1. Information Systems: A Manager’s Guide to Harnessing Technology

2. This work is licensed under the
This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License. To view a copy of this license, visit send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA

3. Chapter 4 Netflix: The Making of an E-commerce Giant and the Uncertain Future of Atoms to Bits

4. Learning Objectives
Understand the basics of the Netflix business model
Recognize the downside the firm may have experienced from an early IPO
Appreciate why other firms found Netflix’s market attractive and why many analysts incorrectly suspected Netflix was doomed

5. Learning Objectives
Understand how many firms have confused brand and advertising, why branding is particularly important for online firms, and the factors behind Netflix’s exceptional brand strength
Understand the “long tail” concept, and how it relates to Netflix’s ability to offer the customer a huge (the industry’s largest) selection of movies
Know what collaborative filtering is, how Netflix uses collaborative filtering software to match movie titles with the customer’s taste, and in what ways this software helps Netflix garner sustainable competitive advantage

6. Learning Objectives
List and discuss the several technologies Netflix uses in its operations to reduce costs and deliver customer satisfaction and enhance brand value
Understand the role that scale economies play in Netflix’s strategies and how these scale economies pose an entry barrier to potential competitors
Understand the role that market entry timing has played in the firm’s success

7. Learning Objectives
Understand the shift from atoms to bits and how this is impacting a wide range of industries
Recognize the various key issues holding back streaming video models
Know the methods that Netflix is using to attempt to counteract these challenges

8. Introduction
When Netflix went public, financial disclosure rules forced the firm to reveal how profitable it was
Rivals such as Blockbuster and Wal-Mart showed up
Competitors underestimated Netflix because:
It was an Internet pure play without a storefront
It’s overall customer base was microscopic in comparison

9. Introduction
Newcomers mimicked Netflix with cheaper rival efforts forcing Netflix to cut prices
Netflix survived big competitors, a price war, and spending on the rise

10. Why Study Netflix?
It gives us a chance to examine how technology helps firms craft and reinforce a competitive advantage

11. Netflix CEO Reed Hastings
Source:

12. How Netflix Works

13. How Netflix Works Netflix settled on a DVD-by-mail service model
It charges a flat-rate monthly subscription
Customers don’t pay mailing expenses and late fees
Videos arrive in Mylar envelopes containing:
Prepaid postage
Return address
After watching the video, consumers:
Slip the DVD back into the envelope
Drop the disc in the mail

14. http://latimesblogs. latimes

16. How Netflix Works
Users make their video choices in their “request queue” at Netflix.com
Consumers use the Web site to:
Rate videos
Specify movie preferences
Get video recommendations
Check out DVD details
Share their viewing habits and review

18. Tech and Timing: Creating Killer Assets
Building a great brand online starts with offering exceptional value
Advertising builds awareness, but brands are built through customer experience
Subscribers expectations from Netflix:
Huge selection
Ability to find what they want
Timely arrival
Ease of use and convenience
Fair price
Search function
Technology drives all of these capabilities
Technology is at the center of the firm’s brand building efforts

19. Selection: The Long Tail in Action
Netflix offers its customers a selection of over 100,000 DVD titles
Traditional retailers cannot offer this because of shelf space constraints
Traditional retailers can determine their breakeven point by considering:
Number of customers that can reach a location
Store size
Store inventory
Payback from inventory
Cost to own and operate the store

20. Selection: The Long Tail in Action
Internet firms can have just a few highly automated warehouses
Long tail: A phenomenon whereby firms can make money by offering a near-limitless selection

21. Figure The Long Tail

24. Selection: The Long Tail in Action
The long tail works because:
Cost of production and distribution drop
It gives the firm a selection advantage that traditional stores cannot match
Geographic constraints go away and untapped markets open up

25. Selection: The Long Tail in Action
Netflix has used the long tail to create close ties with film studios
Studios earn a percentage of the subscription revenue
Netflix gets DVDs at a very low cost
Studios do not spend on additional marketing (after box office and DVD releases)

26. Cinematch: Technology Creates a Data Asset that Delivers Profits
Netflix uses a proprietary recommendation system called Cinematch
Each time a DVD is returned, Cinematch asks the customer to rate it
Collaborative filtering: A classification of software that monitors trends among customers and uses this data to personalize an individual customer’s experience
It can be mimicked by competitors

27. Cinematch: Technology Creates a Data Asset that Delivers Profits
The data provided by Cinematch is a switching cost
To see how strong switching costs are is to examine Netflix’s churn rate
Churn rate: The rate at which customers leave a product or service
In mid-2008, churn rates for Netflix’s most active regions were below 3 percent
Netflix’s marketing costs benefit from satisfied customers, as referrals are a better choice than advertisements
Netflix launched a crowdsourcing effort known as The Netflix Prize

28. A Look at Operations
Technology lies at the heart of Netflix’s warehouse operations
Netflix has a network of fifty-eight ultrahigh-tech distribution centers
Distribution centers are all located close to U.S.P.S. facilities
Trucks collect DVD shipments from these U.S.P.S. hubs and return the DVDs to the nearest Netflix center
Scanners pick out incoming titles
Netflix presorts outgoing mail before dropping it off at the U.S.P.S. facilities
All DVDs are hand-inspected for cracks and smudges
Warehouse processes are linked to Cinematch

29. A Look at Operations
Staff members are expected to focus on improving the firm’s processes
Quality management features are built into systems
Netflix can monitor and record the circumstances surrounding any failures

30. Killer Asset Recap: Understanding Scale
Netflix’s size gives it a huge scale advantage
Scale economies allow firms to:
Lower prices
Spend more on customer acquisition, new features, or other efforts
Smaller rivals have an uphill fight
Established firms end up straddling markets

31. Killer Asset Recap: Understanding Scale
By moving first, Netflix gained scale advantages
Largest network of distribution centers
Largest customer base
The firm’s industry-leading strength in brand and data assets

32. From Atoms to Bits: Opportunity or Threat?
Many media products are created as bits (digital files)
When we buy a CD, DVD, book, or newspaper, we’re buying physical atoms that are a container for the bits
Atoms to Bits
The idea that many media products are sold in containers (physical products, or atoms) for bits (the ones and zeros that make up a video file, song, or layout of a book). As the Internet offers fast wireless delivery to TVs, music players, book readers, and other devices, the “atoms” of the container aren’t necessary. Physical inventory is eliminated, offering great cost savings.

33. Access to Content
When Netflix launched its streaming video option, only 17,000 videos were offered
Legal issues involved in securing the digital distribution rights
Windowing restricts the number of titles available
Wal-Mart uses its bargaining power to encourage studios to:
Hold content from competing windows
Limit offering titles at competitive pricing during the new release period

35. But how does it Get to the TV?
Netflix initially developed a prototype set top box
It then developed a software platform that allowed firms to build Netflix access into their devices
Advantages of the atoms to bits model
Netflix will eliminate a huge chunk of its shipping and handling costs
Bandwidth costs are minimal
Hulu.com & Hulu Plus

36. But how does it Get to the TV?
Disadvantages of the atoms to bits model
Wrangling licensing costs is a challenge
The switch to Blu-ray DVDs means that Netflix will be forced to carry two sets of video inventory
Standard
High-definition

37. From Atoms to Bits
The shift from atoms to bits is realigning nearly every media industry. Newspapers struggle as readership migrates online and once-lucrative classified ads and job listings shift to the bits-based businesses of Craigslist, Monster.com, and LinkedIn.
Apple dominates music sales, selling not a single “atom” of physical CDs, while most of the atom-selling “record store” chains of a decade ago are bankrupt.
Amazon has even begun delivering digital books, developing the Kindle digital reader.
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38. http://money. cnn. com/video/news/2011/06/21/n_comcast_ceo_netflix

39. Subscription movie rental service Netflix (NFLX) is launching new, unlimited DVD-only plans in the U.S. -- but as a part of that move, it's scrapping unlimited plans that include both physical DVDs and online streaming.
Netflix said that the changes are meant to "better reflect the costs" of each option. The changes cut prices slightly for customers who only want DVDs, but streaming video will now cost extra. Customers who want both options will essentially have to pay for two plans, raising their overall bill.
Netflix's unlimited streaming-only plan will remain at $7.99 a month, while its "1 DVD at a time" plan will also cost $7.99. That means customers who want both streaming and DVDs will have to shell out at least $15.98 a month.
That's a big jump from the $9.99 a month customers currently pay for a plan that offers unlimited streaming plus 1 DVD at a time.
The move comes as Netflix continues to shift its focus toward online streaming video -- an option that, while popular, costs Netflix loads of cash
Netflix first introduced streaming plans in Since then, the service's membership has climbed from 6 million to 23 million in the U.S.

40. A Threat to Netflix: The Rising Licensing Fees
Netflix relies on licensing deals to stock its on-demand offerings -- and the cost of those deals is about to skyrocket.
Print
Netflix's vanished Sony films are an ominous sign
Comment
By Julianne July 11, 2011: 5:26 PM ET
Netflix relies on licensing deals to stock its on-demand offerings -- and the cost of those deals is about to skyrocket.
NEW YORK (CNNMoney) -- In the not so distant past, Netflix was known mainly for its red envelopes. The DVD-rental-by-mail service was the company's core, and streaming video was a side perk for subscribers.
Fast forward to 2011, and online movies and TV couldn't be hotter. Google, Amazon, Hulu and others have jumped into the fray -- putting studios in the power position. They want to be paid more for the content they're providing.
That spells trouble for Netflix's streaming content costs.
"Netflix has another year or two on most of these contracts, and then the game completely changes," says Michael Pachter, analyst at Wedbush Securities.
Pachter predicts Netflix's streaming content licensing costs will rise from $180 million in 2010 to a whopping $1.98 billion in 2012.
When streaming video was new, Netflix was able to secure contracts with the likes of Warner Bros. Studios and MTV to license big TV and film catalogues for about $5 million to $10 million per year. This time around, Pachter says, those costs could increase more than tenfold.
"The content owners realize they can't give Netflix all the leverage," he says. "Netflix had the power when they were the only bidder. But you don't have as much leverage when you suddenly have competition."
Netflix expands to 43 new countries
Netflix subscribers got a taste of the studios' new hardball approach last month, when hundreds of Sony (SNE) movies -- including high-profile titles like "The Social Network" and "Salt" -- abruptly vanished from Netflix's "watch now" catalog.
In a blog post, Netflix pinned the blame on a "temporary contract issue" between Sony and Starz, a pay cable network that licenses Sony's movie catalog. Back in 2008, Netflix struck a four-year deal with Starz that gave it streaming access to Starz' offerings.
But Starz' deal with Sony included a cap on the number of subscribers who can watch Sony movies online, a source told the LA Times. Once Netflix' audience exceeded the cap, the contract was null. Starz' catalog of Disney movies available for online streaming is on the verge of triggering a similar contractual cap, the newspaper reported.
In a letter to shareholders earlier this year, Netflix called the Starz arrangement "one of our most important deals," because it's one of the few that gives Netflix access to relatively recent films. The deal runs through early 2012, but the Sony/Starz standoff could accelerate the renewal talks.
0:00 / 3:27 Comcast CEO: Why Netflix won't kill us
"Studios are starting to put their foot down," says ThinkEquity senior analyst Atul Bagga. "They weren't paying attention to streaming at all, but now they see an opportunity to monetize. And they're going to take it."
That's a big threat to Netflix. On the other hand, the company has the money and motivation to spend more to keep its rapidly growing subscriber base happy.
"The cost of content is going to go up, no doubt about it," Bagga says. "It's going to come down to who has the ability and the willingness to write big checks. Netflix is probably the one to do it."
Netflix (NFLX) had a $161 million profit last year on sales of $2.2 billion, and it ended last quarter with $342 million in cash on hand.
But Netflix's rivals have much bigger wallets. At the end of the first quarter, Amazon (AMZN, Fortune 500) had almost $7 billion in cash, and Google (GOOG, Fortune 500) had a whopping $37 billion.
In another bit of uncertainty, Netflix's most direct competitor, Hulu, is on the block. Walt Disney Co. (DIS, Fortune 500) Chief Executive Robert Iger said at a conference last week that Hulu's owners -- who include Disney -- are "committed to selling" it.
The list of interested potential Hulu buyers includes Google, Microsoft (MSFT, Fortune 500), Amazon, Yahoo (YHOO, Fortune 500) and nearly every other tech giant, plus telecoms like AT&T (T, Fortune 500) and Verizon (VZ, Fortune 500). Landing Hulu would give any of them a strong beachhead for challenging Netflix.
Right now, no one else has cracked the code. Netflix's global subscriber base grew almost 70% over the past year, to 23.6 million users. In contrast, Google's movie offerings on YouTube and Amazon's streaming catalog are still new and fairly paltry compared with Netflix's arsenal.
"Netflix is the first and the biggest," Bagga says. "In a broad sense, the rivals aren't competing with each other. Everyone is competing with Netflix."
But if this turns into a clash of titans, Netflix is still a small player battling much larger and richer giants.
"Netflix is merely a conduit," Pachter says. "Of all the people who want to be in the business -- Google, Amazon -- they're smaller by far. The big boys will take share of subscribers, or bid up the cost of content. Either way, Netflix loses."

41. Update
Netflix has more than 23 million subscribers. The company has a very popular online streaming program that's available on dozens of electronic devices, including computers, video-game systems, television set-top boxes, smartphones and tablets.
In Canada, Netflix offers only the streaming service, not the DVD mailings.
However, the streaming program's convenience and ubiquity is sometimes overshadowed by its dearth of quality movies available for streaming, relative to those contained in Netflix's extensive DVD catalog.
(CNN) -- If Netflix had filed Tuesday's price-hike news in a movie genre, it would be either drama or horror.
U.S. customers of the DVD-by-mail and Web-streaming service are storming the Internet to protest Netflix's plan to increase the prices of its most popular packages.
"The changes you guys have made in the last 4-6 months have turned me from a serious Netflix Geek into considering cancellation. It's a damn shame," wrote a customer named Justin Block, one of almost 6,000 commenters on Netflix's blog.
Netflix's Facebook page attracted more than 28,000 comments as of Wednesday morning, most of them critical of the move. And thousands of consumers were voicing complaints under #DearNetflix on Twitter.
Netflix 60% price hike
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Netflix has adjusted its offerings, separating physical disc mailings from Internet video. DVD-only subscriptions start at $7.99 per month, the same price as a streaming-only plan. But a monthly plan that combines physical DVDs with Web streaming costs almost $16 -- a 60% price increase.
For prospective customers, the new pricing structure went into effect on Tuesday. For current subscribers, the rates will change on September 1.
Netflix, which did not respond to a request for comment, outlined the adjustment in a company blog post. In the message, a spokeswoman was very upbeat, describing each plan as "a terrific value."
Commenters weren't as enthusiastic.
"The only way that this is terrific for the customer is if you plan to offer your entire collection available for streaming," wrote Scotty Fagaly, a self-described longtime customer whose comment was "liked" more than 4,800 times. "Otherwise, this is just yet another way to choke more change out of your customers."
Time.com: Here are some Netflix alternatives
Netflix has more than 23 million subscribers. The company has a very popular online streaming program that's available on dozens of electronic devices, including computers, video-game systems, television set-top boxes, smartphones and tablets.
In Canada, Netflix offers only the streaming service, not the DVD mailings.
However, the streaming program's convenience and ubiquity is sometimes overshadowed by its dearth of quality movies available for streaming, relative to those contained in Netflix's extensive DVD catalog.
"I realize Netflix cannot stream what the studios do not allow, but this is a disparity that really should be acknowledged in the price scheme," wrote Travis McClain, a decade-long Netflix subscriber who felt compelled to express his frustrations on the company's website.
The price hike came shortly after Sony Pictures Entertainment pulled its films from Netflix's streaming program last month -- a move Netflix maintains is "temporary."
Rivals Hulu, Amazon Instant Video and other online subscription programs have failed to match the size of Netflix's catalog.
However, Netflix can't fall asleep on the couch. The cost to license from Hollywood is likely to increase substantially as deals expire and Netflix gains more influence on the studios' businesses, analysts say.
As a workaround, Netflix plans to ink exclusive licensing deals with high-profile producers, Netflix CEO Reed Hastings said at a technology conference last month. For starters, the company will broadcast "House of Cards," a show starring Kevin Spacey and directed by David Fincher, maker of "Fight Club" and "The Social Network."
Media executives have not been bashful in their recent panning of Netflix.
Comcast CEO Brian Roberts wasn't convinced about Netflix's impact on the industry, he said at a recent event hosted by Fortune magazine. Likewise, Jeffrey Bewkes, CEO of Time Warner, which is working on competing initiatives with HBO Go and TV Everywhere, likened Netflix to the unthreatening Albanian army. Time Warner also owns CNN.
In this case, Netflix is likely in search of additional revenue to offset the growing bandwidth and infrastructure costs, analysts say.
Until now, customers have been getting streaming services at a bargain, said Robert Levitan, the CEO of Pando Networks, a firm that provides streaming software to gaming companies and previously to NBC Universal.
"Consumers have an unlimited appetite for consuming streaming right now," Levitan said. "We all tend to think, as consumers, that we just click 'play,' and it comes down. We don't realize the physical and financial costs of serving that data."
Among many consumers, Netflix is beloved. The company has ranked No. 1 for customer satisfaction in four consecutive years, according to surveys by market research firm ForeSee Results. But Amazon.com, which recently launched its own video-streaming service, narrowly edged Netflix in the most recent annual survey.
Some bloggers offered a broader contextual perspective on the price changes.
"The machines are still featuring people whining about Netflix's fee hike. Meh," wrote Alexis Madrigal of The Atlantic on Google+. "Look at the price of a car. Or college. Or a gallon of gasoline. Or lunch at Applebee's. Or a movie ticket. People don't calculate hourly entertainment value very well."

42. Unlimited streaming will cost $7
Unlimited streaming will cost $7.99 per month, as will taking out one DVD at a time. The combined cost is $15.98 per month, a huge price increase for those who currently pay $9.99 for a combined streaming-plus-one-DVD plan August 2011
After watching customers leave and the company's stock price plummet, Netflix Chief Executive Reed Hastings on Sunday admitted that he had fallen victim to "arrogance" and announced changes to the DVD offering.
The company's DVD-by-mail service will get a new name, Qwikster, and add the option to order video games along with movies.
"We chose the name Qwikster because it refers to quick delivery," Hastings wrote in a blog post and an sent to subscribers. "We will keep the name 'Netflix' for streaming."
Netflix in August announced that it would separate the pricing for online video streaming and DVDs, resulting in a hike of up to 60% for people who utilize both options. A number of customers were outraged, and last week Netflix disclosed that it is on track to lose 600,000 subscribers in the current quarter, after previously telling investors to expect that it would add 400,000.
As a result, Netflix stock fell 26% in two days, equating to a loss of $2.6 billion in market value.
In the post, Hastings defended the policy, which he said will generate more revenue and lower shipping costs so the company can spend more acquiring digital rights to movies and television series. He said the problem was in communication.
"In hindsight, I slid into arrogance based upon past success," he wrote. "Inside Netflix I say, 'Actions speak louder than words,' and we should just keep improving our service.
"But now I see that given the huge changes we have been recently making, I should have personally given a full justification to our members of why we are separating DVD and streaming, and charging for both. It wouldn't have changed the price increase, but it would have been the right thing to do."
A new Qwikster website will launch within a few weeks, Hastings said, separating the company's DVD library and ordering process from the video streaming one. People who use both will have separate charges on their credit cards.
The addition of video games to Qwikster is a change of policy for Netflix after the company for years denied that it was interested in adding titles for the Wii, Playstation 3 and Xbox 360 to its DVD collection. It also puts Qwikster into competition with Gamefly, the long-standing leader in subscription video games by mail.
-- Ben Fritz

43. Netflix in August 2011 announced that it would separate the pricing for online video streaming and DVDs, resulting in a hike of up to 60% for people who utilize both options. A number of customers were outraged, and last week Netflix disclosed that it is on track to lose 600,000 subscribers in the current quarter, after previously telling investors to expect that it would add 400,000.
As a result, Netflix stock fell 26% in two days, equating to a loss of $2.6 billion in market value.
Netflix to lose Starz, its most valuable source of new movies
September 1, 2011 | 3:17pm 53
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Premium cable network Starz Entertainment will end its deal to provide movies to Netflix, a surprise decision that will deprive the popular online video service of its most valuable source of recently released movies.
Analysts had said that if Starz were to renew its agreement, which expires in February 2012, it could have been worth as much as $300 million to John Malone's Liberty Media-owned network.
However, executives at Starz apparently concluded that they would lose even more money by giving consumers a reason to subscribe to Netflix instead of the cable channel.
"This decision is a result of our strategy to protect the premium nature of our brand by preserving the appropriate pricing and packaging of our exclusive and highly valuable content," Starz said in a statement Thursday. "With our current studio rights and growing original programming presence, the network is in an excellent position to evaluate new opportunities and expand its overall business."
Starz, which controls pay-cable rights to movies from Walt Disney Studios and Sony Pictures, signed its current agreement with Netflix in At that time, online video was watched by only a small number of tech-savvy young people and the estimated $30 million per year the cable network received was seen as new revenue that would have little impact on its traditional television business.
But Netflix now has 25 million subscribers, the majority of whom watch video online through a variety of devices, including Internet-connected TVs, tablets and smartphones. By providing recently released hit movies from Disney and Sony such as "Alice in Wonderland" and "The Karate Kid," Starz has helped to fuel that growth.
The only other recently released movies Netflix gets for its streaming service come from Paramount Pictures, Lionsgate and Metro-Goldwyn-Mayer via cable channel Epix. HBO, which has offerings from 20th Century Fox, Universal Pictures and Warner Bros., has refused to partner with Netflix.
Starz typically costs about $15 a month for cable and satellite television subscribers, while Netflix streaming costs only $8 a month and doesn't require a pay television subscription.
The move comes two months after Sony movies disappeared from Netflix due to a provision in its deal with Starz. However, people close to the matter had said at the time that they expected Sony movies to return to Netflix soon. With Starz choosing not to renew with Netflix, that will now be a moot point.
The Starz development came on the same day that Netflix implemented a previously announced, controversial price increase that eliminates hybrid plans and charges a minimum of $8 a month to receive DVDs through the mail and $8 a month for online video.
The latter service is likely to become less valuable in the eyes of consumers with the disappearance of Starz's movies and original TV series such as "Camelot."
Starz earlier this year implemented a 90-day delay from the premiere of original series episodes until they became available on Netflix, the first sign that it was reconsidering the value of the partnership.
Netflix stock plunged 8% in after-hours trading Thursday on the news, while Liberty Media stock was flat.
[Updated at 4:57 p.m.: Netflix spokesman Steve Swasey provided the following statement in response to the news:
Starz has been a great content partner since 2008 and we are thankful for their support. While we regret their decision to let our agreement lapse next February, we are grateful for the early notice of their decision, which will give us time to license other content before Starz expires. While Starz was a huge part of viewing on Netflix several years ago because it was some of the only mainstream content Netflix offered, over the years Netflix has spent more and more licensing great TV shows from all four broadcast networks and many cable networks, and we have licensed 1st run movies from Relativity, MGM, Paramount, Lionsgate and others. Because we’ve licensed so much other great content, Starz content is now down to about 8% of domestic Netflix subscribers’ viewing. As we add even more content in Q4, we expect Starz content to naturally drift down to 5-6% of domestic viewing in Q1. We are confident we can take the money we had earmarked for Starz renewal next year, and spend it with other content providers to maintain or even improve the Netflix experience. We have tremendous respect for the Starz creative team, and we look forward to someday licensing some of their original or licensed content.]

44. For only $7.99 a month, you get unlimited movies & TV episodes instantly over the Internet to your TV or computer. There are no commercials, and you can pause, rewind, fast forward or rewatch as often as you like. It's really that easy!
During sign up, you can add unlimited DVDs (1 DVD out-at-a-time plan) for only $7.99 more a month. With DVDs by mail, you'll get an even broader selection of movies & TV episodes. You can exchange each DVD as often as you want with no due dates or late fees — ever! You can add access to Blu-ray discs to your account at any time for an additional $2 a month.

45. Copyright Laws
This is because copyright law applies very differently to Netflix's DVDs and streaming videos. With DVDs, Netflix can rent whatever it wants thanks to the First Sale Doctrine. Once Netflix owns a DVD, it has the rights to rent it to whomever it wants, at whatever price it wants to charge. Unfortunately, that's not the case with streaming video. There, the rights stay with the owner of the content, and those owners are charging more in licensing fees, and might be charging way more very soon. They also decide which videos can and cannot be streamed. DVD rentals, despite the relative inconvenience of rental by mail, might look like a bargain by comparison for many customers.
Netflix: plenty of pitfalls in the fine print
By Dan Mitchell, contributorSeptember 19, 2011: 3:54 PM ET
Netflix's bold move to split itself into two business is being heralded by many. That doesn't mean it won't be fraught with difficulties.
FORTUNE -- In applauding Reed Hastings' decision to split Netflix (NFLX) into two separate companies, one for streaming and one (to be called Qwikster) for the "legacy" DVD business, several commentators have cited The Innovator's Dilemma, Clayton Christensen's much heralded 1997 book about how to deal with fundamental changes to existing markets wrought by technological innovation. Hastings is a genius, these commentators have declared, in recognizing that the future of video rental lies in streaming.
They might be right, but there are a few huge caveats. The most immediate one being that people sitting at home trying to rent and watch videos probably aren't thinking much about disruptive technologies and innovators' dilemmas. They just want to watch a movie, as cheaply and conveniently as possible. The loud backlash that ensued after Netflix split its pricing plan in two is being turned up several notches today as customers wonder how this latest move will affect them. Mainly, they see it as only making their hassles worse, on top of the price increases many of them are already coping with.
More fundamentally, though, while spitting the business in two (this is a real split – the businesses will be run separately, operate on separate Web sites, and customers of both will get two separate billing statements) probably makes sense in the long-term, it poses serious immediate risks to Netflix's streaming business.
This is because copyright law applies very differently to Netflix's DVDs and streaming videos. With DVDs, Netflix can rent whatever it wants thanks to the First Sale Doctrine. Once Netflix owns a DVD, it has the rights to rent it to whomever it wants, at whatever price it wants to charge. Unfortunately, that's not the case with streaming video. There, the rights stay with the owner of the content, and those owners are charging more in licensing fees, and might be charging way more very soon. They also decide which videos can and cannot be streamed. DVD rentals, despite the relative inconvenience of rental by mail, might look like a bargain by comparison for many customers.
Furthermore, Netflix until now had the option of giving customers access to DVDs if the company couldn't get streaming rights to a particular video. That gave media companies a further incentive to allow Netflix to stream their videos. That incentive is now mostly gone, because if Netflix can't get streaming rights, it will have to shunt customers off to a completely different company (albeit one wholly owned by Netflix) to get the DVD.
Not that this is an easy problem. DVDs will eventually fade from the scene as streaming replaces it. It's true, as Hastings wrote in his "apology" to customers, that "streaming and DVD by mail are becoming two quite different businesses, with very different cost structures, different benefits that need to be marketed differently, and we need to let each grow and operate independently."
The important word there is "becoming." If there were just as many good movies available via streaming as there are on DVD, at the same cost, it would make sense for Netflix to not merely spin-off the DVD business, but to drop it altogether. Unfortunately for Netflix and for its customers, the market is a total mess, with lots of titles not available for streaming and with future pricing highly uncertain. And it's unclear what will happen when movies do become more widely available via streaming. Will Netflix even be a major player at that point? Nobody can say for sure.

46. Additional References
Netflix addresses customers 'upset' with price hike
Netflix's vanished Sony films are an ominous sign
Why Hulu is so hot right now
Why corporate America needs more Reed Hastings
Netflix hikes prices for DVDs + streaming
Netflix addresses customers 'upset' with price hike 5
Print
Comment
By Julianne July 25, 2011: 6:41 PM ET
Netflix CEO Reed Hastings
NEW YORK (CNNMoney) -- When you're a new tech company with a cool product, life is good. But once you become an industry leader, pleasing people is a lot tougher. Just ask Netflix.
Netflix enjoyed a strong second quarter, but it wasn't good enough to satisfy investors on Monday. And the company spent much of its earnings release discussing problems -- namely, a recent price hike that launched thousands of online complaints.
Although Netflix (NFLX) reported earnings of $1.26 a share, easily topping estimates from analysts polled by Thomson Reuters who expected $1.11 a share, sales missed forecasts.
Revenue rose 52% to almost $789 million. Analysts were predicting sales of $791 million. The stock fell nearly 8.5% in after-hours trading on the news.
Customers reacted angrily when Netflix announced earlier this month that it's hiking prices on plans that include DVDs and streaming, in a move that highlights the company's shift from physical discs to online video.
"It is expected and unfortunate that our DVD subscribers who also use streaming don't like our price change, which can be as much as a 60% increase," Netflix said in its earnings release.
The company acknowledged that "some subscribers will cancel Netflix or downgrade their Netflix plans, [but] we expect most to stay with us."
Analysts asked several questions about the price hike on a post-earnings conference call. One question noted the thousands of comments on Netflix's own blog announcing the new pricing strategy, as well as tweets under the hashtag #DearNetflix.
But the social media "noise level was actually less than we expected, given a 60% price increase for some subscribers," said Reed Hastings, the CEO of Netflix. "We knew what we were getting into."
Netflix price hike? Stock's pulled back!
Netflix warned that it "will see only the negative impact of the pricing change" in the third quarter. The company expects to earn 72 cents to $1.07 a share next quarter. Analysts had been expecting earnings of $1.09 a share for the quarter.
Nearly 75% of Netflix's new customers during the quarter signed up for streaming-only plans. Netflix now has 25.6 million subscribers across the globe, up from 15 million customers a year ago. It has about 24.6 million in the U.S. alone.
But the company said that domestic subscriber growth in the third quarter will be relatively sluggish. Netflix expects to finish the quarter with between 24.6 million and 25.4 million U.S. subscribers -- close to flat from the current figure.
Netflix said DVD shipments have likely peaked already, but it's still setting up "a dedicated DVD division" with "no intention of selling it." The company will resume marketing its DVD-by-mail service in the fourth quarter, something it hasn't done in several quarters.
Content costs and new competitors: As streaming video gets more popular, Netflix is facing two headwinds: studios and potential rivals.
Netflix was able to score comparatively cheap streaming deals when the service first launched, but now content providers want to be paid more for the content they're providing. One analyst predicts Netflix's streaming content licensing costs will rise from $180 million in 2010 to a whopping $1.98 billion in 2012.
0:00 / 3:30 Mad as hell about Netflix hikes?
Google and Amazon have launched their own streaming video services, and Netflix's most direct competitor, Hulu, is on the selling block. Walt Disney Co. (DIS, Fortune 500) Chief Executive Robert Iger said at a conference earlier this month that Hulu's owners -- who include Disney -- are "committed to selling" it.
The list of interested potential Hulu buyers includes Google (GOOG, Fortune 500), Apple (AAPL, Fortune 500), Amazon (AMZN, Fortune 500) and Yahoo (YHOO, Fortune 500) plus telecoms AT&T (T, Fortune 500) and Verizon (VZ, Fortune 500). Landing Hulu would give any of them a strong foothold in challenging Netflix.
But Netflix said in a letter to shareholders Monday that it will not bid on Hulu. Netflix cited the fact that "most of [Hulu's] revenue is from providing free ad-supported streaming of current season TV shows, which is not our focus."
First Published: July 25, 2011: 4:22 PM ET
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