Why Netflix’s split won’t help with its real problems

Today’s announcement by Netflix of changes to its longrunning service will do little to solve the very significant challenge in front of Netflix streaming: content licensing.

In his blog post, Netflix CEO Reed Hastings compared his company’s challenges to those of AOL and Borders:

Most companies that are great at something – like AOL dialup or Borders bookstores – do not become great at new things people want (streaming for us) because they are afraid to hurt their initial business. Eventually these companies realize their error of not focusing enough on the new thing, and then the company fights desperately and hopelessly to recover. Companies rarely die from moving too fast, and they frequently die from moving too slowly.

While all of that is true, Netflix is nothing like these companies. AOL and Borders died largely because of internal conflicts and lackluster attention to emerging technologies (broadband in AOL’s case, e-readers for Borders). Those are not the real challenges that Netflix faces.

Hastings and Netflix have always been forward thinkers. The company was launched at a time when DVD players were just starting to take off — but it wasn’t named DVDFlix. They experimented with creating their own digital media players before spinning out Roku. They have gotten Netflix streaming into virtually every device out there.

I have great respect for Netflix and Hastings. Not long ago, I heavily praised Netflix for making many right moves to be as successful as they are.

Netflix’s biggest problem is not internal conflict between the DVD side of the business and the streaming side. Every battle in that realm has clearly gone toward the streaming side. Netflix management has made it very clear that it wants the DVD to go away.

But they need the content owners to cooperate for that to happen — and so far, there has been limited cooperation.

Content providers are more than happy to sell Netflix old library content that they have no meaningful way to monetize. (Some of which is of such low value that it’s not even worth pressing DVDs.)

Content providers are much less willing to give access to new release movies, HBO Original content like The Sopranos and other high-value content for which there are many other more lucrative markets.

On the DVD side, Netflix doesn’t need to seek permission from the content owners. Under the first sale doctrine, they can rent anything they can get their hands on. Even there, Netflix has voluntarily agreed to delay when it begins renting new-release DVDs in exchange for access to other content from the studios. (Presumably, if Qwikster were truly separate, then it would rent all new-release DVDs as soon as they came out. I bet that doesn’t happen.)

As much as content owners want the revenues that can be generated by Netflix’s 20+ million subscribers, they are worried about Netflix devaluing their content. At $7.99 a month for unlimited access, Netflix is cheaper than the price of a single movie ticket in many cities. Premium content providers don’t like that.

Even if Netflix were willing to pay more for the content than it charges subscribers, content providers wouldn’t play along. Let’s say for the sake of argument that Netflix were willing to pay $14.99 a month for content and could only charge subscribers $7.99 a month. This would generate a loss of $7 a month but the studios would get a lot more money. The studios are unlikely to participate because they want consumers to associate a higher price for their product than $7.99 a month.

This is similar to the Minimum Advertised Price concept in retail, where manufacturers set a minimum price that must be shown whenever their product is advertised. They want consumers to associate a certain value with their product and retailers advertising a lower price undercuts that. (If you’ve ever wondered why Amazon sometimes asks you to put an item in your cart before showing you the price, this is why.)

A similar thing happened with e-books. Amazon used to sell many Kindle books for a loss to promote the adoption of Kindle. With recent changes in the marketplace, the publishers are setting the price and Amazon gets a commission.

A related issue that content providers face is channel conflict. They sell essentially the same product to multiple channels: first-run theaters, second-run theaters, cable video-on-demand, hotel pay channel distributors, premium networks like HBO and Showtime, DVD, basic networks like AMC, Bravo and USA. This “windowing” strategy allows them to maximize revenues for a single piece of content.

In order to keep getting the high prices they get from cable VOD, they can’t sell new release rights to Netflix at low prices. If Netflix goes for $7.99 a month, HBO at $20 a month looks expensive. TimeWarner, which owns both studios and distribution, wants to protect HBOs price point. There are two ways to do that: get Netflix to raise its price or only sell mediocre or dated content to Netflix.

Netflix will have to raise the price of its streaming service in order to get high quality content. Apparently this was a sticking point in the recent re-negotiation with Starz. According to the Los Angeles Times, “Starz didn’t just want Netflix to pay more money for its content. It wanted Netflix consumers to pay more too.”

As much as many consumers hate the tiered model and expense of cable and satellite channels, that model has worked for decades and the entrenched players don’t feel the need to change that. Unless copyright law changes to force compulsory licensing of movies and television content (the odds of a truly entertaining Oscars broadcast are much higher), Netflix will have to play by the rules created by the content owners.

Splitting the DVD and streaming businesses does little to address any of these concerns. While other companies merge for synergies that rarely materialize, the DVD and streaming sides of Netflix are entirely complementary. The DVD side provides a fresh and deep library, while the streaming side provides instant access for when you just need something to watch right away. Recommendations take into account taste preferences regardless of the silly division between physical and digital media. Customer care, Web site development and other operations also have shared value.

I’m as big an advocate of the all-digital living room as anybody. I bought a DVR when they were selling for $1,000. I owned the first-generation Apple TV. If I had to pick between DVD and Netflix streaming today, it’d be no contest: DVD.


About Rakesh Agrawal

Rakesh Agrawal is Senior Director of product at Amazon (Audible). Previously, he launched local and mobile products for Microsoft and AOL. He tweets at @rakeshlobster.
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