Above the Crowd

Understanding Why Netflix Changed Pricing

September 18, 2011:

Many journalists have offered their opinion on Netflix’s recent changes, its stock price decline, and their even more recent branding changes (Qwikster). Yet in each article, it appears as if the journalist all agree that the price move (creating separate prices for streaming and DVDs) was a bad strategic move. As an example, Techcrunch notes:

“Raising prices for those of us who opt for both streaming and DVDs would have been fine if Netflix had a deeper streaming catalog. But the gap is still too big, and the price hike seemed premature. Your customers are extremely loyal. Don’t piss them off.”

The problem with this perspective is, in my opinion, the price move was not a “decision,” so much as a “reality” presented to Netflix from the content owners in Hollywood.

Hollywood is a unique place, and understanding “business” in Silicon Valley leaves you ill-prepared to understand what makes Hollywood tick (for more on this see: When It Comes To Television Content, Affiliate Fees Make The World Go ‘Round). Very few people understand the key underpinning of the Netflix “original” business model — a 1908 Supreme Court Ruling known as “first sale doctrine.” From Wikipedia:

“The doctrine allows the purchaser to transfer (i.e., sell, lend or give away) a particular lawfully made copy of the copyrighted work without permission once it has been obtained.”

Because of the first-sale doctrine, any DVD reseller, including Netflix, can basically buy a DVD at WalMart, and turn around and rent it to someone else the very same day. The content owners have absolutely no control over whether the copy can be resold or rented. Period. As such, Netflix has the ability to rent (via DVD) any movie which has ever been sold on DVD, and its costs are relatively fixed as a result of the retail price of the actual DVD. In some ways, it is a perfect storm.

Fast forward to digital streaming and all bets are off.  More specifically, the first-sale doctrine does not apply. That’s right. For DVDs, Netflix’s rights are unlimited and its costs are constrained. For digital, its rights are constrained and its costs are unlimited. In the absence of the first-sale doctrine, Netflix must negotiate each and every title, and the price of the right to stream that digital title is up to the whim of the content owner. For many titiles, you cannot even obtain digital rights, because they can’t find all the people the need to release the rights to do so.

So here is what I think happened with Netflix’s recent price change (for the record, I have no inside data here, this is just an educated guess). Netflix has for the past several years been negotiating with Hollywood for the digital rights to stream movies and TV series as a single price subscription to users. Their first few deals were simply $X million dollars for one year of rights to stream this particular library of films. As the years passed, the deals became more elaborate, and the studios began to ask for a % of the revenues. This likely started with a “percentage-rake” type discussion, but then evolved into a simple $/user discussion (just like the cable business). Hollywood wanted a price/month/user.

This is the point where Netflix tried to argue that you should only count users that actually connect digitally and actually watch a film. While they originally offered digital streaming bundled with DVD rental, many of the rural customers likely never actually “connect” to the digital product. This argument may have worked for a while, but eventually Hollywood said, “No way. Here is how it is going to work. You will pay us a $/user/month for anyone that has the ‘right’ to connect to our content – regardless of whether they view it or not.” This was the term that changed Netflix pricing.

With this new term, Netflix could not afford to pay for digital content for someone who wasn’t watching it. This forced the separation, so that the digital business model would exist on it’s own free and clear. Could Netflix have simply paid the digital fee for all its customers (those that watched and not)? One has to believe they modeled this scenario, and it looked worse financially (implied severe gross margin erosion) than the model they chose. It is what it is.

Netflix is an amazing company, and Reed Hastings is one of the best CEO’s Silicon Valley has ever seen. That said, at age fourteen, the digital world is forcing Netflix to execute a pivot. And the world they are entering is radically different from the world they are leaving. There is no longer a first-sale doctrine to keep things neat and tidy.

153 Comments

  1. parisianfeline September 18, 2011

    This is really impressive. I’m not a Netflix user, I just never had a need for it. A concern I did have, though, was that if everyone starts streaming, how will that work with internet speeds in the States? I remember being in college, which had free wifi for everyone and often times (especially on a laptop) people experienced a lot of lag if too many people were on the wifi.

    I haven’t spent a lot of time researching how the future of streaming and our limited internet speed intersect, but I think it’s an interesting conversation as more people rely on the internet to watch TV or movies. Especially when coupled with the rising expenses of going out to the theaters and the slow demise of rental places like Blockbuster – I wonder what the future will hold. :/

    Thanks for breaking it down with this post. I hadn’t even thought about how Hollywood factored into this.

    Reply
    • Eric September 19, 2011

      Do you think that this seperation of Netflix’s streaming business and DVD business will lead to an increase in movie/tv titles that will be available for streaming?

      From the article it seems like Netflix is doing this in large part, so that they can increase the amount of content available for streaming. Do you agree?

    • bgurley September 19, 2011

      No — has nothing to do with it. First-sale gave them access to the entire world’s library.

  2. Bob Mann September 19, 2011

    Valid observation, though I would have expected the price of the DVD-only stub to have dropped, not risen. There must still be huge cross-subsidy.

    Reply
    • bgurley September 19, 2011

      It’s a cash cow now. Prices are relatively fixed. You can probably write an algorithm to determine maximum contribution.

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  4. JonnyL September 19, 2011

    Very interesting, sounds quite plausible.

    Reply
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  6. Sanchit Kumar (@sanchk) September 19, 2011

    The arguments you make are very valid… but the change in pricing strategy was rather unexpected, and by all accounts rather hush-hush. If your theory is true, why didn’t Netflix put up a more public fight over the rules? This is something I haven’t been able to figure out, and is also why I lean towards my current belief that this was an internal, strategic business decision gone wrong.

    Reply
    • bgurley September 19, 2011

      1- Theses things are rules they can change. As they like to say, content is king.
      2- They have never spoken outwardly about first-sale, because its something that helped the old business. What is the point?

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  8. Stephanos Piperoglou September 19, 2011

    It’s interesting to note that the first sale doctrine doesn’t apply in other jurisdictions, including the EU, where movie studios have for years charged exorbitant prices for “rental” copies to Blockbuster and its ilk, who end up having very different business models to their US counterparts. All DVD/BluRays sold in the EU carry very explicit warnings that they may not be lent out and many a Mom & Pop video rental store that has broken the rules by renting out “for sale only” discs has been hit with hefty fines.

    I don’t see how we can have serious innovation in the entertainment industry unless some non-discriminatory pricing provisions are attached to copyright law. Not that I’m holding my breath.

    Reply
    • bgurley September 19, 2011

      You aren’t seeing serious innovation? I can stream content to every TV in my house. I listen to Rhapsody and Pandora over Sonos every day. You are in it right now!

  9. J. Cliff Elam (@cliffelam) September 19, 2011

    Great analysis. It’ll be interesting to see if Hollywood has cut their own throat again like they did with music for so many years.

    -XC

    Reply
    • bgurley September 19, 2011

      They are #winning, not throat cutting. This is what it looks like when they win.

  10. Xenochron (@Xenochron) September 19, 2011

    The only problem with your logic is that Netflix had to do nothing more than tell people straight up that this is the case and that the split was forced by the studios because of their licensing model. Why all the guessing games? The shroud of secrecy is manufactured by the media. Hastings has made one stupid move after another and this is just another blunder on his part. His disdain for the DVD side of the business is very evident and this is a way out from under it for him.

    Which brings me to my next point which is Reed Hastings being one of the best CEO Silicon Valley has ever seen. In what way? Compared to who? The only brilliant thing he’s done (which is substantial I admit) is setup Netflix to rent DVD’s and create a vast distribution network to provide them around the USA. Other than that, he’s made one screwed up move after another. He can’t seem to negotiate deals with providers for streaming, if I recall he made a dumb move on the logo change, he’s messed up the web site more than once and continues to do so (it in fact is far less usable than it ever was right now) and he’s managed to piss off his customer base. This is brilliant and the best we’ve ever seen? Not likely. He’s a one hit wonder who’s failings have been saved by the ineptitude of his few competitors (namely Blockbuster).

    In the streaming business, he’s going to have some heavy hitters that are arguable much smarter than he and I think he’s basically just destroyed this Netflix in one move. As always, time will tell.

    Reply
    • J. Thomas Bradford September 19, 2011

      There is no “vast distribution network” that Hastings created. He distributes his DVDs using the good old-fashioned U.S. Postal Service. (And that organization is suffering very badly and may itself have to stop service for two days out of the week.)

    • Carl Zulauf (@existensil) September 20, 2011

      There is, in fact, a vast distribution network. Netflix has strategically placed DVD distribution centers around the country and worked very closely with the post office to ensure they can deliver DVDs to their average customers in just one day. This kind of turn around time for a traditional mail service was previously unheard of and is one of the things that really separated Netflix from every competitor that tried to copy them.

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  13. John Ball (@jpball) September 19, 2011

    While the facts on the battlefield are correct, Netflix seems to ignore the voice of its customer, and I am not talking about those that simply whine about the business decision.

    Hollywood’s model has to change to reflect the demands of customers who will gladly pay for what they consume, but only for what they consume, and not what they might consume. Hollywood’s model was brilliant business concept but its time has passed. Witness the pressure cable companies see to revise their traditional package pricing or lose subscribers to alternatives. We, Netflix customers, demand that Netflix take the lead in this regard.

    Barry Diller makes this clear in a recent keynote IC interview http://www.livestream.com/paleycenter/video?clipId=pla_3504fb8e-68ac-48ac-a5c7-1bc428cd7750

    Reply
    • bgurley September 19, 2011

      Hollywood has been at this for many years, and they know WTF they are doing. That’s why they are going to look like masters of the universe versus the music labels. Just watch. They are #winning.

    • Brett September 19, 2011

      We’ll see. The viewing habits of the vaunted 18-24 demographic are changing, and not in a way favorable to Hollywood’s way of doing business (particularly their reliance on multi-channel cable offerings) . They might buy themselves another ten years (if they’re lucky), but then they’ll find themselves trying to preserve a business model that only seems to be working with a declining, graying group of people, while moving into a market dominated by the platform makers like Apple, Amazon, and Google.

      In the mean-time, piracy has only gotten more convenient. For a lot of pirated content, the days of having to download a dodgy file via Bittorrent are long gone. Quite a bit of it can be streamed over the web without having to download it.

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  15. C, Quenneville September 19, 2011

    So, the writer’s views are that by apologizing to its customers today for their short-sightedness while simultaneously making it twice as difficult for its customers to control their ques as they suddenly remodel into 2 separate entities, (quite clearly for the sake of stock exchanges), and while making no public reference to “Hollywood’s” hand in things- acting as though they aren’t aware that the service that was free to most of its members having a sudden library DEDUCTION of over 30% of its available content, yet charging 60% more for, should be passed off as good business.

    If I find out my extra fees are going for the sake of bank-rolling pathetic media-endorsements… I will not be amused.

    Reply
  16. Lewis Lin September 19, 2011

    Bill, excellent post. Glad Netflix separated into two businesses. One business has a cost assumption based on the first sale doctrine, and another business has a cost assumption based on the evolving streaming licensing structure. Redbox has done a magnificent job exploiting the first sale doctrine in a new way, without incurring the hefty postage costs that Netflix has. I hope to see Netflix competing with Redbox soon.

    - Lewis, Timber Software

    Reply
  17. NItesh Mehta September 19, 2011

    Furthermore, the business split with the name change doesn’t allow other competitors to comp against both businesses (streaming/mail-order). The most obvious example is Redbox. Very strategic and very smart – long $nflx. A HBS student should be drafting a business case study right about now…

    Reply
  18. Oluseyi Sonaiya September 19, 2011

    Could Netflix have set up two wholly owned subsidiaries – say, “Netflix” and “Netflix by Mail” – with independent databases and user systems, but potentially federated login, queue management and movie ratings? Perhaps require users to agree to a “data sharing agreement” between the two subsidiaries, such that the streaming negotiations with the rights holders would be entirely based on the “Netflix” userbase and the “Netflix by Mail” userbase (which overlaps) would continue to be governed entirely by the first sale doctrine?

    This, to me, would have reached the same fiscal and legal goals without degrading the user experience and engendering significant backlash. The severe convenience losses of having to have two accounts with two companies through two different websites, independently manage queues and not see ratings cross-pollinate devalues both offerings to users (like me) who enjoyed both services.

    Is there some legal constraint I’m overlooking (aside from the possibility that the studios refused such an arrangement)?

    Reply
  19. Jim C September 19, 2011

    100% agree on the reality of the situation.

    However, the strategic moves surrounding this “reality decision” were very poorly executed and created confusion and conjecture for everyone (customers, analysts, investors…and probably employees).

    Confusion for all these groups was the huge strategic mistake. Instead, Netflix/Reed/investor relations/customer service should have been crystal clear in their collective communications and should have “controlled the story” vs. the classic MBA case study that has now created.

    The result equals scrambling to communicate better and a crisis of confidence.

    Yes, the reality is financial strategy is now clearly trumping customer strategy and the fallout and change of focus is learning for all of us.

    Reply
  20. Ken Houghton September 19, 2011

    “Because of the first-sale doctrine, any DVD reseller, including Netflix, can basically buy a DVD at WalMart, and turn around and rent it to someone else the very same day.”

    Actually, that’s not true. They are few and far between, but video stores were closed down for renting DVDs purchased in that manner–the generic DVD license specifically excludes permission to rent.

    Which doesn’t mean it won’t be done, because there are enforcement costs to consider. But there is a difference between your local video store (where prosecutions were rare, but they have occurred) and a nationwide for-profit organization. Indeed, the strength of NFLX was that it was willing to contract for all DVD properties offered, not just the ones available at WalMart. Leveraging “the long tail” was a primary key in beating Blockbuster–it enabled one-stop shopping for a family that wanted to see, e.g., both Ringo and Detour.

    Don’t fool yourself; it wasn’t “first-sale doctrine” that led to NFLX’s success as a DVD agent. But it is the synergies between the growing streaming crowd and the shrinking DVD crowd that would have kept them as contenders.

    Now they are dropping those, bifurcating their database and pointing out to their customers that there are alternatives in both areas. (Amazon Prime, for instance, costs 5/6 the price of NFLX Streaming and offers other values. Might more than 200,000 people give up the greater variety of NFLX Streaming for that, using their $16 per year savings to increase their Redbox rentals? Three months ago, that was much less of an issue. Three months from now, with two different firms and non-synergies of queues to be managed, it will be more of one.)

    You can rationalise the pricing necessity: we might disagree on timing, magnitude, and method of announcement, but that’s just haggling, and there are certainly firms–AOL, anyone–that have survived on customer inertia that is much more blatant than NFLX needs.

    Acting as if you’re doing customers a favor (“we need to focus on rapid improvement as streaming technology and the market evolves”) while taking away the thing that made you unique (“without maintaining compatibility with our DVD by mail service”) is at best disingenuous, at worst clueless. Especially when your entire missive gives absolutely no hints about those “rapid improvements” you’re planning to make.

    (For instance: does this mean that the streaming features will have Closed Captioning available in all cases where there is a CC option? That would be a customer benefit [to at least some segment]. But there’s no discussion of what those “improvements” might be in Hastings’s missive, the result of which is that more people will notice how poor NFLX’s current streaming offering really is. Can this possibly be good for the company?

    Reply
    • xzolox September 21, 2011

      Your argument against First Sale is not accurate. Netflix buys wholesale, which is cheaper than WalMart. And they accepted rev share with certain accounts because it was in their best interest to do so… otherwise they wouldn’t have agreed to it because they didn’t have to. There is no way it would ever have been financially feasible to offer unlimited DVD rentals for $10 without First Sale enabling wholesale sell-thru DVDs to be used for rental.

    • bgurley September 21, 2011

      You are right — eventually they moved to this model for new releases. But first-sale gives them breadth of catalog in DVDs that they can’t touch in digital. It also gives them an achor point for negotiation.

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  23. Iggy Fanlo September 19, 2011

    BIll,

    As usual, great and timely analysis. What’s your thinking on their long term margins? I see pressure on the COGS side from content fees (content is king) and simultaneous pressure on the pricing side from Amazon and others. What are the long-term moats that they’ve built? Is distribution first mover enough?

    Reply
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  25. martymankins September 19, 2011

    This is a great observation and you hit the nail on the head with the digital streaming being a licensed deal where the price and length of license time can change all the time. In fact, my opinion is that licensing deals and the hassle over them is what is mainly the killing point in all of these Netflix and Hulu streaming services. You average non-techy users and viewers don’t understand license deals, which is why Reed didn’t go into all of it. He could have and should have to start the education of the difference between physical media vs. digital media.

    As for your point about going to Wal-Mart and getting a DVD, you seem to imply this is how Netflix gets it’s DVDs and how they have no limits to renting DVDs. Not so, as we have seen with several studios limiting Netflix (and Redbox) from having new releases for the first 28 days. If Netflix was getting their DVD media from your local big box store, they wouldn’t have the limiting deals on renting them. Of course, this really isn’t how it works for the DVD rental market, nor how it worked for VHS rentals for years. Maybe I read this in your post wrong, but this was what I got out of it.

    BTW, this post was shared on Twitter which I how I landed here.

    Reply
    • bgurley September 19, 2011

      Once again, it still supports breadth of catalog.

    • xzolox September 21, 2011

      Also, First Sale Doctrine set an artifically low perceived value for rental DVDs. VHS tapes were $100 to account for the profitability of renting a tape out. DVDs were priced for sell-through, most wholesale for $5-10. No one in their right mind would ever intentionally sell a movie for $5 that could be rented out indefinitely. First Sale Doctrine is what enabled Netflix to grow into the player it has become. None of these arguments would be relevant without First Sale because Netflix wouldn’t be Netflix without First Sale.

  26. Derek September 19, 2011

    You provided a good analysis that I think spot on from Netflix perspective. However, I think you are discounting the customer perspective. Part of the reality for Netflix is what the customer base perceives. While the most customers won’t understand the complexities Netflix doing business, they mostly likely don’t care. Customers just want the service in a way that is convenient for them. This may be unfair but it is a reality.

    At the moment I write this, Hastings blog post has generated over 12,000 responses. I admit haven’t looked through all of them but the 300-400 that I did read were negative. While Netflix may be doing the right thing for its business, it has not been successful at communicating why the changes needed to take place. Until Netflix is successful in the communication piece, it may find that itself on a rocky road. Without the customer there is no business. This is a reality that Netflix can ignore at its own peril.

    Reply
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  28. Wayne September 19, 2011

    First sale doctrine and “Wal-Marting” DVDs hasn’t been a valid option since January 2010 when they signed a deal with Warner Brothers to delay their rentals for 28 days to allow WB first crack at selling discs, which was part of their deal to cover NEtflix’s streaming of WB content.

    Once the studios started tying their streaming deals to DVD rental restrictions, the law of the land of first-sale doctrine was voluntarily ceded by Netflix. So while that 1908 Supreme Court ruling was the basis for Netflix’s business through 2009, it rapidly fell by the wayside starting way back in 2010.

    Reply
    • bgurley September 19, 2011

      It still allowed them to provide breadth.

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  30. Quang September 19, 2011

    I’m afraid this move will simply hurt Hollywood more so than Netflix as people will simply download (on demand) from pirated sites. It’s important for media companies to train users to pay for content first (even if its little) than to encourage pirate behavior.

    Reply
    • bgurley September 19, 2011

      Disagree.

    • trlkly September 20, 2011

      @bgurley: Then explain it. Saying “disagree” adds nothing to the conversation and someone of your caliber ought to be better than that. Either explain why the logic is wrong, or don’t say anything.

      I sure as hell know that Netflix’s decision has led me to go back to pirating. The advantage of Netflix streaming was that it came free with real DVDs, which have extras and thus actually add to the content, vs. streaming which doesn’t.

  31. amorde September 19, 2011

    While the first right doctrine is valid, it hasn’t apply to Netflix for some time. In the old days, Netflix and Redbox would both purchase DVD discs and rent them the same day they go on sale. In addition, they would sell the used discs after a few weeks to buyers for as low as $5-$7. However, Hollywood hated this practice because they believe it cut into their DVD sales revenues.

    So they struck the “28 days delay” window for services such as Redbox and Netflix. They also forbade both services from reselling the discs. Now the discs are destroyed if no longer used. In return, Redbox and Netflix received a bulk discount for purchasing their discs directly from the studios and NetFlix also received commitments and content for their streaming service.

    So Netflix is now effectively shooting the dog to save the farm. Leaving the legacy business and pouring their whole resource into the future. It’s probably a smart move in the long run. It’ll be interesting to see if the Qwister service do away with the 28 day delay for movie released on discs.

    Reply
    • bgurley September 19, 2011

      True, but it still allowed first-sale to protect the breadth of the catalog.

    • xzolox September 21, 2011

      First Sale also put the studios in the disadvantageous position of negotiating for rev share from a place where Netflix could continue using First Sale Doctrine if they didn’t like the terms.

      More recently tho, Netflix’s use of rev share has been more harmful to indies who have less retail spread and rely on Amazon… to a consumer Amazon and Netflix require the same number of keystrokes but one is free if you’re a member. Most consumers don’t even realize that indies aren’t receiving any revenue for Netflix rentals and believe they are supporting the filmmakers.

  32. doug rivers September 19, 2011

    “Reed Hastings is one of the best CEO’s Silicon Valley has ever seen.”

    Not quite in the Steve Jobs/Andy Grove category.

    Reply
  33. Latif September 19, 2011

    Hmmm…good analysis Bill. Could Reed perhaps have taken a page from the book of another famous CEO in the valley who had much better luck with content owners…Steve something :)

    Reply
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  36. Carl Brooks (@eekygeeky) September 19, 2011

    This is a superb piece; spot on. Hollywood took a look at netflix stock prices about 2008-ish and said, “Here is an easy way for us to capitalize on the whole ‘digital internets’ thinggummie- someone else has done the hard work, we will now leverage our commodity assets and force him to pay vig”. Netflix is now on the hotseat. Does anyone seriously think they wanted to take a revenue model that took them through 4 years of exponential growth and CHANGE it? Netflix is not yet in the position to turn the clamps on subscribers; They’re in a corner and shucking and jiving.

    Left unsaid, but instantly and easily extrapolated, is that there is a significant chance Netflix will not be able to make the numbers add up and will either be bled dry or wither away on its lame streaming catalogue. The road is littered with online media delivery- Joost, anyone?

    Hollywood does not understand the concept of a golden goose- it’s rare that any cartel does. Look what they’ve done to the movie theater business. prices are through the roof and ten straight years of sh*tty box office numbers.

    They’d rather see netflix out of business and online media delivery stunted before they’d open up and license what people want to see online. They want to own the action or see it gone- there’s nobody with enough leverage, right now, to make them play ball.

    A few more years of box office garbage and reboots, kill off the remains of the theater business, maybe a major studio will fold; that would have brought them to the table. Not now, tho, they’re going to cripple Netflix, have a stab at it themselves by partnering wit the cable companies, provided they can get a few Republican terms in the White House(to put in the fix at the FCC) and launching various Netflix-style services.

    Reply
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  40. Davis Freeberg September 19, 2011

    You have a misunderstanding of how Netflix has purchased their content in the past and why they’ve made changes to those contracts now. You’re right that it ties into the first sale doctrine, but I think that you’re jumping to the wrong conclusions.

    When Netflix first started, they would have been fools to pay big money for content that people might not watch because there was no guarantee that they could sell that content to a big audience. By leaving streaming free they were able to convince customers to try something without having to pay. This eliminated one of the biggest barriers to entry that other streaming services face and really put the rockets on streaming growth. Look at why Vongo (starz), CinemaNow and others failed and it was because of the high minimums they gave Hollywood + per rental fees on top of that.

    On the other side of the business though Netflix was making shrewd calculations. By looking at the number of times a disc rented and dividing it by the cost of the disc, Netflix was able to achieve a maximum average price that they could cap digital content as.

    For example, if a new DVD sells for $15 and Netflix can rent it 25 times before my dog turns it into a chew toy, then on average Netflix’s cost for that content is $1.45 per rental (0.85 for postage and .60 for the DVD) If they know that demand for that disc will likely be 25,000 people then they’d have to buy 1000 discs. In this scenario Netflix is able to offer up to $1400 (1.40 * 1000 +.05 to pay bandwidth) for the digital content. If they can convince 50,000 people to watch it because it’s instant and there aren’t better movie available then they start saving money when you stream online. Since Netflix is the one that has access to their numbers, they could do the internal calculation for which was a better way to spend and cherry pick the worst/cheapest digital content. If the studios did get greedy then A.) customers could always rent the DVD and B.) the studios would start losing money to streaming competition eventually because thats what consumers preferred.

    As long as Netflix was the little guy, this worked out great and allowed them to use one part of the business to support the other. If the studios wanted $100 million, they could tell them to kick rocks and still offer it as a choice to their customers. Somewhere along the way though, streaming took off for Netflix and started to attract competition. By changing tactics and paying top dollar for movies, it is putting pressure on Amazon, Hulu and others to pay the same. From Amazon’s perspective how can they justify paying $200 million per year when they have to grow their service from start. Maybe in 5 years they could, but today it will saddle them with costs that keep them uncompetitive. Even the almighty Apple hasn’t been able to solve the minimum contract nut, but the studios would support Netflix because if they didn’t other people would. With the most number of subscribers, Netflix can now afford to set the bar for digital content very high. If the studios get greedy and charge upstarts more then it only works to Netflix’s benefit.

    If the studios are demand x# of $ per month then they could have said no and still kept a strong business, but by agreeing to contracts where they revenue share for big money or exclusivity, they can keep the streaming market from becoming competitive. Frankly, I think the whole thing stinks to high heaven for consumers and would not be surprised to see anti-trust lawsuits filed by the new scheme. Over the longer run, I think they just made the new Blockbuster the only real competition out there.

    Reply
    • Rich Thomas September 20, 2011

      Davis,

      You forget that all copyright is anti-competitive. It is a legal monopoly on that piece of content. It gives the content providers a lot of power over how the content is offered

  41. Ric September 19, 2011

    Thank god a voice of reason that proposes the same logical that anyone with insight into the situation would agree with. I get so sick to death of active Netflix users whining about the moves they are making because they dont necessarily understand all the nuance.

    Well, that also means they are not tipping their hand to the content providers as well. They have changed the face of the content delivery model for movies and I dont think they are done either! Netflix has delivered insane value to me over the years and in return I offer loyalty for that value. I cut the cord 15+ years ago and that dinosaur industry cant compete with what Netflix offers even at the higher price!

    As to the moron that mentions listening to the voice of its customers, I think it is time for the customers to look a little deeper and trust in a company that has innovated where everyone around them wanted to stagnate and gouge their customers so they could deliver less and milk the customer for more!

    Besides, many of you whiners out there would still be forced to use inconvenience bit torrent if it wasnt for Netflix! Or how about those $3 to $5 blockbuster rentals not including late fees? How easy these punks forget!

    Reply
  42. jiamei September 19, 2011

    While the first sale doctorine does apply in some cases to the DVD’s, Netflix by agreement was using a revenue sharing program with the studios on a good portion (about half according to an old Hacking Netflix article). A lot of assumptions in this article might be slightly off given this fact.

    Reply
    • bgurley September 19, 2011

      many have made this point — but first-sale still allows for the marketing of the broad catalog and long tail.

  43. Steven Moody September 19, 2011

    Excellent insight, I hadn’t considered the other players.

    Reply
  44. Erich Ocean (@erichocean) September 19, 2011

    I think your “It is what it is” comments is perhaps masking something important: that Netflix’ business model is in danger.

    There is no reason why Netflix should get a price break to stream content vs. cable providers. They know it, cable providers know it, and the studios certainly know it. Content providers will hold firm here, I’m certain of that.

    If this latest split is really a recognition of this underlying reality (and I agree with you that it is), having a “brilliant” CEO isn’t going to fix this. It is what it is, to use your phrase: Netflix cannot compete given the new cost structure.

    And really, Netflix is the only company with something to lose here. We already pay large sums each month to Comcast or Time Warner for our internet — that’s not going to change, no matter how high Netflix raises their prices. When push comes to shove, Netflix is the one who’ll get squeezed, and it’s already starting to happen.

    I just don’t see a way out. It’s balsy to recognize you’ve lost, I suppose, but Hastings (IMO) is destroying far more shareholder and customer value as Netflix continues its descent into irrelevancy than it needed to. Sometimes, you just need to milk the cow after you’ve grown it. He’s slaughtered it, and there’s no other cow to be milked.

    Reply
  45. Red pencil September 19, 2011

    An interesting perspective sullied only by news-anchor cliches like “perfect storm” and “fast forward” (back to back? Weep) and “It is what it is.” Stop those, please.

    Reply
  46. jlawson September 19, 2011

    Someone mentioned on here that Netflix should do like Steve Jobs did with music and apply it to the movie industry. I think when that happened, music was in a very different place then movies are now. While I could be completely wrong (and if so, someone please correct me) but I feel as though the movie industry hasn’t been hit as hard as the music industry when it comes to pirating. Finding and downloading movies is a bit harder and takes longer than downloading movies and there is still a strong desire to see something on the “big screen” rather than on a small monitor. With music, how it is experienced doesn’t have as big of an impact as it does with movies and therefore hasn’t impacted the movie industry as much. Because of this, I don’t feel that the movei industry is as eager to negotiate terms with companies like Netflix.

    Reply
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  51. Alyse Lamparyk September 19, 2011

    As a netflix user who was a bit irritated and confused about the switch, I’m thankful for your insight. It makes a lot more sense now!

    Reply
  52. Pingback: Why did Netflix spin-off it’s DVD service? | Swiftfilm

    • bgurley September 19, 2011

      Bingo.

  53. Pingback: Netflix Spins Off DVD Rental Business to Qwikster, Retaining Video Streaming | Experts Bto

  54. Joseph September 19, 2011

    Bill,
    You are correct about why Netflix needs to separate their customers , because unless they can greatly reduce the number of customers paying for streaming content they face an early termination of service because they have exceeded their customer cap.
    Where you failed is thinking that Reed Hastings is a one of the best CEO’s Silicon Valley has ever seen , I would leave that to Steven Jobs.
    The failure at Netflix is that Mr. Hastings is a horrible communicator that has failed to connect with what had been a faithful and devout customer base.
    There are some major problems facing Netflix, content costs that will be north of 10X what was being paid. New contracts being signed by the media companies that will prohibit streaming of many movies for some 8 years after release. Losing their relationship with Starz and the lose of the Sony and Disney content. Losing their Showtime content.
    The plus side is that Netflix is developing its own content but it is my stance they should go all out and try and buy studio libraries and or launch their own production company and go head to head with the other content producers.

    Reply
    • bgurley September 19, 2011

      I think Reed has created an amazing about of equity value. Sure Steve J did more, but that’s the best comp in the business. Reed is top 3 (with Bezos). Marc B on their heels!

  55. Becks September 19, 2011

    I would have paid $20 a month if I could’ve got better movies along with the streaming.

    Reply
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  57. ClayMillennium September 19, 2011

    Wow great analysis and the first I’ve read like it.

    Reply
  58. Statspotting September 19, 2011

    I am not sure if that is so simple. This simplifies the pricing decision so much.

    Reply
  59. Toob September 19, 2011

    “Because of the first-sale doctrine, any DVD reseller, including Netflix, can basically buy a DVD at WalMart, and turn around and rent it to someone else the very same day.”

    Is this an US-thing? Here in Sweden there are even huge texts stating that you are forbidden to basically do anything but watch the movie by yourself (God forbid if you invite your neighbors to watch the movie with you!)

    Reply
    • bgurley September 19, 2011

      Yes — read the Supreme Court ruling.

    • Carl Zulauf (@existensil) September 20, 2011

      Content distributors (the MPAA in particular) are notorious about putting warnings on content that state you can’t do things you actually have a legal right to do. The warnings in the US are the same, and fail to inform you of your first-sale rights, your fair use rights, your legal copying rights, and many other rights our copyright laws guarantee US citizens. While Sweden might not have a similar first-sale rule (though they may) from what I’ve read it sounds like Sweden does have some guarantees in your copyright laws that provide some of the rights we call “fair use” in the US.

    • Jim September 20, 2011

      America has some weird rules like that too that I’ve heard of. I haven’t read/seen the text myself, but have friends who have, and who have had to deal with it all. For example we’re not supposed to show a home movie to a group larger than… 20 or so, something like that. We can’t charge admission, Public vs. private property makes a diff, etc.
      They are rules that not to many know or care about though, cause how can they enforce such a thing. But I will also have to look into the US Supreme Court ruling to find out more.

    • Terry Chay September 20, 2011

      In Europe, it’s the reverse. I believe it’s called, “Droit de suite.” http://en.wikipedia.org/wiki/Droit_de_suite

  60. Adrian Cockcroft September 19, 2011

    While it sounds plausible, this analysis is completely wrong. Buying content is complex, but Netflix does not buy content in the pay-per-view window (like iTunes movies and many others), it buys rights for a time period for a price in a later window (i.e. the content is older). That price is decided up front, not by how many people watch the content. Netflix does have the money to buy the content, and is outspending it’s competition. Go look at the revenue and what it’s spent on in the quarterly letter to investors. This pivot is about setting up for rapid expansion of global streaming. The DVD to streaming pivot happened a few years ago.

    Reply
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  65. Fred Wilson (@fredwilson) September 20, 2011

    awesome post Bill

    first sale doctrine is a lot like the compulsory license for internet radio. once you go to on-demand, you are negotiating with the rights holders and then you are in a different game.

    i reblogged my favorite part of this post

    http://fredwilson.vc/post/10438212545/hollywood-is-a-unique-place-and-understanding

    Reply
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  67. spider42 September 20, 2011

    Most interesting… also shows the flaw for all the people I know who were obnoxious about how they never need to buy another dvd and tossed out their players and all that, only to face the reality I told them would come when sooner or later every business either through market conditions or by a choice to make more profit WILL increase the price when they are ruling the roost.
    Ah well… Nice piece, enjoyed reading it.

    Reply
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  69. TechyDad (@TechyDad) September 20, 2011

    This does sound like the real reason why Netflix is separating their services. The problem is that they didn’t just say this. They didn’t say “To get great streaming content, we need to pay a certain amount per user with access whether or not that user actually accesses the content. Thus, if we split the businesses, we will only have the customers who want streaming and will wind up paying less for the content. This, in turn, will help us stave off future price increases while allowing us to get more content.”

    Instead, Hastings said: “We feel we need to focus on rapid improvement as streaming technology and the market evolve, without having to maintain compatibility with our DVD by mail service.” Perhaps he meant to say the above statement, but without the full explanation it comes off as “We’re doing this to improve the customer experience, despite the fact that customers will have to deal with the inconvenience of 2 different accounts and queues to manage.

    Customers are often willing to be understanding, but by not being transparent Hastings takes a decision that might have actually been a good one and turned it into a “shooting your food, reloading and shooting the other foot” moment.

    Reply
  70. Bryan Bertón Tanner September 20, 2011

    It all makes sense now.

    Reply
  71. SRBAC September 20, 2011

    Don’t know if your analysis is correct, but its very likely streaming cost played some kind of part in the events. Netflix has made some very good business decisions for years and I don’t believe they suddenly got dumb.

    Making major corporate changes will always draw some fire from the consumer. If Netflix continues their good customer service practices the objections will subside. In the long run separate is better.

    Reply
  72. Joe September 20, 2011

    Who cares about Reed problems, that is his job. He dumped his promlems on the consumer and consumer is angry. They are leaving to anyone else offering similar priced service just because perception is negative now for netflix. With this split netflix is less competitive. it have to compete in two different categories (dvd vs streaming) and will get beaten in each ..netflix just fried itself by this stupid move.

    Reply
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  74. Rob September 20, 2011

    Too bad…

    Had a download subscription with Netflix for several years. But truly disliked that 90% of the movies I wanted to watch were only DVD only. (Which would cost more). When the price raised…they lost my business.

    On the side, I have better luck at the local library for free and I can walk there. A little exercise, then a movie. It all works in the end.

    Reply
  75. Pingback: Netflix Splitting into Two Companies, Adding Video Games to Mix | Gaming Bus

  76. Carl Zulauf (@existensil) September 20, 2011

    I think a possibly more significant incentive for Netflix to separate their DVD business from streaming had to do with content providers using their streaming agreements as leverage to force changes to Netflix’s DVD rental service. I imagine this is how Warner Brothers was able to get Netflix to agree to not rent out their DVDs until 30 days after release. Netflix has no incentive to do so unless WB was dangling a lucrative streaming contract in front of Netflix.

    By divesting themselves of DVDs Netflix may be avoiding the numerous pitfalls of negotiating with content distributors who want to impose their will on Netflix’s DVD-by-mail business. A Netflix that does streaming only may also be a bit less scary to content providers who fear Netflix will “take over” and may lead to much easier content acquisition negotiations, which I think is pretty much the point you made, I’m just suggesting additional motives.

    Reply
    • bgurley September 21, 2011

      I think you are likely correct!

  77. Pingback: NetFlix Messes Up Again: More Expensive and Harder to Use | Digitivity

  78. Jeanette September 20, 2011

    Everything the article says except for what it doesn’t say: Of Netflix cannot afford something at a certain price say so and don’t trick anybody. Once I saw Red Hastings pulling tricks I stopped my subscription and sold my shares of Netflix (lucky enough I bought at 153 and sold them, at 226.

    Reply
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  81. tarotworldtour September 20, 2011

    People underestimate the power of Hollywood worldwide, as epicenter of global propaganda and opinion formation. When I lived in South Korea the first time in 2007, we could get DVDs on the street for about $2.50 which were of films just released. The following year there was a massive raid instigated by the studios and a lot of people I dealt with were sent to jail for a while. Not only are they naturally out to make money to sustain themselves (which is perfectly reasonable), they have to fund their ideological expenses which ensure 1) English hegemony and continuation of it as lingua franca, 2) maintaining the war on terror mentality, and 3) preparing the population for an era of scarcity but still keeping their taste for gadgetry. Thanks for the market news!

    Reply
  82. Terry Chay September 20, 2011

    A friend linked your article. Here is my take on the above:

    http://terrychay.com/article/dvds-by-mail.shtml/comment-page-1#comment-682862

    (I apologize for the directness of my critique. I am speaking that way to hammer a point to a third party, and wouldn’t be nearly this crass in person.)

    Reply
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  84. Josh Woodlander September 20, 2011

    Right on the money and very insightful. You point out the same thoughts that came to my mind… This does not sound like some clever boardroom business plan idea at play. This sounds like a decision one makes when one has a gun to their heads… aka Hollywood laying down the law to NetFlix. It is a disservice for journalists to miss this point. Thanks for the excellent analysis.

    Reply
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  86. observer September 20, 2011

    Sorry but this analysis is counter intuitive to me. What you are communicating is that netflix wants to constraint the number of streaming users otherwise we maybe in for another price hike? I believe the business model was flawed to begin with, realization was a tad too late and is proving costly.

    I can see netflix delivering content with ads to offset costs whilst keeping prices in check.

    Reply
    • bgurley September 21, 2011

      No. Simply put why pay a per month “cost” for someone that is not using the service.

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  89. Matthew C September 21, 2011

    Thank you for your opinion. This is the first thing I have read about these moves that makes any sense, but this further points out how flawed Reed Hastings decisions have been. He has never explained this. I know that they can tell who is streaming and who isn’t. I have to provide login information in order to stream. They don’t need to split the companies in order to provide data of who is streaming or even who has the rights to stream.

    I don’t think you are ever going to have a streaming service where you can watch whatever you want for a low monthly subscription. There will always be too many people who want a cut. Thank you to Netflix for helping me realize that we will never have a movie rental company like Blockbuster or the old Netflix again.

    Reply
    • Brian September 23, 2011

      “They don’t need to split the companies in order to provide data of who is streaming or even who has the rights to stream.” – This misses the point a bit. Yes, Netflix could do that. But the movie studios don’t want to be paid per user who *does*, they want to be paid per user who *could*. Kind of like a movie studio wanting a theater to pay per customer who is physically able to get to the theater… Greedy

  90. Pingback: Netflix: How Not to Communicate with Customers, Part 2 « Kathy Lisiewicz

  91. Matty Yohannan September 22, 2011

    First-Sale Doctrine is also the reason Redbox has thrived.

    I agree with Bill Gurley – this is something Netflix HAD to do. That said, for some time now the bear argument on the stock has been all the advantages Netflix has is in DVD-by-mail world goes away in the streaming world.

    Additionally, you are now competing with REALLY GOOD well-capitalized Internet players (AMZN, GOOG) with different motivations that Netflix.

    From a consumer perspective – if you are forcing me to make a decision (NFLX subscription just went from costing one beer/mo to two beers/mo), unless you are giving me more utility (better content and more access, or similar) – then there’s a high likelihood I leave until something changes. AND you’ve made it really easy to sign back up again.

    Reply
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  102. Jose Gonzalez October 1, 2011

    Excellent article. The fact still remains for the consumer; Watch Instantly provides a large selection of poor films in contrast to the mail option’s full selection of DVDs. Netflix presents every obscure serial Western from the 30s, 40s, and 50s and is typical to their Instant Watch method; stream marginal presentations (most pulp with some classic material) with a small percentage of quality films in rotation. It is comical how difficult it is to find decent films and how slow the fare changes. Ideally, full content would be provided on Watch Instantly as it cost the same as the DVD alternative. And additionally, cable would provide shows on demand. I have cancelled my cable and am about to cancel Netflix. Thanks for detailing the problem’s legalities, but it soon will not be my problem.

    Synopsis: How to stream Three-Card Monte.

    Reply
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  104. shredster October 5, 2011

    Why didn’t Netflix segment the base? i.e. $7.99 for DVDs with the option of paying $3.99 extra for streaming? This would have been more reasonable for current users. And bridges the gap of content between online and DVD. Finally, it also deals nicely with the studios requirement that they get paid for everyone with access.

    Reply
  105. Neal October 12, 2011

    Bill – On DVD “doctrine of first sale”, why did Netflix start delaying their rental till 30 days after DVDs are for sale?

    Reply
    • bgurley October 13, 2011

      My best guess, and there is some documentation to this affect.

      The content owners have been pushing against first sale with all their might, and have made some headway. Most importantly, they are terrified of DVD rentals impacting DVD sales (which are much, much more profitable). This gives them some leverage in a negotiation.

      Also, if there is a hot new movie, Netflix would need thousands and thousands of copies — they would have trouble gathering that many discs. So the “Delay” is the result of a negotiation. As you can see in the comments here, Netflix has been negotiating with Hollywood for some time on bulk rental. They are not 100% “first sale,” but first-sale does allow them the deep and broad historic catalog.

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  107. Ty November 3, 2011

    I don’t buy any of that.

    The could easily have split the two services in a revenue-neutral fashion. Instead they increased revenues by 60% while addressing the digital rights issue. This happened because they had a massive boost in subscriptions and were nearing monopoly status. This is the reason why people should be turned off by massive companies and stop giving them their money; it’s you who’ll pay in the end for your “sweet deal”.

    Reply
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  110. Benson Garner December 29, 2011

    Great article!

    Reply
  111. Robin Smith February 3, 2012

    Good work on CNBC. Your interview is what encouraged me to go to this site. And I NEVER do that. Then I read your thoughts on the NFLX pricing and found that very enlightening, as I wait to get back to even. Sent the EDMODO recommendation to a couple people who I believe will be interested to see it.
    Thanks.

    Reply
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  114. mike March 17, 2012

    Although the reasoning you give is realistic to the company, the companies sole and only reason to function is the end user. This was a briliant idea at the onset, customers, and personally myself have been a fan from the begining. I am sure they realize this now, but everyone is eating their lunch, the likes of redbox, amazon prime, and untold other competition, have been invited in like vultures to lure their customers away. The arrogance of customer relations and the self inflated (can’t live without us menatality) has brougt a fine idea and model to a grinding halt.
    It really does not matter why they did what they did to the average customer, we all know that we no longer are getting the deal that we once enjoyed, and they are confusing people, (frustration) is one way to turn off the well spring.

    This is not the only company that has lost the trust of its valued customer, it goes on a daily basis.
    the mishandling of the consumer, although out of their entire control, the on demand catalogue is a limited joke. Amazon prime members who already subscribe to that service ro $80 a year for shipping and other services, they just now took over the on demand portion of netflix.
    Confuse your customers, give them all but what they wanted in terms of the value, and your likely to sink a ship. So needless to say i am dissapointed with the company of which i have been a fan. In these increasingly tight times, the value of a dollar is still the value of a dollar.

    Reply
  115. rileth63 March 26, 2012

    Very insightful. Thanks

    Reply
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  117. John June 10, 2012

    It makes sense, and I think people should understand. The only thing problem with Neflix is, that they do not have the latest movie for streaming and they should do that more than DVDs. Because, there are customers who only have streaming option and we would like to get content sooner than running into red box and paying again redbox.

    Other than that, Netflix has less choices when it comes to International movies. We would like to see more Indian movies, as there are quite a lot of Indians in America. Specially, good Hindi, Tamil movies. I have already informed their support staff, and they started putting in some movies, but that is not enough for Tamil viewers who would love to see tamil movies through netflix.

    Reply
  118. Glen Maddern June 18, 2012

    Hi Bill, it’s been about 9 months since this article – I wonder if you’d care to comment on the latest development with Netflix closing its doors to third party services? I agree Netflix has undergone a pivot in the last year, but I wonder if this is a backwards step – http://goodfil.ms/blog/posts/2012/06/18/netflix-quietly-smothers-3rd-party-app-ecosystem/

    Reply
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