The Qwikster and the Dead

This morning I found an apology-laden missive in my inbox from Reed Hastings of Netflix, explaining that they'd really messed up the transition when they announced the end of free streaming, and that in order to fix it, they had . . . decided to more decisively split their DVD and streaming services.  The DVD part will now be called "Qwikster" and have its own website; the streaming service will retain the Netflix brand.

The internet's collective reaction sits somewhere between foaming rage, and an enormous collective "What the hey, Netflix?"

The whole thing reminds me of a quote I once heard from some foreign diplomat about the US.  "You Americans never made simple stupid decisions.  You only make complicated stupid moves that make the rest of us wonder if we aren't missing something."  It's so bizarre that I spent an hour this morning desperately searching for the logic.  They can't have just decided to do this for absolutely no reason, can they?

But I remain mystified.  What problem does this solve?

It's not that Netflix doesn't have a problem.  They have a huge problem.  The company never wanted to be in the mail-order DVD service long-term; it's not a good business.  Redbox was threatening to carve off the casual users, leaving them with the high-traffic movie buffs who don't make them money; meanwhile, the warehouses necessary to maintain the business at high traffic levels are costly to build and operate.  Plus any idiot can see that the future is likely to be in painlessly streaming movies over the internet, not putting physical discs in little envelopes and mailing them.  The fact that the Postal Service is near bankruptcy tells you a lot about the viability of business models based on mailing things.

The problem is that they tried to build their streaming service by giving it away for free, as an add-on to their snail-mail service.  This was a good way to add customers.  But the history of the internet indicates that once you convince people something is supposed to be free, or close to it, you will have a devilishly hard time getting them to pay for it.  People decided that they were supposed to be able to stream unlimited movies for $10 a month--or $0 a month if you got DVDs. The web was full of people proclaiming that it was stupid to pay for cable when you could get as many older programs as you want on Netflix.  Both analysts and users seem to have been confidently predicting a future in which most people would, for a nominal fee, get rid of their cable box.

This never made any sense; people were confusing the marginal cost with the average cost.  Content providers were willing to license their movies and television shows cheaply to Netflix as long as Netflix had a small customer base: it was extra revenue for the companies, and it was probably mostly substituting for DVD rentals, which they didn't make money off of anyway, so it was essentially free money.

You can get a sweet deal if you are the customer who gets marginal cost pricing.  Medicare does this--reimburses hospitals at above their marginal cost, but below their average cost, so that private insurers have to pick up most of the hospital overhead.  European countries do this with prescription drugs: reimburse above the marginal cost of producing the pills, but below the total cost of developing the pills, so that the US has to pick up most of the tab for drug development.

The problem is that as voters and as customers, we often get the notion that this can be extrapolated to everyone.  So liberal policy wonks want to save money by putting everyone on Medicare, or some equivalent program that uses the government's monopsony pricing power to get lower prices for everyone; thrifty customers think that everyone should drop cable and just pay $14.95 for streaming plus DVDs.

But everyone cannot be the marginal cost consumer.  Someone has to cover things like development costs.  The average household was probably paying somewhere between $100-$150 a month for internet + media content, with about $50-60 of that going to the pipes, and the rest to cable and movie rental.  The idea seems to have been that the cable providers would meekly sit by as Netflix stripped off the most lucrative part of their business, leaving them as owners of a low-margin, tightly regulated utility provider of broadband services.  Meanwhile, the content providers would smilingly allow Netflix to charge something like $10-15 a month for watching their shows on demand.  Netflix wouldn't have the margin of a cable provider, but it would make it up in volume--at that pricing level, it would eventually dominate a large segment of the market.

The cable networks certainly weren't having it--they've already launched what I think is an ultimately doomed, but nonetheless expensive and time-consuming, regulatory war against Netflix.  More importantly, the content providers had absolutely no intention of allowing Netflix to kill off their DVD and syndication businesses with a cut-rate service that couldn't possibly yield anything close to their current revenue streams.  They're demanding more money--and in the case of Starz, higher pricing on the Netflix side.

In defense of the providers, I'm not sure they have much choice.  Unlimited instant streaming of movies and television at the prices Netflix was charging will not support the content generation machine that currently fills your cable channels.

But regardless of whether you think the content providers are wrong, the fact is, they own the content, and Netflix can't stream it unless they pay for it.  That meant that prices were going to go up, or quality (measured by availability of content) was going to go down--and in fact, both of those things happened.  Unfortunately, users had been conditioned to expect unlimited free ice cream; they didn't like having to pay for it.  Subscriptions dropped instead of rising, as analysts had been conditioned to expect.  And analysts didn't like that.  Netflix stock went into the sort of rapid decline that usually only plagues the heartbroken heroines of Victorian novels.

So I understand that Netflix was in a bad place.  But I don't understand how Qwikster solves any of these problems.  It doesn't improve their bargaining position with the content providers (though contra Tim Lee, I don't think it makes it any worse, either.)  It doesn't soothe angry customers who don't like having to pay for stuff they used to get for free--indeed, if some critics are right, and the websites don't inter-operate, it just makes those customers madder.

The best I can come up with is that this is a version of what analysts used to call "Big Bath Accounting": if you have to release bad news, try to release all your bad news in the same quarter.  People are already hammering your stock, so you might as well pile on every conceivable problem that could beset your company; later, you can get a nice stock bump by reversing any excessively pessimistic charges and having an upside earnings "surprise".

So maybe the idea is that while customers are already mad, and analysts gloomy, you might as well make them as mad and gloomy as possible.  The DVD business has to die eventually, so do what you can now to hasten the demise, even if it alienates a few more customers. Meanwhile, use the opportunity to herd Netflix customers into the streaming service, while creating a new brand eventually gives Netflix the psychological distance they need to shut the DVD business down.  (We're not pulling a service!  We're shutting down an unprofitable business unit.  It's not even called Netflix!).

But frankly, I doubt it's this clever or strategic. The psychological effect of separating the brands seems pretty nebulous compared to the immediate and tangible and effect of making already-mad customers even madder.  Is a big bath really preferable to a series of moderate dips?

The thing feels like a panicked reaction to last week's stock gyrations, the product of my favorite Bryan Caplan syllogism:

1.  Something must be done
2.  This is something
3.  Therefore, this must be done.

Unfortunately, as in so many situations where that logic is deployed, I'm afraid that Netflix will have simply made things worse.  To judge from my twitter feed this morning, they've alienated a lot of customers.