Why Reed Hastings should be applauded for Netflix split

If you haven’t read Reed’s explanationof this split make sure you do so. 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 would like to take the opposite side of that debate.

If you haven’t read my post on the Future of Television and 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 writes from the studios).

So why on Earth should Netflix split into two businesses?

1. 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 & 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 & 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 it’s Office franchise by aggressively pursuing a Google Docs like strategy. Yeah, I know they did, but too little, too late, too lame.

2. Focus – By having two separate businesses, each with it’s 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 that 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 won’t die quickly – 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 worse 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. Charge the right prices for the right services – But as less 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 outwhat’s happened with Netflix’s biggest content partner who 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).

b It’s rare in business to see somebody like Reed Hastings tackle the massive changes happening to their businesses and deal with them before they’re too late. Imagine of 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 industry

I argued ages ago that Yahoo! should have come out early and say, “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 CEO’s to run MySpace after the founders’ departure, I argued the same.  Announce you’ve lost that battle and that you’re now focused on a narrower business for gamers and for music. In stead the press story for 2 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?


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