19 September 2011

Old Neflix = New Netflix + Qwikster?

Reed Hastings, CEO of Netflix, has had a bad few months and he probably made his situation worse today.

A short time ago, the company enjoyed great growth, great word of mouth and, not surprisingly, a frothy stock price. Then he made the decision to upset the apple cart -- separating the streaming and DVD-by-mail businesses, effectively raising the price dramatically (60%) for the most popular combination package.

I've covered the motivation for the changes in this earlier post and another commentator did a nice job on the same subject. Irrespective of the motivation, the changes were not well received.

Today's news, delivered by Hastings via email to Netflix subscribers and blog post, is an explanation/apology -- not for raising the prices, but for communicating poorly.  And the "solution" Netflix is providing is to split the DVD-by-mail business off into its own brand and website: Qwikster.

Uh, that's not a solution, that's a bigger problem.

As a subscriber to both -- which I think should be a good thing for N+Q and behavior it should reward -- this reduces the functionality of the services. Now I have to search in two places for the content that I want.  I have to log into two sites to check my queues.  It is a significant step backwards for user friendliness with no offsetting consumer benefit.

So why do it?  I do agree that this will make it easier to talk about the two parts of the company. If the company is going to spin-off the Qwikster business, the new brand name and division makes sense.

However, I'm not sure the spin-off makes as much sense.

The great thing about the DVD-by-mail business is that there is a natural marketplace constraint on the cost of content. Netflix, er, Qwikster, always has the option to buy DVDs at retail prices and is then not subject to the studio's request for a 28-day holdback.  This option sets a floor for "how bad a deal" Qwikster can get in any content negotiation.  That's not that bad a floor -- to the extent a studio raises retail prices on DVDs, it impacts its sales -- it has a natural equilibrium.  With the 28-day holdback, Qwikster always has something with which to negotiate for a more favorable price per DVD (it could even offer a longer holdback to get a better price). Note that for newer titles Netflix usually does not provide a retail DVD version of the movie (with the DVD extras), but a vanilla disc with only the movie itself, another concession the studios can only earn at the bargaining table.  The DVD-by-mail business also has wonderful barriers to entry -- it is expensive to run warehouses and process all this mail. It is true that the physical disc sales business is probably mature, but that's been true for a long time.  Negotiating for content is always easier when you are a bigger customer. The risk of a shutdown of the postal service is probably manageable.

The streaming business was an easy win for Netflix in the short term, but I'm not sure that is the case in the long term. It appears that Netflix thought, perhaps naively, that they could pass along the postage savings to the studio and make everyone happy. However, anyone who has dealt with the studios knows that they are rarely happy for long. Streaming Netflix has to negotiate for all content with no floor.  This means that it is likely there will be content interruptions as the parties try to sort out appropriate pricing. There are small barriers to entry into the streaming business -- a competitor only need to create a website and an app to run on Roku or an Internet-connected TV or Blu-Ray player. Several companies already have this infrastructure (e.g., Amazon, Apple/iTunes, Walmart/Vudu, Sony/Crackle, BestBuy/Cinema Now, Dish/Blockbuster). While Netflix has scale advantages on all of its competitors now and for the immediate future, none of the studios have any interest in providing Netflix sustainable competitive advantages in this arena. A spin-off also breaks a bigger customer into two smaller customers which is not usually advantageous in a negotiation. The over-the-top streaming business also has the looming threat of user bandwidth caps becoming widespread in the US (the way they are already in Canada). If you are a studio, you want the streaming business to have several viable options for consumers, all of which compete fiercely with each other for market share and make do on slim margins.

Streaming may be the future, but that barreling towards that future might be premature.

My former colleague Will Richmond did a fine job summarizing this several days ago:  "It's still a mystery to me why the company felt compelled to split its services and hike prices so quickly given the clear benefits of the DVD plus streaming value proposition that nobody else could offer. Even more puzzling was that the price increase offered zero new value as an offset. For 2 years, no company has epitomized the potential disruption of the video industry more than Netflix. Now the tide has turned and Netflix must confront its own challenges."

Today, Netflix added a few more challenges for itself to confront.

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