Netflix divorces discs, now what?

qwikster

Video streaming and video rental giant Netflix rocked its world for the second time in as many months on Sunday, announcing the company will be spinning off its DVD rental business into an independently-operating new business dubbed Qwikster. Qwikster’s CEO will be Andy Rendich, who has served as Netflix’s chief service and operations officer.

The announcement follows on the heels of a controversial restructuring program that significantly raised fees for customers who use both streaming and DVD rental services. In a letter to shareholders (PDF), Netflix forecast the changes would result in the loss of some 800,000 DVD rental subscribers and about 200,000 streaming subscribers.

Explaining Qwikster’s spinoff, Netflix CEO Reed Hastings took responsibility for alienating customers and attempted to outline the case for separating the businesses, noting that “companies rarely die from moving too fast, and they frequently die from moving too slowly.” But the moves leave several questions: where are Netflix and Qwikster headed in such a hurry, and will customers get whiplash from Netflix moving “too fast?”

The deal for customers

The Netflix-Qwikster split will have a very real impact for existing Netflix DVD rental customers, very soon. Netflix’s existing DVD-by-mail and video streaming businesses will be separated into two separate Web sites, with separate accounts, separate queues, separate recommendations, separate reviews, and separate billing. What used to be an integrated experience of browsing both streaming content and material available for rental will become two completely disconnected services. Qwikster will launch with a snapshot of customers’ Netflix account data, but from there the services will diverge. Where customers used to receive one bill, they will receive two; if a film or TV series is reviewed on one service, that review will not be available on another service; and neither Netflix nor Qwikster will consider selections on the other service when making recommendations or helping users manage their queues. However, streaming customers will no longer be frustrated searching for content only to find it’s only available via DVD (or not available at all): For streaming customers, unavailable content simply won’t exist.

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Equally importantly for consumers, Qwikster is not changing the recently-increased prices for DVD-by-mail service: an unlimited one-at-a-time DVD-by-mail service will still run $7.99 a month. Customers can add Blu-ray options to their choices for an additional $2 per month, and Qwikster will actually have an option not available under the existing Netflix DVD-by-mail service: video games. Like Blu-ray, users will be able to pay an additional $2 per month to rent game discs for the Xbox 360, PlayStation 3, and the Nintendo Wii.

The bottom line for many of Netflix’s 12 million customers who subscribe to both DVD rental and streaming services is that prices just increased from a minimum of $9.99 to $16.98 per month back in July. Now, on top of that price increase, the services will be more difficult to use, thanks to separate accounts, separate sites, and separate billing. It’s a move that hardly smacks of “innovation.”

The deal for Netflix

Netflix is positioning the Qwikster spinoff as the best way to handle the divergent businesses of streaming and DVD rentals. There’s little doubt they are different. Where DVD-by-mail needs warehouses, inventory management, mailing services (and the goodwill of the postal service), plus all the paraphernalia of dealing with a business shipping physical goods, streaming is a more-global business that has to deal with data centers, content delivery networks, and software — whether that be for tablets, smartphones, smart televisions, set-top boxes, or old-fashioned PCs. Netflix argues that by separating the businesses, both can innovate separately without worrying about ramifications to the other. “Our view is with this split of the businesses, we will be better at streaming, and we will be better at DVD by mail,” Hastings wrote by way of explanation.

Innovating the streaming business will likely mean insinuating Netflix into even more consumer electronics devices, as well as striking new deals for digital content distribution that don’t have to be tied to DVD rentals. Netflix has already been forced to grant studios windows of exclusivity on DVD releases, and recently lost its long-term agreement for streaming content from Starz. Separating the streaming business will enabling Netflix to negotiate with studios separately from DVD release windows, and possibly offer new types of streaming availability, like limited release windows or even pay-per-view or per-title rental options for premium content.

Netflix has been operating for 14 years; in that time, Hastings has always been clear that the business he wanted to build was literally Netflix — video delivered online — rather than DVD-by-mailflix. The DVD rental business, although a mammoth success, was just Hastings’ leg up until a streaming-only business became a practical reality. Separating out the DVD rental business enables Hasting to focus on what he really wanted to do: create an industry-leading online video service.

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And Netflix’s streaming is a practical success: even by its downwardly-revised estimates in the wake of price hikes, the company expects to have 9.8 million customers to its streaming-only service, compared to just 2.2 million who will subscribe to a DVD-by-mail service. Factoring in customers subscribing to both, Netflix’s streaming business is considerably larger than its DVD rental business: 21.8 million subscribes, compared to 14.2 million for DVDs. In other words, over 60 percent of the company’s customers currently pay for streaming service.

The Qwikster spinoff seems designed to make sure the majority of those 12 million DVD-and-streaming subscribers stick with Netflix. Already stung by a price hike and now facing separated accounts, services, and billing, many of those dual customers will cut their losses by choosing one service or another. Although adding video games to the DVD services may sway some rent-by-mail subscribers, it’s a good bet the majority will choose to stick with the streaming service  —after all, streaming customers are already the majority of Netflix’s overall customer base. Short of lowering prices, or increasing the number of DVDs available at different price points, it’s not clear how Qwikster can “innovate” the DVD-by-mail business much further. (However, Qwikster will be able to advertise its service separately, which may eliminate some confusion over what, exactly, Netflix is.) And even Hastings concedes Qwikster’s days may be numbered. “DVD by mail may not last forever, but we want it to last as long as possible,” he wrote.

Can Netflix compete on its own?

Netflix is currently the 400-pound gorilla of the video rental and video streaming industry, but ditching its DVD rental business means the company will have to go up against other streaming video services without a core base of DVD subscribers. As a streaming-only proposition at $7.99 a month ($95.88 per year), Netflix costs more than Amazon Prime (available for $79.99 a year, or $6.66 a month — plus users get unlimited two-day shipping from Amazon and other benefits). In terms of subscribers, Amazon may be Netflix’s biggest competition: Amazon Prime reportedly has 10 million customers. Hulu Plus currently runs $7.99 a month and is Netflix’s closest competitor in terms of the number of television shows offered, and it offers new shows the day after their original broadcast. However, Hulu’s pending sale has cast doubts on the future of the service.

Netflix’s advantages in the streaming business come from deep integration with consumer electronics devices — everything from the Apple TV and iOS devices to Roku set-top boxes to every major game console to a plethora of Internet-enabled televisions, Blu-ray players, and (of course) TiVo. Netflix has had the most success in enabling consumers to sit down in their living rooms and easily tune in to Netflix streaming content.

Netflix’s biggest competitors in the streaming video space may not have emerged yet. The other 400-pound gorilla in the room is Apple, which has built a solid digital video business in its iTunes store. Although Apple is gearing up to offer video and music synchronization services via iCloud, the company has so far shown absolutely no interest in getting into the streaming video market — in fact, Apple recently stopped offering television show rentals via iTunes, saying customers vastly preferred buying TV episodes. In contrast, Netflix doesn’t sell anything — either movies or television.

Another player could be Google. Although the initial release of Google TV was an underwhelming flop, the company remains committed to the platform. Future iterations of Google TV will be able to run Android apps, and if anybody can successfully combine television and movies with the Internet, social media, advertising, and commerce, Google has pockets deep enough to pull it off.

Why Qwikster feels like a bait-and-switch

For folks who have come to Netflix by way of its streaming service — perhaps embedded in a TV, Blu-ray player, or installed on a game console — these changes may not seem like a big deal: after all, $7.99 a month still buys unlimited streaming. However, for many of Netflix’s longest-standing customers, the Qwikster spinoff feels like another kick in the teeth.

Netflix started out as a purely DVD-by-mail service, and it particularly appealed to movie fans and home-theater buffs eager for access to a vast library of DVDs without the hassles (and late fees) of renting from brick-and-mortar video stores. The model proved so successful it drove Blockbuster into the ground.

Video streaming was initially offered as a free value-added service to a DVD-by-mail subscription. It was a novelty. Netflix’s main service was DVDs by mail, but adventurous customers with broadband could try streaming to their computers or home theater PCs. Those same movie fans and home theater nuts were still happy: Sure, streaming was unreliable, often had crappy quality, and didn’t offer much content, but it wasn’t costing them anything and, occasionally, worked out well.

In the last few years, Netflix has worked to beef up its streaming service, inking deals with broadband operators, bringing some current television programming to the service, and adding a growing selection of current films and catalog titles. Streaming selection is still limited, but many users can quickly find something to watch, and as broadband has become more ubiquitous Netflix has been able to improve streaming quality. The company has also worked to make its clients (both on PCs and mobile devices, but also in TVs, consoles, and other in-home devices) easier and more useful. And those changes seem to have resonated with consumers: After all, the company expects 60 percent of its 36 million customers will pay for streaming service.

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In a particularly sagacious comment, Hastings also described the benefits of the streaming service as being considerably different than DVD… and that means the customers most likely to be alienated by the Qwikster spin-off are the same ones who built Netflix into a Blockbuster killer. The reason is as much about cost as selection. The universe of content available on DVD is very large, and more than a single person could hope to view in a lifetime. However, of all the television and movies produced in the world, only a small fraction is available on DVD — after all, unless studios and publishers think there’s a viable market for a film or show, they’re not going to invest in transferring the material to digital, remastering it, and publishing it on disc. That content is moldering away in vaults, if it hasn’t disintegrated already, and will not likely make the jump to digital. In many cases, it’s a shame.

The same notion holds true for streaming, but on a smaller scale: Only a tiny fraction of material available on DVD can be streamed from Netflix. Far from offering a vast and comprehensive content library, Netflix streaming is limited to a few hundred “classic” catalog titles; the rest focuses on recent television and recently-released films, many of which are unfamiliar to even die-hard movie fans. Sure, some of the oddball titles are upstart independent films that may never get much non-digital distribution, but others are essentially exploitation films or detritus released by studios to cut losses on failed projects. And users who do find an intriguing title should watch it fast: Thanks to complicated licensing, it could disappear at any time.

By spinning off its DVD-by-mail business into Qwikster, Netflix risks becoming a flailing middle-man service peddling mainly current television shows and whatever releases studios are promoting at a given time. Out with the old, in with the new. That may be enough for folks looking to catch up on a past season of a reality show, or who might watch any film with Megan Fox or Ashton Kutcher just so they have something to tweet about at the water cooler. But folks who are serious about their movies and TV — or just slightly off the mainstream path — Netflix’s streaming-only service could easily prove too limited.

How many of those people are there? When Netflix announced its pricing changes in July, the company “realized that there is still a very large continuing demand for DVDs both from our existing members as well as non-members.”

Fin

Reed Hastings is right about one thing: Netflix has done a terrible job communicating with its customers. In his message , Hastings apologizes for not justifying Netflix’s recent price hike and admits he “slid into arrogance based on past success.”

However, I doubt Netflix customers feel Hastings has clarified Netflix’s position. Most consumers understand if a business needs to pass along increased costs in order to continue offerings services. When fuel prices increase, so do the costs of plane tickets and bus fares. But Netflix is not saying it raised prices because its costs have gone up. Instead, it has only said that it believes $7.99 for streaming and $7.99 for one-DVD-by-mail ($15.98 per month combined) represents a “terrific value,” leaving one to wonder what kind of value they thought they were offering for the same services at $9.99 a month. And instead of explaining the reasons price increases in his mea culpa, Hasting only says Netflix wants to “focus on rapid improvement.”

Unfortunately, to most consumers, making an existing service more difficult to use at higher prices is not an improvement. They will vote with their feet — and their wallets.

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