This article was written with Kasturi Rangan.
In October 2011, one of the great backflips in the annals of business strategy took place. Netflix Inc., the most prominent video rental service company in the world, had begun to charge separately for its DVD-by-mail service and its streaming service in July, which in effect had increased prices by 60 percent for customers who used both services. Then, in September, Netflix had gone further, announcing it would split those services into two separate businesses, renaming the DVD-by-mail operation Qwikster. Consumer protests, conducted largely over the Internet, forced the retraction in October; Netflix announced it would revert to providing a combined service under one brand. By November, the company’s market cap had dropped by 70 percent and more than 800,000 subscribers had fled. The online mea culpa that CEO Reed Hastings wrote to customers only added fuel to the flames. In January 2012, a group of investors sued the company for loss of profits. Clearly, a bit of the company’s luster as a Silicon Valley darling has been lost, and Reed Hastings’s reputation as a strategically adept CEO has been damaged.
The unfolding lawsuit will undoubtedly raise more questions about Hastings’s judgment and culpability. The company stumbled, and in the end the consequences may be serious. But when you take a deeper look — beyond the hype and recriminations — the implications for business strategy, particularly in the Internet era, are more nuanced. Reed Hastings and his team got some important things wrong in changing the Netflix strategy, but they also got a great deal right. Here is our scorecard.
The business split. They got this right. The natural boundaries between the physical (mail) and virtual (streaming) markets for pre-recorded movies are increasingly sharp, especially as the streaming market takes off. These two delivery models require distinct assets and capabilities to be successful, and each faces a very different group of competitors. Physical competitors include Blockbuster and Redbox, whereas virtual rivals include Amazon, Hulu, iTunes, LoveFilm, and cable TV companies.
Netflix’s decision to split the businesses was the right one because it created focus and increased the company’s chances of being successful with distinctive business strategies tailored to different natural markets. To thrive, Netflix will have to find a way to execute well with these two bifurcated operating models under one corporate umbrella. As Hastings recently said, Netflix can expect to lose mail-only subscribers every quarter from now on. Thus, he and his team will be managing one business (DVDs by mail) for decline while growing its replacement (streaming) in the face of fierce competition from a new set of formidable rivals. This is one of the toughest challenges a company can have.
Pricing. They got this right, too. Services that deliver discs by mail have different demand curves from those that stream video content, and they also have very different costs to serve their customers. That’s why different pricing schemes make sense. Netflix’s much-decried 60 percent price increase was assessed only on those who signed up for both mail and streaming. Most observers didn’t recognize this point. The net effective price increase, when applied to Netflix’s entire subscriber base, was closer to 20 percent.
Before July 2011, Netflix had bundled streaming with its core delivery-by-mail service because it was a nascent market and the selection of available videos was limited. The market had not been ready for a stand-alone streaming-only business. During that period, Netflix subsidized the development of its streaming business by essentially giving it away to its DVD-by-mail subscribers. Later, though, with competition from the likes of Apple and Amazon, that would have to change.