Understanding Why Netflix Changed Pricing

I think a possibly more significant incentive for Netflix to separate their DVD business from streaming had to do with content providers using their streaming agreements as leverage to force changes to Netflix’s DVD rental service. I imagine this is how Warner Brothers was able to get Netflix to agree to not rent out their DVDs until 30 days after release. Netflix has no incentive to do so unless WB was dangling a lucrative streaming contract in front of Netflix.

By divesting themselves of DVDs Netflix may be avoiding the numerous pitfalls of negotiating with content distributors who want to impose their will on Netflix’s DVD-by-mail business. A Netflix that does streaming only may also be a bit less scary to content providers who fear Netflix will “take over” and may lead to much easier content acquisition negotiations, which I think is pretty much the point you made, I’m just suggesting additional motives.

You have a misunderstanding of how Netflix has purchased their content in the past and why they’ve made changes to those contracts now. You’re right that it ties into the first sale doctrine, but I think that you’re jumping to the wrong conclusions.

When Netflix first started, they would have been fools to pay big money for content that people might not watch because there was no guarantee that they could sell that content to a big audience. By leaving streaming free they were able to convince customers to try something without having to pay. This eliminated one of the biggest barriers to entry that other streaming services face and really put the rockets on streaming growth. Look at why Vongo (starz), CinemaNow and others failed and it was because of the high minimums they gave Hollywood + per rental fees on top of that.

On the other side of the business though Netflix was making shrewd calculations. By looking at the number of times a disc rented and dividing it by the cost of the disc, Netflix was able to achieve a maximum average price that they could cap digital content as.

For example, if a new DVD sells for $15 and Netflix can rent it 25 times before my dog turns it into a chew toy, then on average Netflix’s cost for that content is $1.45 per rental (0.85 for postage and .60 for the DVD) If they know that demand for that disc will likely be 25,000 people then they’d have to buy 1000 discs. In this scenario Netflix is able to offer up to $1400 (1.40 * 1000 +.05 to pay bandwidth) for the digital content. If they can convince 50,000 people to watch it because it’s instant and there aren’t better movie available then they start saving money when you stream online. Since Netflix is the one that has access to their numbers, they could do the internal calculation for which was a better way to spend and cherry pick the worst/cheapest digital content. If the studios did get greedy then A.) customers could always rent the DVD and B.) the studios would start losing money to streaming competition eventually because thats what consumers preferred.

As long as Netflix was the little guy, this worked out great and allowed them to use one part of the business to support the other. If the studios wanted $100 million, they could tell them to kick rocks and still offer it as a choice to their customers. Somewhere along the way though, streaming took off for Netflix and started to attract competition. By changing tactics and paying top dollar for movies, it is putting pressure on Amazon, Hulu and others to pay the same. From Amazon’s perspective how can they justify paying $200 million per year when they have to grow their service from start. Maybe in 5 years they could, but today it will saddle them with costs that keep them uncompetitive. Even the almighty Apple hasn’t been able to solve the minimum contract nut, but the studios would support Netflix because if they didn’t other people would. With the most number of subscribers, Netflix can now afford to set the bar for digital content very high. If the studios get greedy and charge upstarts more then it only works to Netflix’s benefit.

If the studios are demand x# of $ per month then they could have said no and still kept a strong business, but by agreeing to contracts where they revenue share for big money or exclusivity, they can keep the streaming market from becoming competitive. Frankly, I think the whole thing stinks to high heaven for consumers and would not be surprised to see anti-trust lawsuits filed by the new scheme. Over the longer run, I think they just made the new Blockbuster the only real competition out there.

“Because of the first-sale doctrine, any DVD reseller, including Netflix, can basically buy a DVD at WalMart, and turn around and rent it to someone else the very same day.”

Actually, that’s not true. They are few and far between, but video stores were closed down for renting DVDs purchased in that manner–the generic DVD license specifically excludes permission to rent.

Which doesn’t mean it won’t be done, because there are enforcement costs to consider. But there is a difference between your local video store (where prosecutions were rare, but they have occurred) and a nationwide for-profit organization. Indeed, the strength of NFLX was that it was willing to contract for all DVD properties offered, not just the ones available at WalMart. Leveraging “the long tail” was a primary key in beating Blockbuster–it enabled one-stop shopping for a family that wanted to see, e.g., both Ringo and Detour.

Don’t fool yourself; it wasn’t “first-sale doctrine” that led to NFLX’s success as a DVD agent. But it is the synergies between the growing streaming crowd and the shrinking DVD crowd that would have kept them as contenders.

Now they are dropping those, bifurcating their database and pointing out to their customers that there are alternatives in both areas. (Amazon Prime, for instance, costs 5/6 the price of NFLX Streaming and offers other values. Might more than 200,000 people give up the greater variety of NFLX Streaming for that, using their $16 per year savings to increase their Redbox rentals? Three months ago, that was much less of an issue. Three months from now, with two different firms and non-synergies of queues to be managed, it will be more of one.)

You can rationalise the pricing necessity: we might disagree on timing, magnitude, and method of announcement, but that’s just haggling, and there are certainly firms–AOL, anyone–that have survived on customer inertia that is much more blatant than NFLX needs.

Acting as if you’re doing customers a favor (“we need to focus on rapid improvement as streaming technology and the market evolves”) while taking away the thing that made you unique (“without maintaining compatibility with our DVD by mail service”) is at best disingenuous, at worst clueless. Especially when your entire missive gives absolutely no hints about those “rapid improvements” you’re planning to make.

(For instance: does this mean that the streaming features will have Closed Captioning available in all cases where there is a CC option? That would be a customer benefit [to at least some segment]. But there’s no discussion of what those “improvements” might be in Hastings’s missive, the result of which is that more people will notice how poor NFLX’s current streaming offering really is. Can this possibly be good for the company?

The only problem with your logic is that Netflix had to do nothing more than tell people straight up that this is the case and that the split was forced by the studios because of their licensing model. Why all the guessing games? The shroud of secrecy is manufactured by the media. Hastings has made one stupid move after another and this is just another blunder on his part. His disdain for the DVD side of the business is very evident and this is a way out from under it for him.

Which brings me to my next point which is Reed Hastings being one of the best CEO Silicon Valley has ever seen. In what way? Compared to who? The only brilliant thing he’s done (which is substantial I admit) is setup Netflix to rent DVD’s and create a vast distribution network to provide them around the USA. Other than that, he’s made one screwed up move after another. He can’t seem to negotiate deals with providers for streaming, if I recall he made a dumb move on the logo change, he’s messed up the web site more than once and continues to do so (it in fact is far less usable than it ever was right now) and he’s managed to piss off his customer base. This is brilliant and the best we’ve ever seen? Not likely. He’s a one hit wonder who’s failings have been saved by the ineptitude of his few competitors (namely Blockbuster).

In the streaming business, he’s going to have some heavy hitters that are arguable much smarter than he and I think he’s basically just destroyed this Netflix in one move. As always, time will tell.

The arguments you make are very valid… but the change in pricing strategy was rather unexpected, and by all accounts rather hush-hush. If your theory is true, why didn’t Netflix put up a more public fight over the rules? This is something I haven’t been able to figure out, and is also why I lean towards my current belief that this was an internal, strategic business decision gone wrong.