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”
What would you do?