Business Models, Experimentation, Technology

The Qwikflip 780: Netflix Trails Only HP in the New Olympic Sport of Corporate Strategy Flipping

Netflix

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A firestorm has been fanning across the interwebs over the last couple months as Netflix has made a series of changes, culminating in the announcement from CEO Reed Hastings that they are splitting up the company — and then a follow-up announcement that said, “Actually, just kidding everyone, we aren’t.”

To rewind for those of you that are not Netflix subscribers or avid follows of technology news, when Netflix introduced movie streaming in 2007 (at first via the PC and subsequently via TVs and a growing array of mobile devices), they did so without charging customers any additional fees. If you were a Netflix subscriber already, you just got this new service and could stream an unlimited amount of movies for the same price you were already paying. The only downside was the selection, which was (and remains) not as good as their selection of DVDs.

Of course, Netflix was trying to drive adoption and get customers used to the service so they could later charge them for it. Additionally, they wanted to reach a critical mass in terms of audience, which would allow them to go back to the studios to negotiate for more content. But most importantly they understood that this was the direction that the market was going, and they either needed to get in front of it or they would be steamrolled under it.

As Hasting puts it:

For the past five years, my greatest fear at Netflix has been that we wouldn’t make the leap from success in DVDs to success in streaming. Most companies that are great at something – like AOL dialup or Borders bookstores – do not become great at new things people want (streaming for us) because they are afraid to hurt their initial business. Eventually these companies realize their error of not focusing enough on the new thing, and then the company fights desperately and hopelessly to recover. Companies rarely die from moving too fast, and they frequently die from moving too slowly.

Netflix should be commended for making enormous investments in what was, in 2007, an emerging technology. And their bet has paid off. Netflix is now the single largest source of Internet traffic in North America (granted, feature-length videos take a up a lot of bandwidth, but still not too scrappy a statistic). Netflix is the only paid service to crack the Top 10 streaming sites, ahead of competitive behemoths like Apple and Amazon.

Except that Netflix was not, until recently, a paid streaming service because their streaming service was, as noted above, bundled with DVDs by mail. So, five years after launching the service, Netflix decided that it was now time for streaming to stand on its own two feet and become a paid service of its own.

So they unbundled streaming from DVDs by mail.

Which is what ignited the firestorm. Or rather, their new unbundled pricing did.

Previously with the bundled plan, a customer could purchase a $9.99 service that included unlimited streaming plus one DVD at a time by mail. In the unbundled scheme, the streaming service is $7.99 and the DVDs by mail service is $7.99, resulting in the same services for 60% higher than previously paid. Users did the math (actually, Netflix did it for them) and many came to the conclusion that they were not happy with the change.

The uproar has been much bigger than expected, with more Netflix customers cancelling their service than predicted. Overall, Netflix is down 1 million subscribers from where it thought it would be, which has put Netflix’s stock price in the toilet.

To be fair, we would be wise to recall where we would be without Netflix. If you are anything like me, you likely used to pay more than $7.99 a month in late fees to the video store before Netflix came along. For ridding the planet of late fees, and Blockbuster Video along with them, Mr. Hastings should be given a Congressional Medal and a Nobel Prize. If Netflix is charging me $15.99 (assuming I still want DVDs), I’m still better off than I was during the dark days of 1980-2000 when the Land of Mordor had an outpost in every town and city in the form of a chain video store.

I also feel I should point out that that Netflix is the victim of its own high bar. If I provide a service whereby, for $10 a month, I send a Swedish masseuse to your house on a flying unicorn to provide a one-hour massage and a gallon of calorie-negative ice cream that actually causes you to lose weight while eating it, and after five years I want to separate the two services and charge you $10 for the ice cream, you are probably going to complain. People are like that.

In the midst of this firestorm, Netflix issued a bit of an odd mea culpa. In it, CEO Reed Hastings apologized for bad communication (but quite explicitly not for separating the services nor for the pricing changes) and then went on to announce they are splitting up the company, with Netflix retaining the streaming service and a new company, unfortunately and yet predictably named Qwikster, handling the DVDs by mail — which fanned the flames yet further.

Then, a week later, in response to the protests from customers, or the lackluster response from the market, or perhaps the shake of a Magic 8-Ball sitting on his desk, Hastings issued another message saying that, upon further reflection, he was not going to split up the company (at least not this week), thankfully sparing subscribers from ever having to utter the phrase “I’ll have to put that one in my Qwikster queue” to co-workers around the water cooler).

As this week could bring yet another 360, or a half-turn, or even a Double McTwist 1260, I thought it might be time to lay out the case for and against splitting up the company (also because I have now revised this post three times due to the back-and-forthing, and it is time to get this analysis out the door).

The Case for Splitting the Company Up

  • Escaping the Innovator’s Dilemma

It is obvious from the paragraph quoted above that Hastings has read “The Innovator’s Dilemma” and “Only the Paranoid Survive.” He understands that Netflix is at an inflection point and that they need to move completely to streaming at some point in the near future. But it’s extremely difficult to pivot a company away from a strong revenue stream even if you know that revenue stream will be dwindling in the future.

Netflix managed to initiate this pivot by making substantive investments (with no return) for five years because they believed this was where the market would end up. Breaking up the company is taking a big step further and (to mix my metaphors) is akin to burning the boats on the shore. But as Christensen documents again and again in “The Innovator’s Dilemma,” not taking this kind of decisive action can result in getting blown past by your competitors as they plunge headlong into a market you are only dipping your toes in. By the time you get up to your waist, the race is over.

  • Raising revenue and the long-term value of their shares.

Despite all the reaction from Wall Street, it turns out that losing a million customers is a good deal for Netflix. Let’s say each of those subscribers was paying $9.99. That means they are down $9.9 million per month. However, they have 12 million people that are paying them $5.99 more per month, which means their overall revenue is up $61.9 million per month or $744 million annually. Also, Netflix was pretty accurate in their forecast for how many subscribers would opt for their streaming service, which is the future of their company. Their projections were only off to any significant degree on the DVDs by mail service, which they are transitioning away from.

So overall, Netflix has done pretty well. It has continued to invest where it thinks the market is going and has been rewarded with a $774 million bump in revenue for its perseverance, with all of the increase landing on the streaming side of the house. Over the next five years, the DVDs-by-mail service will likely see its subscriber base erode further, and breaking up the company might be prudent so that the DVDs-by-mail decline will not drag down Netflix’s stock price.

  • Ensuring their customers continue to receive a high level of service

By focusing 100% on streaming, they are likely to make further strides in terms of the streaming service than they would with a split service model and two foci. It is a bit of an Applesque move. When Apple decides that one technology will replace another, they bet on the future and dump the old technology, even if a lot of people are currently using it (e.g., Flash, floppy drives, and more recently CD drives). It can be frustrating, but it focuses the company the future, saves time and resources spent on retrofitting for technology they believe is going away, and ultimately helps move the market along faster (we are seeing the innovations in HTML 5 today largely because iOS devices forced developers to start moving away from Flash). In this vein, by jettisoning their DVDs-by-mail business and pushing full-steam toward where they think the market is going, Netflix is going to provide a better steaming service and keep further ahead of their customers.

The Case for NOT Breaking up the Company

  • Makes consumer conversion easier

Netflix still has 14.2 million DVDs by mail customers. Many of them may not yet be ready for the conversion to a streaming-only service. By splitting the company, it might be harder to convert those customers who still want DVDs to streaming over the next few years. By keeping those customers, Netflix can continue to develop and deploy incentives to convert this customer base.

  • Gives a short-term advantage vis-à-vis Apple and Amazon

Netflix has two of the fiercest possible competitors for its streaming service in the form of Apple and Amazon. Its DVDs-by-mail service is a differentiator and one that these competitors don’t support. For the 14.2 million customers that still want the DVDs by mail service, Netflix is the only option. When these customers drop the service and move to streaming-only, Netflix will be a good position to convert them. These customers likely have relationships with Apple and Amazon already. If Netflix pushes them over to a new company — even a sister company — they remove some friction for Amazon and Apple.

  • Buys time to improve selection

The big problem that Netflix has in converting customers to streaming-only is that their streaming selection is not as good as their DVDs by mail selection. And it just got worse as they recently lost a renewal deal with Starz, their largest source of new releases. Until this changes and they are able to match their DVDs by mail selection, they are going to find it hard to convert many customers. Maintaining the DVDs by mail service under the same roof buys them some time to do just that.

  • Avoids use of the name “Qwikster”

Enough said.

What would you do?

 

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About Michael Clarke

Michael Clarke is the Founder and President of Clarke & Company (www.clarke-company.com), a management consultancy focused on digital information strategy, product development, and marketing related to professional and scholarly publishing. Prior to founding Clarke & Company, he was Executive Vice President for Product and Market Development at Silverchair Information Systems. Additionally, Michael has held positions at the American Medical Association, the American Academy of Pediatrics, and the University of Chicago Press. He currently serves on the board of directors for Silverchair Information System, the Society for Scholarly Publishing, and the Council of Science Editors. A graduate the University of Colorado and the University of Chicago, Michael is a frequent contributor to the Scholarly Kitchen.

Discussion

8 thoughts on “The Qwikflip 780: Netflix Trails Only HP in the New Olympic Sport of Corporate Strategy Flipping

  1. Come on, where’s the proper respect for “Strong Leadership”? …. that which Americans demand of the their president, for example. You know — “I’m not going to change my mind just because i have new information that shows we are going in the wrong direction.”

    Personally I respect new information more than I respect dogmatism so I think Netflix deserves some plaudits for changing its mind.

    I also think they are now on the right track. Breaking up the company does nothing for customers. The solution to the innovators dilemma is to understand the innovators dilemma and manage the internal operation of the company — and not corporate butchery that harms customers. For example, if you want focus on a particular aspect of the business, organize and incent the company to focus on that aspect. Isn’t that what executives are paid the big bucks for?

    The benefits of breaking up? “breaking up the company might be prudent so that the DVDs-by-mail decline will not drag down Netflix’s stock price.” Translated that says “because Wall St is too dumb to look past the bottom line growth number”.

    Posted by Dave Pullin | Oct 19, 2011, 8:05 am
    • As Emerson said, “A foolish consistency is the hobgoblin of little minds…” Indeed. I agree that it is a fool that fails to change/his her tack in response to market conditions. Strategy is relative to the environment in which you find yourself — if that environment changes, your strategy needs to as well.

      Also agree that anyone who dumps a stock the day after the company unveils a strategy to raise revenue by over $700 million while protecting the long-term value of the company should not be entrusted to trade stock. But that is Wall Street today.

      There is a difference between changing strategy in the face of environmental changes, however, and flailing about. Netflix may have ended up in the right place, but if you are going to break up the company (or not break up the company) those decisions should be carefully weighed and presented to customers (and shareholders) via a thoughtful and well executed communication campaign. You don’t just make an announcement on your corporate blog and then reverse it the next week via another announcement.

      It might be the corporate communication office and the not the strategy office that bungled this one but it is still a miss.

      Posted by Michael Clarke | Oct 19, 2011, 11:17 am
  2. A few additional data points might make the picture clearer:

    The really big reason Netflix had to make this split is speculated to come from a different licensing scheme now being enforced by their movie studio partners:

    Netflix has for the past several years been negotiating with Hollywood for the digital rights to stream movies and TV series as a single price subscription to users. Their first few deals were simply $X million dollars for one year of rights to stream this particular library of films. As the years passed, the deals became more elaborate, and the studios began to ask for a % of the revenues. This likely started with a “percentage-rake” type discussion, but then evolved into a simple $/user discussion. Hollywood wanted a price/month/user.

    This is the point where Netflix tried to argue that you should only count users that actually connect digitally and actually watch a film. While they originally offered digital streaming bundled with DVD rental, many of the rural customers likely never actually “connect” to the digital product. This argument may have worked for a while, but eventually Hollywood said, “No way. Here is how it is going to work. You will pay us a $/user/month for anyone that has the “right” to connect to our content – regardless of whether they view it or not.” This was the term that changed Netflix pricing.

    With this new term, Netflix could not afford to pay for digital content for someone who wasn’t watching it. This forced the separation, so that the digital business model would exist on its own free and clear. Could Netflix have simply paid the digital fee for all its customers (those that watched and not)? One has to believe they modeled this scenario, and it looked worse financially (implied severe gross margin erosion) than the model they chose. It is what it is.

    Also, one of the main complaints about the split was that users who wanted both DVDs and streaming now had to manage two separate queues on two separate sites. Had Netflix done a better job with their user interface and allowed customers to manage one queue for both services, the outrage would have been a lot smaller and they might have pulled this off.

    Glad you mentioned Apple here as a company that’s long been willing to “knife the baby” in order to move their business forward. Though unlike Netflix, they trust in their vision and don’t seem afraid to face criticism.

    Posted by David Crotty | Oct 19, 2011, 8:29 am
  3. That is helpful background. Though it still doesn’t explain the “we’re splitting the company up!/oh wait just kidding” response. I understand that they needed to split up the services but this does not seem to require two separate brands (Netflix/Qwikster) never mind two separate companies. That beings said, there are other reasons for splitting/not splitting up the company though it would seem to me those reasons are as valid today as they were a few weeks ago so the mystery is in the careening about like a drunk teenager on a go-cart course.

    Posted by Michael Clarke | Oct 19, 2011, 11:24 am
  4. Gentlemen, is Wall Street really dumb? What have you described here? Here is a successful company that has developed (for a short period of time) a very successful and profitable business service. As often happens in the tech world, along comes a new technology that disrupts this model. The one lesson that I have learned over the past twenty years – at least in tech sensitive industries – five years is a life time. I might buy Coke and hold it until I retire (they are unlikely to come up with an App that will replace Coke). But as for Apple, Netflix, Microsoft, IBM, et. al. well, these companies have a shelf-life and a short one at that. Apple is flying high at the moment but 13 years ago it was on the verge of bankruptcy. Ten years ago Nokia was the belle of the ball – now it is a has been, same goes for RIM. I wish I had bought Netflix ten years ago. If I had, you could rest assured I would have sold it back in 2007 – when they entered digital streaming. The right lesson to be taken from this story is not that Wall St is stupid. Wall St didn’t get to be master of the universe by being stupid. The real lesson is: it is time to sell Apple.

    Posted by Mark Danderson | Oct 19, 2011, 4:20 pm
    • Yes, the big elephant in the room with regard to Netflix’s long-term viability is Apple, Google (including YouTube), and Amazon – and anyone in a garage that come up with a disruptive idea as indeed Apple and Google both did once upon a time.

      The barrier to disruption thus far has been Netflix physical infrastructure with regard to DVDs-by-mail (which obviously goes away in a streaming model) and the complexity of negotiating with the studios – though Apple and Amazon are already doing that.

      It may or may not be time to dump Netflix (and/or Apple – though I suspect Apple has enough of a center of gravity and Jobs-approved product pipeline to go for a while yet) but that long-term viability has nothing to do with the sell-off triggered by Netflix recent moves. I suspect, as Kent notes below, that Wall Street has long confidence in management due to their communication tactics – just like many of their customers.

      Posted by Michael Clarke | Oct 19, 2011, 7:14 pm
    • “Is Wall Street really dumb?” A variety of answers of different length with differing levels of snark.

      tl;dr:
      Kinda.

      Short and snarky:
      Well, how many Wall Street analysts declared the iPhone 4S a horrible disappointment or a “remarkably sucky, shoddy, sloppy, slapped together disaster of a phone.” How accurate a measure did they have of consumer interest that they were willing to dump enough Apple stock for the share price to fall $12 during the event?

      Apple announced this morning that it sold more than 4 million iPhone 4S units over the weekend. That is an Apple record, a mobile phone record — according to Apple — and maybe even a consumer electronics record.

      You make the call.

      Medium length, less snarky:
      Wall Street is not dumb, but it is often, very often wrong. In nearly every transaction, there’s a winner and a loser. Anyone who sells a stock for less than they paid for it, anyone who sells a stock before it goes up in value is essentially wrong when compared with the other half of the transaction. To buy low and sell high, someone must axiomatically be selling low and buying high. Wall Street is full of all sorts of mistakes so I don’t think they’re the place to look for wisdom.

      Lengthy and better-thought out:
      Wall Street is not dumb, it just has a different set of priorities than what we’re speaking of here. We’re talking about building a business and long term health of a company. Wall Street has morphed into a hacker’s paradise, a game that’s set up for people to try to find an edge and generate instant profit. It no longer serves the purpose of providing investment capital for building a business:

      The only people who know what business Wall Street is in are the traders. They know what business Wall Street is in better than everyone else.  To traders, whether day traders or high frequency or somewhere in between, Wall Street has nothing to do with creating capital for businesses, its original goal. Wall Street is a platform. It’s a platform to be exploited by every technological and intellectual means possible.

      The best analogy for traders? They are hackers. Just as hackers search for and exploit operating system and application shortcomings, traders do the same thing.  A hacker wants to jump in front of your shopping cart and grab your credit card and then sell it.  A high frequency trader wants to jump in front of your trade and then sell that stock to you. A hacker will tell you that they are serving a purpose by identifying the weak links in your system. A trader will tell you they deserve the pennies they are making on the trade because they provide liquidity to the market.

      The long term health of a company is of little interest to someone who is buying and selling over the course of microseconds.

      As you note, Wall Street did not get to be master of the universe by being stupid, Wall Street got to be master of the universe by wisely donating enough money to the right campaigns to get nearly all of their actions deregulated. If they were wise and cared about long term financial health, would our economy be in the situation it is now?

      As far as tech investments having a shelf life, Apple incorporated in 1977 and its stock just hit an all-time high. Is 34 years a reasonable shelf-life for a stock? What about IBM which dates back to the late 19th century? Remember how they were wiped out of relevance by Microsoft? How’s IBM’s stock doing these days?

      Posted by David Crotty | Oct 19, 2011, 8:30 pm
  5. I think one lesson of all this is that Oscar Wilde was wrong — not all publicity is good. Why you’re in the news matters. The Netflix brand has been tarnished by these vacillations, and people who were proud to be associated with the brand were given reason to reconsider their loyalty. Netflix had customers on their side. Now, I think that’s been diminished. There still may be a switching cost keeping people from leaving Netflix, but it’s better to never ask your customers to start evaluating that cost actively.

    Posted by Kent Anderson | Oct 19, 2011, 5:15 pm

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