Ever since Netflix announced its new pricing structure, I thought the structure odd as there’s no discount for subscribing both to DVDs and streaming. The resulting subscriber loss erased 2.8 billion is market value between Wednesday’s market close and Friday’s close after new subscriber projections were announced. 25.6% of Netflix market cap evaporated over two days even as the S&P 500 rose 2.3%. Today, Netflix announced that it’s renaming and separating the DVD business. This move is a stunning gamble as it will likely lead to further subscriber erosion and is the underlying reason for the new pricing structure which is leaving money on the table in the short run.
The lack of bundle pricing is costing both revenue and profit today. A quick thought experiment illustrates how: First, figure out the highest price you would pay for Netflix’s unlimited streaming service. This what economists call your reservation price. It’s the price at which one penny more would cause you not to buy the service. Next, figure out the highest price you would pay for Netflix’s DVD service. Now assume that you already have Netflix’s streaming service. Either someone gave it you or you purchased it. Now what’s the highest price you would pay for DVD service? For most people, the reservation price for DVDs falls if they already have streaming. People already have so much demand for entertainment and once they have some options, the value they place on additional options falls.
This substitution effect between Netflix’s two services is easily addressed by bundle pricing. A discount for subscribing to both services would have meant less canceling subscribers as some customers would have found the bundle to provide enough value even though buying both separately did not. The customers who are closest to their reservation prices are likely to the DVD customers who turn over their DVD’s the least often and are thus the most profitable, as costs in the DVD business primarily driven by postage. Not offering bundle pricing loses customers and reduces both revenue and earnings though higher subscriber loss.
The Netflix brand has enjoyed a very strong reputation. The DVD business being renamed means that DVD business will lose the benefits of the brand. Building a new brand from scratch is a difficult, long-term, and often expensive endeavor. In the customer’s mind, offering both DVD and streaming both fit within the brand. Separating the brands, doesn’t provide any business value today.
An Impaired Product Experience
The integrated streaming and DVD website provided a great experience customers who subscribed to both services. Ratings a movie improved recommendations for both services. Searching for a movie shows both the streaming and DVD options. Separating the two services means users have to rate on two different sites to get recommendations and search for movies they want to see twice. This is a degraded user experience and one customers have been quick to point out the Netflix blog.
A Huge Gamble
Given all the immediate negatives for the business Netflix has today, the move to separate the streaming and DVD services places a huge bet on it’s streaming service. And while it’s clear the growth opportunities are in streaming business, what’s not clear is where to capitalize on the streaming opportunity required forgoing a substantial immediate value in the DVD business.
Most great companies can handle multiple related lines of business. Apple didn’t marginalize the Mac business to capitalize on the iOS opportunity. Other than the management challenges of managing related lines of business, there’s no external reason that Netflix could not have kept multiple integrated services under one brand. It will be quite interesting to see how this gamble turns out in the long run. I suspect the Netflix stock will be in for a rough ride in the short-term.