some TV shows and movies, but not all.

Subscribing to a service that has access to some shows and movies, is very different (and distinctly worse for the customer) than subscribing to one that has access to all of them.

Searching a database that contains some shows and movies is very different (and distinctly worse for the customer) than searching one that has access to all of them.

And subscribing to two different services, with two different brands, bills, and customer support, is much more of a pain in the ass than subscribing to one.

What percentage of Netflix’s customers value its “one stop shop” feature? Half.

Netflix subscribers fall into one of three buckets:

  • DVD-only (~2.2 million target for Q3, by far the smallest)
  • Streaming-only (~9.8mm target for Q3)
  • Hybrid (12mm target for Q3)

Netflix’s largest customer segment, in other words, is still choosing to pay for the ability to either stream or order DVDs by mail, despite the massive 60% price increase for this plan that Netflix just enacted.

This suggests that half of Netflix’s customers very much value this option.

Will all of Netflix’s “hybrid” subscribers maintain their DVD service subscription now that they’ll have to search another web site and get another bill every month from “Qwikster”? We doubt it. And, in any case, it will be considerably more of a pain in the ass.

(One question we have for the company is whether both databases will still contain ALL movies and TV shows — or whether the databases will be limited to the movies that that particular service offers. If the streaming database does not contain the DVD movies, we imagine Netflix will lose a lot of free marketing for that service).

We understand that Netflix wants to discourage customers from ordering DVDs, and the split will certainly do that. We also understand that, eventually, Netflix’s whole business will be streaming (or other digital delivery) and that DVDs will go away. And so we understand why Reed Hastings and Netflix are being applauded for facing reality and embracing the future.

But…

For the moment, and for the next couple of years, Netflix’s value to half of its customers has just dropped. Put differently, this seems a distinctly customer-unfriendly move.

It seems so customer-unfriendly, in fact, that one suspects there is more behind it than merely the desire to have a separate management team for each company.

Benchmark (VC) partner Bill Gurley offers one guess as to what this unstated factor may be.

Gurley observes that the licensing for content for DVDs versus streaming is entirely different. To rent a DVD, Netflix need merely buy it: The company does not pay any per-view or per-customer licensing fee to the studios. To stream a show or movie, meanwhile, Netflix has to pay a direct licensing fee, which is based on its number of subscribers.

Gurley believes that the Hollywood studios are now insisting that Netflix pay a per-subscriber-per-month licensing fee, whether or not its subscribers actually ever stream movies. This demand, Gurley reasons, may be forcing Netflix to pay per-month-fees on way more subscribers than it will ever recoup any value for (because many never use the streaming option).

By splitting the businesses in two, Gurley continues, Netflix will be able to negotiate streaming licenses on a much smaller subscriber base — say ~15 million, versus the ~25 million total subscriber base — thus reducing its streaming content costs.

This, too, makes sense from a business perspective, and, if true, it explains a lot.

But it still sucks for “hybrid” customers.

Henry Blodget is the editor of Business Insider.

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Comments
12 comments so far

In past months, Netflix has been a poster child for “worst business practices”.

I’ve written about this on http://www.softwaremarketingexperts.com as “Netflix: customer-driven vs. driving customers away”.

On http://hollistibbetts.sys-con.com an article is being published today about Arrogance as a Worst Business Practice – featuring Netflix.

Posted by SoftwareHollis | Report as abusive

“It still sucks for “hybrid” customers”. Oh, the injustice of it all! They now have to actually cover the cost of the product they are getting, AND maintain TWO accounts! Can you believe it?

The streaming model Netflix was using was not sustainable. The studios were not going to continue licensing their content at the same terms, once they saw how successful Netflix was at streaming, and how much it cut into their other revenue streams (like TV).

The math for nearly-free all-you-can-watch streaming content was flawed from the start, and the only reason it lasted as long as it did was because the management of the studios is so inept. Netflix did what they had to do, and recognizing that plastic discs will soon be obsolete, decided to attach their brand name to the streaming business. I’m amazed that they have extracted as much profit from DVDs as they have, but their best days are over. Now they will be at the mercy of Hollywood, which is incapable of digesting the implications of technology, and intent on trying to force people to buy what they want to sell, instead of selling things that people want to buy.

Posted by KenG_CA | Report as abusive

FTA ” This demand, Gurley reasons, may be forcing Netflix to pay per-month-fees on way more subscribers than it will ever recoup any value for (because many never use the streaming option)”

This makes no sense, Netflix has around 25 million subscribers, of that 2.2 million are opting to move to DVD only the rest are option to use streaming only or streaming and dvd’s, this shows that at least 22 million people are opting to stream content. This alone would give me pause when reading this article for any true insight, so when I read a paragraph like this:

“We suspect, eventually, that Reed Hastings will once again be proven right about the price increase and that those who have written the company off for dead will once again have to hang their heads in shame.”

I can’t help but laugh, it fails to take into account the simple problem that Netflix just took on, – losing content value.

Starz, the sole reason that Netflix has a deeper library of newer released movies and higher 4 – 5 star films in it’s library is moving on next Feb. and HBO has already made it’s intentions clear that it will not license any of it’s content deals to Netflix, given that HBO hold’s licensing rights to 4 of the major studios and Stars held the rights to two others makes for a very damning future for Netflix. Now take into account that Netflix (the streaming service) has just split off it’s only movie value branded service that was a guarantee and it makes me think that this might be the day we look back on as the end of Netflix as a brand, not today but in a few years time.

Posted by jb1974 | Report as abusive

I totally agree! I’m really glad I canceled my Netflix service. At least, I still have the TVDevo website’s service and get movies and TV for cheaper than what Netflix offers.

Posted by laurastammer | Report as abusive

And this improves their business model, KenG_CA, exactly how? At least when they offered everything on one platform, you could see options: DVD customers started seeing more Streaming availability (substandard in many ways) and probably grew to value that. (You can tell that because some of them still have both accounts, despite the price increase.)

If, as you admit, the Hollywood business model doesn’t work, why would you delude yourself into believing that NFLX should follow it?

(As for streaming, I’ll note the obvious here: Amazon Prime offers Streaming–plus several other values, such as free shipping for books–for 5/6th the price of NFLX. Yes, AMZN Prime has a more limited catalog. But if I want pure Streaming and 95% of what I want is available for about 16.6% less, why would I stay with NFLX? My reason used to be that I could also rent DVDs: one-stop shopping and no need to compare with other services. DVDs got people in the door, but it is DVD+Streaming that was going to keep them there, even after the price increase. But now even that is going away.)

NFLX is going from being a department store to being two specialty shops on different blocks that attract many of the same customers. And some of those customers, in going from one to the other, are going to pay more attention to rather similar shoppes than they would have when the trip was from one floor to the next. Betting that the stores divided will outperform the original department store is a mug’s game.

Posted by klhoughton | Report as abusive

I posted this at Balloon-Juice but I thought it belongs here as well:

I got an email yesterday from the manager of my grocery store R. Hastings, they plan on separating the liquid and dry items and putting the dry items in one store and the liquid items in another store right down the street. He says if I need both liquid and dry items I’ll have to travel to each store and get the items separately.

He says that this just makes sense; since liquid items and dry items are not at all alike and you shouldn’t expect to buy them in one place. He says “They’re different businesses, with different cost structures and different delivery, marketing, licensing, and management challenges, and they will be easier to run better if they’re managed separately.”

He thinks maybe if he does this he can get the makers of dry items to send him more dry items. He doesn’t think that there is much future in liquid items, and he’ll probably sell off that store later. Liquids being a dying industry and all.

Posted by BottyGuy | Report as abusive

klhoughton, they don’t have a choice. They were getting access to the streaming content for an unsustainably low price. The studios finally woke up, and started pricing it in accordance with their usual obsolete policies (i.e., oblivious to the changing demands of consumers). If they kept the model the same, and the licensing costs increased, they would have to raise the price for everyone, even if they weren’t using the streaming service.

At some point, Hollywood will come up with a rational licensing scheme for streaming content, probably when broadband speeds increase enough so people can start sharing video files with the same ease that they shared music files. In the meantime, NFLX needs to be ready, and this establishes them as the leader in all-you-can watch streaming.

I use AMZN prime, and their catalog of free content is pretty useless, and nowhere near as good as netflix. My kids watch a lot of old TV shows on NFLX, so it’s worth it for that. For movies, I usually end up paying for a rental, either on AMZN or Apple TV.

Yes, NFLX is going to change into two different specialty shops, but one of those shops will be out of business soon (do you see many stores selling CDs or records these days? DVDs will follow them). I don’t think NFLX is betting that the divided stores will outperform one big mall, but rather they are preparing for the inevitable.

Posted by KenG_CA | Report as abusive

The weirdest thing about this is that there’s an obvious case to be made for the idea that Netflix could make more profit selling a bundle. Some customers want only DVDs. (That would be me; my experiences with streaming have been uniformly negative — bad a/v sync, digital artifiacts in the picture, and of course issues with buffering so the whole program will just stop for a minute. Bandwidth in my neighborhood stinks.) Some want only streaming. But some folks want both; and when they are using one, they can’t simultaneously be using the other. A person who is watching a DVD can’t also stream at the same time. So these customers are, from the perspective of each service, going to pay a subscription fee for a service they’ll use somewhat less. A smart businessman would figure out approximately how much less, and then split the savings, making customers happy while still pocketing a bit of extra profit.

Instead, we have this total divorce of the two services, so you have two queues to manage (annoying), and your ratings are separated out, which means the rating algorithm won’t get complete input. Given that Netflix famously does recommendations than competitors like Amazon, this seems really dumb.

Posted by Auros | Report as abusive

You have to figure that some part of this has to do with the studios — that they were threatening to cut off Netflix’s rights to stream if it kept the services combined. I can’t see them doing something this blatantly boneheaded otherwise. But if that’s the case, they ought to say so, and tell customers to write to the studios and tell them to get with the 21st century.

Posted by Auros | Report as abusive

I agree with Auros. The DVD-by-mail system offends the content providers because copyright law prevents them from controlling or taxing it. It is profitable adnbut probably doomed as an inferior technologically. Hence Netflix is allowing itself to be blackmailed into cutting DVD’s loose, to protect the streaming business it has always seen as its future (note the name).

Posted by kenjd | Report as abusive

When you need to license other content from the studios, it makes it harder to leverage the Doctrine of First Sale in the physical DVD business. Hastings needs to separate the mail and streaming businesses legally and cash-flow wise so the studios can’t squeeze both businesses with one contract.

I’m guessing the conversation Hastings has with the CEOs for the studios went something like this:

Hastings: I know we are getting content on the cheap, we unbundled streaming from DVDs. Lets discuss your cut of the streaming revenues.
CEO: How about $1.50 each time you stream an IP and $1.00 each DVD that you send by mail – on top of the upfront cost of the DVD.
Hastings: I thought we were discussing the streaming revenues.
CEO: You need the streaming content. All your money is on the table now.

Posted by TurtleBay | Report as abusive

The problem for Netflix in any configuration is that it is a middleman who doesn’t control any content…and in the end it is always the middlemen who get cut out of distribution systems/supply chains.

After all there is no reason whatsoever why the people who own the content can’t provide the exact same streaming service that Netflix provides…

Posted by mfw13 | Report as abusive
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