Why Reed Hastings Should Be Applauded For The Netflix Split

By now you probably know that Netflix is splitting its business into two parts: its digital streaming business (retains the name Netflix) and its DVD mailing business, which was its original business (to be called Qwikster).

If you haven't read Reed's explanation of this split make sure you read it (of course, after you're done with this post here. It's simply brilliant.

1. He acknowledged mistakes in his past communications and apologized
2. He offers a transparent explanation of his business and;
3. [most importantly]—It's a great strategic decision.

With nearly 25 million customers using Netflix it's clear that everyone will have an opinion on this. And many short-termists will think it's a bad idea. Indeed, my Twitter stream tells me so. I find much of the criticisms so far fairly reactionary. I would like to take the opposite side of that debate.

If you haven't read my post on the Future of Televisionand the Digital Living Room you might enjoy that as a primer. In it I talked about how I believe that Netflix has a very strong lead in the battle for the "head end" of the digital living room. Right now they're the leading platform for streaming movies. Hulu is the leading player for streaming television.

Frankly, I'm surprised Netflix doesn't buy Hulu. In my opinion it's the most natural fit and it would give Netflix a very strong presence in Los Angeles and in TV (obviously subject to getting the right rights from the studios).

So why on Earth should Netflix split into two businesses?

1. Solving the Innovator's Dilemma
In his seminal book The Innovator's Dilemma, Clay Christensen talks about why industry leaders almost always fail to act when "disruptive change" enters their business. He defines this as new products that are dramatically cheaper, lower quality, lower margin, but larger markets. Incumbents can't react.

If you haven't read his book please do yourself a favor and buy it. It's the most profound book I've read on thinking about how the Internet is changing business. Period. But for now feel free to read my short summary of the key principles.

The reason that incumbents can't react is that their revenue and defensibility are continued by serving the high end of the market for which it would take too much time and money for any competitors to effectively challenge. In Netflix's case this is their DVD distribution business. It's hard to imagine somebody else being able to effectively compete with that.

But the real threat comes from the change in technologies that rule the old business obsolete. Streaming. It's clear that in the future movies and TV will be delivered to our homes from the cloud. Indeed for many this is already the case.

To win the future he needs to attack his core assets by building new ones. Very few companies ever do this. It would be like if Microsoft undermined its Office franchise by aggressively pursuing a Google Docs-like strategy. Yeah, I know they did, but too little, too late, too lame.

2. Improved Focus
By having two separate businesses, each with its own CEO and own teams, they can focus on their two very different businesses and develop the right strategies for each. The Qwikster team can't make any excuses for not hitting their numbers and can't argue that their resources are being funneled onto streaming projects.

The execs of Qwickster have got to continue to sell the merits of that DVD business—the most notable of assets is the much deeper library than the streaming business.

Equally, the streaming business has got to accelerate content acquisition, focus on customer retention, improve streaming technologies to make it better for users/worse for competitors, and they've got to continually improve the UI.

3. DVDs Aren't Dead Yet
As Mark Twain would say, "The reports of my death are greatly exaggerated." We all predict that technology change will cause obsolescence of previous technologies much more quickly than they actually do.

MapQuest was (and is) a much shittier product than Google Maps, yet people used it for years. It defied logic. People still pay for AOL dial up years after they no longer need to. And many people actually still use Evite. Crappy. Old. Evite.

Many people are happy to receive their regular DVD mailers and for these people (still 14 million subscribers!) this service will continue.

4. Pricing Right
As fewer people take the DVD service over time, there will be less revenue to cover the relatively high fixed cost structure of the mailer (Qwikster). So it wouldn't be a surprise to see price increases in Qwikster in the future. No time soon. But eventually. It seems logical.

And what about streaming? This business will adapt, too. Who says that "all you can eat" pricing is the right one for a streaming service? Maybe it is, maybe it isn't. In the DVD world they could always limit you because you could only have a certain number of videos outstanding and any time. With streaming, this is harder to enforce.

Plus, content rights are harder to secure for streaming. If you haven't followed this check out what's happened with Netflix's biggest content partner, which has withdrawn from the service.

It's possible that the best structure in the future is PPV (pay-per-view) or different tiers of content pricing (i.e. new arrivals plus library versus just library) or even create channels (i.e. kids movies priced as a separate package). Who knows?

Separate businesses allow them to play around with different pricing models without affecting the other business line.

5. Transparency for Investors
I also love the transparency that is created when you have two businesses that will move in opposite directions, have different strategies and different economics. For investors this is huge. As Dan Frommer pointed out, all of the news reports on Netflix said that they had lost 1 million customers from their recent price increase. In fact, they are projected to only lose 200k streaming customers (800k DVD).

6. Positioning for the Future
It's rare in business to see somebody like Reed Hastings tackle the massive changes happening to their businesses and deal with them before it's too late. Imagine if the record labels had been as bold. By making the separation, Reed can now point the Netflix business squarely at the future. Netflix can stop having to answer questions about its DVD business.

A note for the industry

I argued ages ago that Yahoo! should have come out early and said, "We lost the search war to Google but we still have a have a great media business and we're going to focus on that." They dithered for years. Imagine if Carol Bartz or the Yahoo! board had had Reed Hasting's clarity and boldness.

When Fox first hired its triumvirate of CEOs to run MySpace after the founders' departure, I argued the same. Announce you've last that battle and that you're now focused on a narrower business for gamers and for music. Instead the press story for two years was about how they were losing to Facebook and continuing to hemorrhage revenue and people.

Reed is showing the cojones that so many others haven't.

Any Hollywood studios taking notice?

What do you think about the Netflix decision?

Reprinted from Both Sides of the Table

Mark Suster is a 2x entrepreneur who has gone to the Dark Side of VC. He joined GRP Partners in 2007 as a General Partner after selling his company to Salesforce.com. He focuses on early-stage technology companies. Follow him at twitter.com/msuster.

[Image: Flickr user tricky]

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14 Comments

  • Jason

    There's nothing in this analysis that couldn't have been done with having a DVD division and a streaming division, with separate leadership, but tied together by Netflix's largest advantage:  the single queue and it's immediate attendants -- the recommendation system and search function.

    In addition, by divesting itself into two companies, Netflix moves from being an 800 lb gorilla to a couple of 200 lb gorillas.  The two companies no longer have the clout to effectively deal with the content providers, especially when you have giant telecom companies trying to get in on the streaming action, as well as other places like Amazon or Apple, who can bring a lot of consumers (read: revenue for advertising or direct payments).

    It is considerably easier to convert or upgrade existing customers who are already satisfied through a variety of means -- promotions of all kinds, discounts, free trials, referrals, etc.  Setting up name recognition for a new company and converting (and keeping) subscribers is difficult, and Netflix has opened the door wide for Someone Else to take advantage of going somewhere else -- either in the streaming business or the DVD business since there is no such thing as the unified queue, unified billing, etc.  Netflix seems to be on quite a "slash and burn" course to alienate their rabid customer base and make them look for alternatives.  Considerable analogues to New Coke come to mind.

    You also seem to ignore the single-brand success stories that are making profits hand over foot without breaking themselves up for silly reasons.  I can go to Amazon and buy toothbrushes, MP3 tracks, books, e-books, streaming video, grills, spin up a server on EC2, store my music in the cloud and about a billion other things.  I really don't care about the internal logistics of the business -- I let Bezos and crew figure that out.  I'm hoping they don't decide this "breaking ourselves up" is a fine idea.

    There are also similar stories at Apple, where the iPod, iPhone, PC's, software, laptops, Apple TV, iTunes and the iPad are all under the Apple brand and sold from one place.  I don't know what business units are running at Apple, and frankly, I don't care.  I give them money and they turn it into success.  Apple also has a history of killing off product lines or making radical shifts in product direction -- but they carry on with everything under the Apple banner and it's very rabidly-protected brands and trademarks. 

    Analogues also exist at Google and many, many other companies who fought for years to develop brand recognition and who do everything possible to retain what makes them unique.  John Deere has a particular shade of green that's instantly recognizable on anything from a string trimmer to a giant tractor.  For a while, at least, Netflix had that very recognizable shade of red that was consistent if you were getting a DVD from the mail or watching streaming video.  But now for some reason, they are throwing that all away.  In a world where brand recognition is so key, I really can't fathom why this is a good long-term strategy.

  • Andrew Case

    I just got a $829.99 iPad2 for only $103.37 and my mom got a $1499.99 HDTV for only $251.92, they are both coming with USPS tomorrow. I would be an idiot to ever pay full retail prices at places like Walmart or Bestbuy. I sold a 37" HDTV to my boss for $600 that I only paid $78.24 for. I use (Bidsget) . (com)

  • MichaelADeBose

    Nothing you mentioned discusses the consumer experience. It's a simple formula. Type in one title in one place and you're told which formats that movie is available in. I don't mind the added expense, what I don't like is the added complexity and that's the big dilemma. I don't see myself sitting around and checking one and then the other especially having already experienced the simple bliss of the original proposition. I'm already up in arms because their lazy programmer haven't gotten around to giving me the option of adding something to my queue and adding it to the top of my queue concurrently so I can choose once and move on instead of the current process where these options are facilitated needlessly in serial.

  • Jason Siebert

    Also, I was SO close to getting my mom to use Netflix on her new iPad she is totally not going to pay for another service to do this. NICE GOING!

  • Jason Siebert

    I don't see how splitting the company up changes anything for the better. This would essentially be like if I ran a video store in the 1980's and decided that I was going to have one store on the north side of town that rented VHS and another store on the south end of town that rents BETA. Maybe this will work itself out in the future but the issue today is that streaming doesn't have the selection that the DVD business has, so now if I get tired of my streaming only account I have to start a new account with a different company and manage a second queue. Where originally I just clicked ADD TO QUEUE and it showed up in my mailbox.

    If you want to convince people to switch over to streaming then why not bundle the services together and give them the chance to get used to the idea? Giving your DVD customers Quikster is only going to make them stick to it harder.

    All business mumbo jumbo aside, IF IT AIN'T BROKE DON'T FIX IT!!!

  • ethan vyce

    wow. terrible article.
    1. Splitting a company in 2 (sort of) is not innovation. Change for the sake of change is not helpful.
    2. They could maintain two teams, "each with its own CEO and own teams" and still maintain a single customer facing site.
    3. Four sentences about Evite in an otherwise useless paragraph. OK then.
    4. Reed said no more price increases. I'm going to trust him on that. And really nothing to do with splitting the business.
    5. The company (and stock) is not actually splitting up so their will not necessarily be any more transparency for investors. Even if there is the same could be accomplished with out the web site split.
    6. Sure, makes sense, again though not sure why the web site has to be split to accomplish this.

  • David Kaiser, PhD

    It was certainly a bold move, and in general, I prefer bold to timid. We'll see how it pays off. I am curious about Netflix future, I wanted to watch a movie while folding laundry last night, and the first three titles I put in were unavailable. Not good, guys. 

    BTW, I haven't had to run an event for a while, what is out that's better than Evite?

    David Kaiser, PhD
    Executive Coach
    www.DarkMatterConsulting.com

    Every Hero or Heroine has a Guide:
    Arthur had Merlin
    Luke had Obi-Wan
    Buffy had Giles
    You have Me

    Time to be Extraordinary!

  • aaeon

    It sounds like a good decision from the business side.

    For the customer, and for Netflix's competitive moat, it is a huge blunder IMO.

    Having one queue to manage your movies was Netflix real value.  Other streaming services may come and go but if you've invested time curating your "want to watch" list on Netflix, it keeps you loyal to the service.

    Customers don't want two bills, two queues.  It is a totally brain dead move.

    Customers want a single place to manage and watch all movies.  Any device.  Any media.  DVD is guaranteed to be an important part as long as studios play hardball with licensing fees.  Does anyone think that is going to stop happening?

    Everyone knows Netflix's streaming catalog is lacking in major ways.  And they are dropping some content (Starz Play).

    So this reorg seems like an obvious brain-dead move to me.  If I have to manage my movie list somewhere else now, why not just pick a competitor.  

    All of this is on top of a history of pissing off customers more and more.

    Netflix needs to do one simple thing, ask "What does the customer want".  

  • A.J. Horst

    I don't disagree with Netflix internally splitting itself into two divisions. What I and many other people think is a boneheaded decision is that they are disintegrating the two services. Half of Netflix's customers, even after the price increase, subscribe to both services. These customers now pay for a less valuable product.

    The splitting of the DVD and streaming services will force customers to
    go to two separate sites, manage two separate ques, use two different
    rating systems, search with two separate search engines, and pay two separate bills. fail, fail, fail, fail, and fail. Netflix is also an extremely valuable brand. Why throw it away for the DVD service that made the brand what it is? They'll have to spend millions on advertizing to make up for the lost brand awareness alone.

  • KPR

    I have to disagree here. Convenience made Netflix the brand it is today. Not DVD's. Netflix has always been about getting you entertainment as fast and as easily as possible. Foresight tells us that it's only a matter of time until DVD's, as a medium, fall by the wayside to online based streaming options. To say they're throwing their brand away by acknowledging this and focusing on the future seems a bit overdramatic. 

    And Netflix will continue to spend money to advertise Netflix. Not Qwikster. Netflix is their bread-and-butter. Streaming content is the future. They may lose some subscribers because of the split but I'd be willing to wager a decent chunk of change that Netflix is on a path to even more success in the future. 

  • Jason

    How does splitting up into two separate companies with a non-integrated queue make this more convenient for the customer?

    I am sure that Netflix would like nothing more than to be able to stream every movie in their DVD collection and do away with the DVD business in it's entirety.  That's a nice vision, but licensing agreements with the studios, technological limitations (server capacity and bandwidth on the Netflix side, as well as consumer side issues (bandwidth caps, bandwidth limitations and ability to get HD content because of the previous two) means that DVDs are still going to be going out in the mail for some time to come.  They might even become more popular as ISPs try to move away from the "all you can eat" model to a "capped transfer" model.

  • Daniel Ogren

    To further elaborate on this thread, one of the
    primary decisions I make relates to the availability of the content for
    streaming. This requires a single view of all content and the tagging of the
    content as DVD and/or Instant Queue. If available for streaming, it goes in my Instant
    Queue. If only available as DVD, it goes to my DVD queue. If while in my DVD
    queue it becomes available for streaming, I move it from one queue to the other queue. As mentioned above, if Netflix
    truly separates the website into two sites and they do not offer a unified, integrated
    view of the content and queues, they will become even harder for customers to
    do business with. Until Netflix is able to negotiate more current content through
    steaming, customers seem to be losing out in this strategy. Reed Hastings should
    have a conversation with Tony Hsieh from Zappos.com about delivering happiness
    to customers rather than applying a private equity strategy of breaking up the
    business into multiple pieces.

  • Murray Jankus

    The advent of Netflix was a boon to customer choice, especially in providing a repository for older movies and uncut versions that cable won't show and no one but true devotees can afford to collect. 

    Now they've reduced customer choice (if only in the immediate decisions concerning how to view at least for now) and they've raised the cost of what is already a modern burden on household budgets.

    They've also made it much easier for the studios and distributers to abandon and then destroy the rich heritage of cinema that was rapidly being lost before they started. 

    It's Disnyfication. Put a classic title on sale, as if there were a fixed supply, and then kill it, so only the rich or eccentric will have access to it in the future. 

    Art and intellectual effort are not industrial products or commodities. It makes sense to treat a refrigerator as a machine that will become obsolete. 

    Without corporate commitment, the great titles will disappear as surely as avocado colored kitchen appliances. 

    This may be a great move for Netflix shareholders in the short and intermediate term.

    It bodes ill for an important part of our national culture—no matter your tastes.