Reaction to Netflix’s decision to spit streaming video and DVD rental into separate business has ranged from awe to bafflement.   Clayton Christen who is the oracle when it comes to disruptive innovation says:

The conclusion I've come to as well via @businessinsider Netflix Splits Itself In Two To Avoid The Innovator's Dilemma http://t.co/M7f3UAlr

— Clayton Christensen (@claychristensen) September 19, 2011

And while it’s always worrisome to disagree with a luminary like Clayton Christen, I’m not buying that streaming video is a disruptive technology for Netflix. The key element of a disruptive technology is that it’s performance is much poorer on some attribute that the incumbents dismiss it. Let’s looks at attributes of streaming vs. DVD:

Streaming’s instant access alone means most people find it superior. Given the choice of the same content library and same price, most consumers (at least the ones with solid broadband connections) would opt for streaming.

Many would argue the content available on DVD is far greater so that’s a strong advantage for DVD. However, that’s not an advantage of DVD technology itself but rather an artifact of US copyright law. As a matter of technology, DVD and streaming are both capable of delivering the same content. And the limitation on catalog is not an issue for content producers who want to enter the streaming video market.

Incumbents like Amazon and Apple embraced streaming video quite early on. The TV studios have gone so far as to create their own service, Hulu. Television networks like ABC, NBC and HBO, all offer their content via streaming through their websites and iPad apps. Cable companies like Comcast offer extensive video on demand services. I’m hard pressed to think of an incumbent in the entertainment space who did not see streaming video coming and enter the market. Retailers without the resources and technical know-how of Amazon are the only ones I can think of.

Looking at the combination of streaming technology not seriously lacking in any performance attribute and most incumbents in the entertainment space already entering the streaming market, I can only conclude that streaming video is a sustaining technology and not a disruptive one at least when it comes to Netflix’s existing DVD business.  The cable and satellite TV business models of expensive packages of channels will experience declines as streaming grows and the reluctance to give up the large revenue streams that channel packages provide may cause the TV providers to move less aggressively into streaming content which is a disruption story.

Netflix’s decision to break streaming and DVD into separate brands services is a risky gambit due to the impacts I outline in my last post.  The rational for separating the pricing makes plenty of sense as content licensing costs will grow as Netflix expands it’s content library and as Bill Gurley points out, licensing costs may be driven by the number of subscribers.  But given that the disruptive technology story does not fit for streaming vs DVD, it’s hard to see how side-lining the DVD business is good move for Netflix’s customers or investors.

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.

Bundle Pricing

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.

Brand Equity

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.