Why Netflix Split Off Its DVD Service, And What It Means For You

Netflix stirred up the hive a bit last night by announcing that they would be splitting their DVD and streaming services into separate entities, not just separate pricing structures. The move was accompanied by a rather heartfelt and surprisingly candid blog post from CEO Reed Hastings, in which he describes the change as possibly being “too fast”. The tone is apologetic and mournful over the reaction to the price hike. This is a good sign.

Netflix made waves in the last couple months by announcing their largest price increase yet. If you wanted to keep the DVD service and still get unlimited streaming, your monthly cost would jump from $10 to $16. Alternatively, you could choose either service individually and pay $8/month, which was actually a decrease in price, but also a decrease in services. Assuming you used both. For those who paid the $10/month and never actually got any discs (yours truly included), it was a discount.

The move sparked a lot of controversy. At the same time, there were also a lot of people ready to defend Netflix. Nobody likes price hikes, but as they go, this was one of the least harmful. $6 per month is a pittance compared to other monthly content services (*coughcablecough*), and the option to actually decrease your plan was seen as consumer friendly by some folks. That is a feat in itself. The fact that the CEO is expressing regret over displeasing a minority of customers is a refreshing change of pace. In most other areas of the tech world, the most forward-thinking CEOs seem to trade on pissing off the minority. Apple’s move to ditch Flash, Google’s approach to Android updates that favor “those that can handle them”, and even the entire tablet market seem to favor serving “most” consumers, and leaving the exceptions to fend for themselves.

Not that the CEO regrets doing it, of course. Just that he regrets how it was conveyed to the customer.

So, the next obvious question is “What happens now?” In case you haven’t noticed, the streaming side of Netflix (henceforth referred to as simply “Netflix”) has reached a bit of a ceiling. Content producers are beginning to pull their content as they see how big Netflix is getting. Netflix has even, in some cases, outgrown their own contracts. Sony content was famously pulled from Netflix after it was discovered that Netflix violated Starz’ contract with Sony.

Confused yet? Here’s how it works: Sony licenses content to Starz. Within that contract, Starz has the rights to re-license content to smaller services. Netflix was among those services. However, also part of Starz’ contract with Sony is the stipulation that Starz is only allowed to stream content to so many users simultaneously. In July, Sony’s content was pulled because Netflix was streaming Sony content to so many users that it exceeded the number of users that Starz was allowed to license. It’s like Mommy and Daddy gave their son, Starz, his own credit for emergencies, then Starz’ buddy takes it and maxes out the card on hot tubs and jet skis. If that makes the content industry sound like a dysfunctional spoiled family, that’s because it is. But that’s not the point.

Which brings us to the crux of Netflix’ problem right now. Much like King Kong—if King Kong adhered to the real principles of physics—the larger Netflix gets, the harder it is to support itself. Eventually, if something wasn’t done, it could get crushed under the weight of its own streaming costs. Up until this point, the DVD Netflix service was subsidizing the cost of the streaming service. As streaming costs rise, though, the business of mailing out DVDs from elaborate and secretive service centers became less of a rich uncle, and more of a mooching stoner.

From this perspective, the price hikes actually make sense. Streaming is no longer a value-add. It’s a business in its own right. Back in the early days, you would never have bought into Netflix solely for the streaming options. Say what you will about how sucky Netfix’ streaming selection is, I can go watch Mad Men, Firefly, Family Guy, South Park, and a host of other movies and TV shows that don’t actually suck. This is a far cry from the dollar-bin-at-Wal-Mart-style selection from five years ago. And those streams cost money. Enough money to justify their own business.

If you’ve been sticking it out through this whole spiel waiting for the point, there it is. Streaming is now its own business. This is the point that Hastings wants to drive home, and the reason behind the split. Netflix can’t afford to shoehorn their streaming business into the sidecar anymore. While we don’t generally trust analysts farther than we can throw them, at least one analyst anticipates that Netflix’ streaming costs for licensing alone could increase from $180 million in 2010, to as much s $1.98 billion in 2012. For the mathematically impaired, that kind of an increase in costs is known as “a whole freaking lot”.

Splitting the businesses allows Netflix to cut costs. It also allows them to market their product as what it is: a streaming service. Internet-based video streaming has always been the long-term plan. Previously, Netflix has been cutting deals with studios based on the number of subscribers that have access to streaming video. This includes folks who get DVDs in the mail, but never touch the streaming features. If Netflix can remove those bloated numbers from their count, then they can get a bit more leeway in negotiations. Netflix likely wouldn’t have violated the Sony-Starz contract so soon if their customers who never streamed anything in their lives weren’t counted towards that total.

The split also gives Netflix the ability to show more accurately just how successful their streaming business is. In the past, Netflix could tout stats about how many of their users are streaming videos, which can be impressive. However, the doubt is always there: would this kind of growth continue if DVDs weren’t part of the equation? Now there will be no doubt. When Netflix walks into a movie studio’s meeting room to negotiate a contract, the growth of Netflix as a company will directly correlate to how much people want streaming video. Assuming Netflix can keep up the type of growth they have in the past, that will send a powerful message. That message, of course, being money. And content providers like that message.

Of course, this is also where the gamble is. Netflix is taking a huge risk here. As we’ve said, Netflix has been able to build their streaming service on the back of the DVD rental service for a while now. After the split, it will have to stand on its own. No more holding mommy’s hand. It would be kind of like if Google split off Android into its own company. The latter takes advantage of a lot of benefits from living in the former’s shadow, feeding off that never-ending cash flow for whatever exorbitant costs it might need.

Maybe it’s a good decision. Maybe it’s reckless. However, Netflix got to where it is today largely because the leadership at the company was looking forward to a day when you wouldn’t need a rental store to get your movies. When you could just fire up your computer, click, and watch. It’s something we internet folks have been wanting for a while, and the rest of the world will likely follow.

This is the part where things start getting interesting.

Source: Netflix Blog

2 thoughts on “Why Netflix Split Off Its DVD Service, And What It Means For You”

  1. It will be interesting to see where each of the two “new” companies is in five years. Which one will have more subscribers? Which will be more profitable? I think Hastings’ tipped his hand at where he sees the the future being – he kept the widely recognized Netflix name for the streaming business.

    1. I certainly don’t want to be employed by Qwikster right now. In the CEO’s message he alludes to the idea that if Netflix doesn’t innovate, and keeps its DVD program as it is now, the business will die. Thats why they kicked the DVD side to the curb. He’s basically created a DOA company with Qwikster, it’s only a matter of time until it rolls over and dies

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