How Netflix Blew It

Where Netflix Went Wrong — And What Reed Hastings Should Do About It

Since 2008 Netflix has become a darling of Wall Street and the envy of media companies around the world. Until this summer it seemed the movie rental company had pulled off the hat trick of paying distributors exceptionally low fees for online rentals while delivering an on-demand video service that rivaled cable and satellite television offerings.

This enabled Netflix to include streaming delivery for the same price as their single DVD subscription plan, just $9.99 per month. Several seasons of a TV series could suddenly be watched over a weekend and avid cinephiles could devour 10-20 film titles per week. No other service before or since could offer anything comparable. Netflix subscriptions soared, growing by more than 50% from 2008 to 2010.

Shares of Netflix stock soared as well, from just $19 near the end of 2008 to $55 at the end of 2010. That year CEO Reed Hastings revealed the numbers for on-demand viewing with a suggestion of perpetual growth going forward as high hard goods costs and long waits for customers were replaced with cheap data transport and instant gratification. Countless bullish commentators made fantastic projections and investors fell in love with the idea of ever-widening margins.

At the start of this year, smart analysts saw that Netflix shares were ready for a fall if anything disrupted the market’s lofty expectations. In July the stock had reached $295 per share.

Meanwhile, Netflix raced themselves to the bottom when they matched the Hulu Plus price of $7.99 for a streaming-only account. With far more titles available from both television and film studios, Netflix had an obvious advantage, but the market was also becoming increasingly competitive. While this was a double-barrel shot at Hulu, it also grossly discounted the real value of the Netflix streaming service to consumers who had never complained about paying $9.99 in the first place.

Too much of a good thing quickly became a problem for the company. After three years of radical growth and low pricing, CEO Reed Hastings had to navigate a perfect storm of unrealistic investors, spoiled consumers and demanding distributors.

As distributors saw fat Netflix sales margins at their expense, the company needed to begin paying more for content without completely eroding the earnings shareholders had come to expect. The only way to do this was to raise prices and trim costs, both of which were bound to upset customers.

Meanwhile, another problem loomed in the background. Investors who had been paying any attention at all since 2010 knew that the company’s most important distribution deal was in trouble. 250 Sony titles available through Starz were pulled from Netflix because the distribution deal put a cap on the number of people who could access those titles online. This brought the entire Netflix deal with Starz back to the table, and losing Starz meant losing films from Paramount, Sony and others — arguably the most valuable content on the site. The breakdown of negotiations to extend the Starz deal became public at the same time new pricing was introduced, striking a deep blow to customer relations.

While being told they would have less of the best content available on-demand, Netflix customers were also told they would have to pay more if they wanted both DVD and streaming delivery. Streaming-only would still cost just $7.99, and a separate DVD-only plan would be discounted to that same price, but customers who still wanted both would now be paying $15.98 per month for two separate services. Netflix users loudly complained that having to pay for both was a betrayal of their loyalty, and not without some good reason. As one industry tracker noted, the price of her subscription plan went up 40% over the course of just one year.

A rapid series of customer surveys and projections naturally reported doom for Netflix as customers threatened to cancel their subscriptions. Brand association turned dramatically negative as customer outrage temporarily took the place of rational value.

Seeing these results, and likely hearing an earful from investors, it seems that CEO Reed Hastings was shaken to his core. He announced that Netflix would be spinning off their DVD service as a separate company.

Though one of my favorite business bloggers Mark Suster suggested the separation made sense because it allowed for product focus, I have always completely disagreed. From the customer’s perspective, Netflix simply offers two variations of a single product — movies. Netflix has a singular identity with a single product, which is an exceptional asset at a time when user behavior and market realities are evolving. The company desperately needs to maintain strong bonds and brand associations more than ever.

It’s important to note that Netflix is also not a startup. Suster was right about the efficiencies of focusing on a single segment, and this benefit would outweigh the costs if Netflix were still a startup. My company, Dynamo Player, offers a paid VOD platform to filmmakers and distributors, and it would be crazy for us to get into the DVD market. It would be distracting, inefficient and a deviation from the brand. In fact we just spun off our media payment platform, TinyPass, for this very reason. But Netflix is in the midst of a transition of their own making, on a massive scale, and the Netflix brand is deeply instilled in all customer segments.

Imagine Ford separating sedans and SUVs into separate companies. They have different pricing, different production lines, different customer segments. But a consumer who loves their Ford Mustang is far more likely to buy their Ford Explorer when it is time to shop for a different kind of car.

Scale matters. Longtime customer relationships matter. Tesla and Brammo should be separate companies, but Ford should offer separate products.

Above all else, the most important issue in this drama is that Netflix expects those DVD accounts to steadily drop off anyway, naturally converting to streaming subscriptions over time. Forcing them onto a separate system with no brand affiliation was never a good idea if the goal was to ultimately retain those subscribers through a long market transition.

THE TRUE VALUE OF CONTENT

It would have been best to be brutally honest with the DVD customers, explaining the costs involved in servicing their small portion of the market (Netflix estimates just 10% of their customers will be DVD-only), and repeatedly pointing out that the DVD-only plan was in fact a discount to the previous plan one-at-a-time DVD price. Sometimes customers simply need to be told ‘no’ and offered a respectful explanation.

Rather than continue the foolish notion that content can and should forever be available for next to nothing, Reed Hastings would have been wise to assess the true value of supply and demand for on-demand titles — and take advantage of that high value.

The real market value of on-demand access to Netflix titles is far higher than $7.99 or even $14.99, and it’s time for Netflix to be frank with customers about the real value of what they are receiving. If Hastings wants to generate enough revenue to keep top tier titles in the Netflix library and stave off direct competition, then it’s time for him to reframe the discussion and politely offer customers the choice of paying a small amount more or trying to find those services elsewhere in the market.

I’d wager that if you had never heard of Netflix or Hulu and someone told you that 60-80% of what you watch could be had for a flat rate just $25 per month without any commercials, including top feature film titles and many popular TV series, you would sign up immediately and be thrilled to spend the money. Instead, all of us have been led to believe that we should have access — that we are entitled to access — to all of this content for the price of a sandwich and coffee.

The least that Hastings can do is maintain a steady course and not discount valuable content any further. Doing so would not only hurt Netflix but continue to damage the media market. Filmmakers and distributors who work with dramas and standard television content already recognize the decline in the buy-side value of their products, and the trend is deeply threatening to what was once a powerful industry.

Consider other media. Unrealistic online discounting has done such damage to newspapers that many have been forced out of the market while others have so badly cheapened their product that readers can’t tell the difference between once-professional news sources and the tripe generated by SEO companies and content farms. The market underpinnings have been whittled away so slowly that nobody seemed to notice until the New York Times was on the brink of collapse. The only thing that promises to preserve journalism quality now is paid content and — surprise, surprise! — consumers are still happy to pay for quality.

Instead of making the same mistakes and devaluing quality video programming, let’s skip that painful process and keep pricing realistic. And if consumers complain about getting access to a vast library of excellent content for less than $10 per month, then Netflix should tell them to try and find it elsewhere.

[Disclosure: I am a co-founder and shareholder in companies that have competed and may compete with Netflix.]

Read more tech news and analysis at roblikes.com.

Photo: CC license, credit: Flickr User “_tar0_”

Rob Millis is an entrepreneur and investor in new technology. He currently works at the intersection of content and commerce as co-founder and CEO of the Dynamo Player video platform, and ...read more

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