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With All Respect To Reed Hastings, The Netflix-Qwikster Split Bad For Customers

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We have nothing but respect for Netflix CEO Reed Hastings, who has demonstrated again and again a willingness to take the long view instead of an easier short-term one--making tough decisions that cause near-term pain in order to improve the company long-term.

In the middle of last decade, for example, Reed decided to cut Netflix's pricing to neutralize a competitive threat from Blockbuster. Hastings and Netflix were scorned at the time for this decision--Netflix would obviously go broke--and Netflix's stock collapsed.

Well, we know how that one turned out: Netflix won the battle, and its stock blasted off for the moon. Blockbuster, meanwhile, went bust.

And now Hastings has gone and made another earth-shaking decision--enacting a major price increase for DVDs-by-mail and splitting Netflix into two companies. And the market has responded by chopping Netflix's stock price in half.

We suspect, eventually, that Reed Hastings will once again be proven right about the price increase and that those who have written the company off for dead will once again have to hang their heads in shame.

And we can also certainly understand why, from the company's perspective, it makes sense to split the DVD and streaming businesses into two separate companies: They're different businesses, with different cost structures and different delivery, marketing, licensing, and management challenges, and they will be easier to run better if they're managed separately.

But what's better for the company, in this case, is worse for most of the company's customers.

One of the big advantages of Netflix's current service is that it's a one-stop shop. Subscribe to Netflix, and you know that you'll be able to watch basically any movie or TV show ever made. You may not be able to watch it instantly, via streaming, but if you can't watch it instantly, then you can order the DVDs. And you can go to a single web site, Netflix, to figure out what your options are.

This is very different offering than most of Netflix competitors have, which is access to some TV shows and movies, but not all.

Subscribing to a service that has access to some shows and movies, is very different (and distinctly worse for the customer) than subscribing to one that has access to all of them.

Searching a database that contains some shows and movies is very different (and distinctly worse for the customer) than searching one that has access to all of them.

And subscribing to two different services, with two different brands, bills, and customer support, is much more of a pain in the ass than subscribing to one.

What percentage of Netflix's customers value its "one stop shop" feature? Half.

Netflix subscribers fall into one of three buckets:

  • DVD-only (~2.2 million target for Q3, by far the smallest)
  • Streaming-only (~9.8mm target for Q3)
  • Hybrid (12mm target for Q3)

Netflix's largest customer segment, in other words, is still choosing to pay for the ability to either stream or order DVDs by mail, despite the massive 60% price increase for this plan that Netflix just enacted.

This suggests that half of Netflix's customers very much value this option.

Will all of Netflix's "hybrid" subscribers maintain their DVD service subscription now that they'll have to search another web site and get another bill every month from "Qwikster"? We doubt it. And, in any case, it will be considerably more of a pain in the ass.

(One question we have for the company is whether both databases will still contain ALL movies and TV shows--or whether the databases will be limited to the movies that that particular service offers. If the streaming database does not contain the DVD movies, we imagine Netflix will lose a lot of free marketing for that service).

We understand that Netflix wants to discourage customers from ordering DVDs, and the split will certainly do that. We also understand that, eventually, Netflix's whole business will be streaming (or other digital delivery) and that DVDs will go away. And so we understand why Reed Hastings and Netflix are being applauded for facing reality and embracing the future.

But...

For the moment, and for the next couple of years, Netflix's value to half of its customers has just dropped. Put differently, this seems a distinctly customer-unfriendly move.

It seems so customer-unfriendly, in fact, that one suspects there is more behind it than merely the desire to have a separate management team for each company.

Benchmark (VC) partner Bill Gurley offers one guess as to what this unstated factor may be.

Gurley observes that the licensing for content for DVDs versus streaming is entirely different. To rent a DVD, Netflix need merely buy it: The company does not pay any per-view or per-customer licensing fee to the studios. To stream a show or movie, meanwhile, Netflix has to pay a direct licensing fee, which is based on its number of subscribers.

Gurley believes that the Hollywood studios are now insisting that Netflix pay a per-subscriber-per-month licensing fee, whether or not its subscribers actually ever stream movies. This demand, Gurley reasons, may be forcing Netflix to pay per-month-fees on way more subscribers than it will ever recoup any value for (because many never use the streaming option).

By splitting the businesses in two, Gurley continues, Netflix will be able to negotiate streaming licenses on a much smaller subscriber base--say ~15 million, versus the ~25 million total subscriber base--thus reducing its streaming content costs.

This, too, makes sense from a business perspective, and, if true, it explains a lot.

But it still sucks for "hybrid" customers.

SEE ALSO: REED HASTINGS: Here's Why We're Splitting Netflix Into Two Companies

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