How Does Netflix Possibly Survive?

The company will split into two, but the two parts may be worth less than the whole

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By now you've probably heard the latest news from Netflix: the company will split its services into two. Netflix will now exist to serve only streaming customers, while it will create an entirely separate division called "Qwikster" to provide DVDs, Blu-rays, and video games by mail. The strategy is perplexing. It also may begin to reveal deeper problems that will plague the company and could lead to its demise.

First, in case you haven't already read a dozen articles on today's news, here's the gist. In July, Netflix announced that it would begin to charge customers a separate fee for streaming movies. This amounted to a big price increase for those who enjoyed by DVDs-by-mail and streaming. Their customers were not pleased. Neither was Wall Street. Last week, the company announced a warning to investors that it would lose a million more customers than anticipated. Its stock price is down nearly 50% since the price hike announcement.

The Typical Netflix Customer

Let's pretend, for a minute, that you're a typical Netflix customer. You want to watch movies or TV shows that you like or might like. What's the best value for your money at this time? The answer probably depends on two things: how you prefer to view movies and what option has the best library.

Viewing, really, is the secondary criterion here. Unless you do not own a DVD player, then you are at least able to view movies on DVD, even if you prefer to stream. Since there probably aren't all that many Netflix customers out there who actually don't own a DVD player, let's assume that the vast majority of customers would be more sensitive to the depth of each option's movie library.

And on that point, there really is no comparison: Netflix's DVD library is far, far more robust than its streaming library. And yet, Netflix is charging the same base fee for either services: $7.99 per month. While you can watch more streaming movies than you can get by mail in a month for this price, you've got far, far better options with the DVD-by-mail option. If you only have bad movies to choose from, then quantity shouldn't seem so attractive to most customers.

The Business Strategy

Some analysts have begun speculating that Netflix intends to sell off its DVD-by-mail business. That's the only logical reason for why they might have bothered fencing it off from its streaming business. But I have to wonder: who the heck would buy it?

The very reason why Netflix is moving towards streaming is because the company understands that streaming is the future. Meanwhile, its DVD-by-mail business faces relatively high ongoing costs due to the need to acquire physical discs and pay for postage. So you've got a business that is becoming obsolete that has very high operational costs. Gee, who wouldn't want to buy that? If this part of its company has any value, then its value is pretty small.

So instead it will focus on its streaming business. But here's the problem: right now, it stinks. Of the 10 movies nominated for the "Best Picture" Oscar earlier this year, just three -- The Fighter, Winter's Bone, and Toy Story 3 are available through streaming. Doing a quick survey of my favorite 10 movies, just one (Good Will Hunting) is available through streaming. Of the top-10 movies in my Netflix queue, zero are available via stream. All thirty of these titles can be obtained by mail, most on Blu-ray.

And here's something even more worrying. Imagine that you're a prospective streaming customer and you go to the Netflix website to browse streaming titles. First, you click on "New Arrivals" to find Futurama, Brief Interviews with Hideous Men, Harper's Island, Thomas & Friends: High Speed Adventure, Barney's Top 20 Countdown, and The Messenger. Meh. What about Comedy? There you find: You Again, Cherry, Still Waiting, Dazed and Confused, The Hustle, and Kung Pow: Enter the Fist. Still not impressed? How about Drama: Last Night, Lifted, The Fighter, Knockout, Middle Men, and Mooz-Lum. If these are the titles meant to entice prospective customers, you can imagine how weak the rest of its streaming library must be.

Here's what I'm trying to figure out: Who these 21.8 million people Netflix estimates will pay $7.99 per month for streaming in the third quarter? I'm not one of them: I cancelled streaming service after the price hike took effect, and retained a 2-DVD-by-mail plan with the Blu-ray option.

As far as I can guess, these streamers people can be put in two main groups: wealthy Americans who have very little price sensitivity and people who haven't yet realized that they're paying a fair amount lot of money for very little value.

Neither group provides much hope for Netflix's future growth. There are only so many rich people out there who don't mind paying too much for a service, and at over 20 million people already streaming, Netflix likely has already a large portion of them signed up. And before too long that other group will come to realize that the streaming service isn't worth $8 per month. Indeed, Netflix's latest move to split its companies apart will likely make them realize this even sooner: now they will have two separate queues to manage. Their streaming queue will likely look sparse and pitiful -- I know mine did before I canceled the service.

What Netflix Should Have Done

However, Netflix is right that streaming is the future. It also rightly understood the problem that obtaining streaming rights is very expensive, and it needed more revenue to pay for additional titles. But it went about this transition all wrong.

A smarter strategy would have been to slowly increase its fees for its mail-plus-streaming plan to pay for additional streaming acquisitions before fencing off the service. Increase the monthly combo plan by something like $1 each year for a couple of years. Once it hits, say, $12 per month (which would have taken two years), then split up the services and charge $8 for DVD-by-mail and $5 for streaming-only. Then, continue gradually increase each. And as you do so, explain that you're increasing the price of streaming due to all of the great new titles you're offering. For example:

"In 2015, we'll be raising the price of streaming to $6 per month. But because of the additional money you're paying, we'll have lots of great new titles for you. The 100,000 additional titles include the Matrix trilogy, the Lord of the Rings trilogy, and the entire Harry Potter franchise."

That's the sort of price increase that customers might grumble about, but will ultimate shrug off and will retain the service. Instead, Netflix felt a huge backlash, which definitely cost them customers and revenue. Eventually, they could have priced the DVD-by-mail plan so high that few would find it worthwhile anyway, and they could have eventually shuttered it, as planned. Instead, the entire company could find itself in ruin, unless it somehow manages to vastly improve its streaming library, very quickly.

Image Credit: jeffgunn/flickr