Last night, Netflix CEO Reed Hastings posted an apology and “reflections” for what the company has been doing recently with splitting streaming & DVD services:

So we realized that streaming and DVD by mail are becoming two quite different businesses, with very different cost structures, different benefits that need to be marketed differently, and we need to let each grow and operate independently. It’s hard for me to write this after over 10 years of mailing DVDs with pride, but we think it is necessary and best: In a few weeks, we will rename our DVD by mail service to “Qwikster”.

Most comments Twitter had to do with how bad the name is (which it is), or how the user experience is going to suck, but there has to be more to it. Reed Hastings is a smart, well-respected guy who has run a very successful company through one of the worst decades in business in the last 100 years.

The question to ask is why? Why spin off that portion of the business? Isn’t that like cutting off an arm because you broke a finger?

One plausible explanation has to do with the first-sale doctrine, which essentially allows a company to buy a DVD and then resell or rent it out an unlimited number of times:

Netflix has for the past several years been negotiating with Hollywood for the digital rights to stream movies and TV series as a single price subscription to users. Their first few deals were simply $X million dollars for one year of rights to stream this particular library of films. As the years passed, the deals became more elaborate, and the studios began to ask for a % of the revenues. This likely started with a “percentage-rake” type discussion, but then evolved into a simple $/user discussion (just like the cable business). Hollywood wanted a price/month/user.

This is the point where Netflix tried to argue that you should only count users that actually connect digitally and actually watch a film (…) This argument may have worked for a while, but eventually Hollywood said, “No way. Here is how it is going to work. You will pay us a $/user/month for anyone that has the ‘right’ to connect to our content – regardless of whether they view it or not.” This was the term that changed Netflix pricing.

If so, the “why” behind this decision had nothing to do with end-users – Netflix simply had to find a way to be able to stay in business profitably, given that the content owners wouldn’t have budged on their cost structure. Read between the lines of what Reed Hasting wrote, and this makes a lot of sense. The very first point that he makes about “different businesses” is cost structures – that has to mean something.

We’re lucky as we analyze this case, because Reed Hastings is very transparent in how he runs Netflix. 10 months ago he posted a deck about Netflix’s Business Opportunity. In it, he has two slides that read:

“To have profitable growth in such a large market, we find a segment in which we can gain and maintain leadership. Netflix’ segment is consumer-paid streaming subscription of TV shows and movies.”

That statement was posted 10 months ago. Netflix splitting off DVD rentals is not a knee-jerk reaction.

What’s clear is that Qwikster is not an arrival, but a beginning. Netflix is being rebirthed as a company betting 100% on streaming, because he honestly believes it is the future, and we all can agree on that.

Hastings knows that the streaming content isn’t robust enough yet, but he wants to become the leader in that segment. You do that by making it your only focus, by doing that one thing really well. You can’t wait until a segment is mature to make your bet – you have to wait until it’s mature enough to dive in head first, and that’s what Netflix is doing.

September 19, 2011