Tuesday, September 20, 2011

The Panic Over Netflix

I'm frankly a bit surprised at the panic and anger following Netflix's recent pricing changes. Here's the email Netflix CEO Reed Hastings sent to customers the other day:

"Dear (Customer name)-

I messed up. I owe you an explanation.

It is clear from the feedback over the past two months that many members felt we lacked respect and humility in the way we announced the separation of DVD and streaming and the price changes. That was certainly not our intent, and I offer my sincere apology. Let me explain what we are doing.

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). So we moved quickly into streaming, but I should have personally given you a full explanation of why we are splitting the services and thereby increasing prices. It wouldn’t have changed the price increase, but it would have been the right thing to do.

So here is what we are doing and why.

Many members love our DVD service, as I do, because nearly every movie ever made is published on DVD. DVD is a great option for those who want the huge and comprehensive selection of movies.

I also love our streaming service because it is integrated into my TV, and I can watch anytime I want. The benefits of our streaming service are really quite different from the benefits of DVD by mail. We need to focus on rapid improvement as streaming technology and the market evolves, without maintaining compatibility with our DVD by mail service.

So we realized that streaming and DVD by mail are really becoming two different businesses, with very different cost structures, that need to be marketed differently, and we need to let each grow and operate independently.

It’s hard to write this after over 10 years of mailing DVDs with pride, but we think it is necessary: In a few weeks, we will rename our DVD by mail service to “Qwikster”. We chose the name Qwikster because it refers to quick delivery. We will keep the name “Netflix” for streaming.

Qwikster will be the same website and DVD service that everyone is used to. It is just a new name, and DVD members will go to qwikster.com to access their DVD queues and choose movies. One improvement we will make at launch is to add a video games upgrade option, similar to our upgrade option for Blu-ray, for those who want to rent Wii, PS3 and Xbox 360 games. Members have been asking for video games for many years, but now that DVD by mail has its own team, we are finally getting it done. Other improvements will follow. A negative of the renaming and separation is that the Qwikster.com and Netflix.com websites will not be integrated.

There are no pricing changes (we’re done with that!). If you subscribe to both services you will have two entries on your credit card statement, one for Qwikster and one for Netflix. The total will be the same as your current charges. We will let you know in a few weeks when the Qwikster.com website is up and ready.

For me the Netflix red envelope has always been a source of joy. The new envelope is still that lovely red, but now it will have a Qwikster logo. I know that logo will grow on me over time, but still, it is hard. I imagine it will be similar for many of you.

I want to acknowledge and thank you for sticking with us, and to apologize again to those members, both current and former, who felt we treated them thoughtlessly.

Both the Qwikster and Netflix teams will work hard to regain your trust. We know it will not be overnight. Actions speak louder than words. But words help people to understand actions.

Respectfully yours,

-Reed Hastings, Co-Founder and CEO, Netflix
p.s. I have a slightly longer explanation along with a video posted on our blog, where you can also post comments."
Punditry has come down on both sides of this issue. CNBC's Herb Greenberg renewed his customary energetic attack on the company, once more reminding one and all of the firm's balance sheet's store of unexpensed acquisition costs. And Greenberg asserts that providers like Netflix will become commodities, thus ruining the firm's business model.
Others, however, side with Netflix for sensibly now splitting two very different businesses. As well as prepare customers for the eventual arrival of bandwidth pricing, which will affect how they use online media.
As for me, I'm rather sick of the whining by pundits (like Greenberg) and customers who are shocked- SHOCKED!- that prices for the physical disc side of Netflix's business have risen.
They remind me of the people who are outraged that Social Security- correctly called a Ponzi scheme by Rick Perry- won't deliver on all of its phony, never-was-possible benefit promises.
In the case of Netflix, pricing was what it was while it was. Initially, they gave away metered online usage according to your pricing plan. Then it became unlimited, which of course encouraged migration to streaming.
But the streaming business has always had a distinctly smaller inventory of video to view. I don't know about other customers, but I viewed the two services- streaming and discs- as two separate vendors, anyway, because of the availability issue.
So it makes a lot of sense to me that Hastings & Co. have finally announced a formal split of what have been two different-looking businesses for at least a year.
Meanwhile, thanks to Tivo and Netflix streaming, I only need to have one disc available now. Much of my video consumption on Netflix is satisfied by selecting videos on the website for Tivo to access for my subsequent viewing on a television screen. My children preferred to view streaming material directly on their laptops.
My use of discs is for special material that is typically arcane, classic and/or no longer very popular, and, thus, not among the limited streaming inventory.
Hopefully, Hastings will go all the way and spin the two businesses- Qwikster and Netflix- into two separate public companies. The segmentation, costs and overall business dynamics are so different as to make that entirely sensible.
As for the anger some customers are experiencing? Get over it. Say goodbye to a business model that simply isn't viable at older price levels anymore.
As for the effect on Netflix's equity price, that's not entirely surprising, either. Thus the benefit of splitting the businesses, with either some sort of transfer price from one unit to the other for content, or a priori shared purchase of said content. In time, the two units should have dramatically different values and growth rates.

Will the streaming business recoup the recent equity price decline? I have no idea. Investor reactions will determine that. If not, then I can confidently predict that the equity representing that business won't be in my portfolio.
Regardless, those who've had Netflix in their portfolios for some time, as my selection process has, enjoyed substantial gains, and if they rebalanced consistently, this recent slide won't be the end of the world. It hasn't even had a drastic effect on my portfolios which include Netflix, as other firms, such as Apple, have continued to gain value, offsetting Netflix's stock price drubbing.

After all, no equity grows in value forever. Not even Apple.

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