Netflix Gone Vile

Netflix Gone Vile: Fourteen Reasons Why Netflix Was Wrong, Or Not

by Mark Chussil

A few weeks ago Netflix raised its prices enough for people to notice. (It also split its DVD-rental and streaming-video services into two companies, Qwikster and Netflix, but it abandoned that move.) They lost 800,000 subscribers, they gained outrage and uproar, and their stock price fell sharply.

Assessment of their pricing strategy: Wrong. Or not. Let’s take a look. Then we’ll find we’ve answered the wrong question, which will lead us to the right one.

Disclaimers. I subscribe to Netflix. I don’t have special knowledge of the company and I haven’t talked to its strategists. I haven’t formally analyzed their strategy. On the other hand, we’re merely going to speculate, so we can relax our standards. Moreover, I have analyzed many other strategies, and one learns a thing or two. End of disclaimers.

Netflix raised their prices. Bad move.

1. They suffered a non-trivial loss of revenue. It amounts to something on the order of $20 or $30 million per quarter. That could sap profits precisely when they need the money to invest in wave-of-the-future streaming.
2. They lost customers that could have migrated to streaming. Those customers now become happy hunting for salivating competitors.
3. They made themselves vulnerable in their bread-and-butter business. As of this writing, Blockbuster’s website launches with an unsubtle ad specifically targeting disgruntled Netflix rental customers. (For more on Blockbuster and mistakes, see It’s Working!)
4. It was an awfully big price boost. Don’t they know there’s a bad economy out there and their customers are hurting? Netflix looks cold and out of touch.
5. The negative publicity might dissuade new customers from giving Netflix a try. They lose not only the 800,000 but also some portion of the people who would otherwise have signed up in the future.
6. Loyalty is essential in subscription-based markets, especially when switching costs are low. It’s generally cheaper to keep a customer than to get a customer, and a customer who leaves in a huff may not soon return.
7. That Qwikster thing was not customer-friendly; people with both DVD and streaming services would have to manage two accounts. If Netflix was tone-deaf enough to propose that, did they really know what they were doing with their prices?

Upstanding strategists, a question

Those are some pretty strong arguments, if I did say so myself. It doesn’t look good for Netflix. But we, being upstanding strategists, know we must consider scenarios and decisions from all angles before we judge.

So, let’s ask a question that I have found ranks among the best an upstanding strategist can ask in his or her career of critical thinking and rigorous decision-making. Let’s ask why a smart person would have done what initially appears not-smart. After all, the folks at Netflix are smart and they want to succeed. They set out to do something smart, not something not-smart.

Netflix raised their prices. Good move.

1. Companies often boost prices when costs go up. Netflix’s costs are going up. Their streaming service requires lots of licensed “content” (movies and TV shows). Those licenses cost more and more as content owners see subscribers growing and realize the value of their content.
2. 800,000 customers sounds like a lot. (Well, it is.) Still, it’s only 3.25% of Netflix’s 24.6 million customers in the USA, as of Q2 2011, and each quarter Netflix adds more than twice as many as the 800,000 they lost. (Key data here came from Business Insider.)
3. Netflix was realistic and had done its homework. They expected to lose some subscribers when they raised their prices. They even took pains to explain their price move to subscribers; how many other companies do that?
4. Pretty much by definition, many or most customers who leave after a price increase are those most sensitive to price and most likely to buy the least-expensive subscription plan. The increase in profits from higher prices could outweigh what those lost customers would cost.
5. Netflix may want or need to amass cash for the major investments it faces. Its strategists know well that much of their market will switch to streaming, and they surely fear a visit from the ghost of slow-to-adapt Blockbuster.
6. Netflix made clear that it is committed to streaming and to the long-term health of its company. Those are important signals to competitors and to investors.
7. It is arguably more important to be a clear market leader in streaming video than it is in DVD rentals. Netflix may want to incent its DVD customers to move to streaming so that Netflix stays in front. (See also Room for One.)

The wrong question

Did you notice the wrongness of the question we implicitly asked? We debated as though Netflix’s strategy had been to lose 800,000 subscribers. But losing subscribers wasn’t their strategy; it was a consequence of their strategy. Perhaps an intended consequence, perhaps unintended; perhaps expected, perhaps a surprise; but not their strategy.

That leads us to the questions we should ask: what did Netflix’s leaders want to accomplish, and, given that objective, did they choose a good strategy?

The right answers

It seems that Netflix wants to be strong in streaming without exiting rentals. Both markets are viable, and it makes sense to me that Netflix would want to be in both. Why forgo the wave of the future? Why turn their back on a prosperous business that can thrive for years to come? I’m willing to accept be-strong-and-prosper as their objective.

My short answer to the second question, did Netflix choose a good strategy, is not just refreshingly brief; it is also admirably accurate. It is this: I don’t know. As I said, I haven’t been inside the company and I haven’t spoken with their strategists.

This is brief and accurate too: whether they chose a good strategy is knowable.

It is not knowable by citing their loss of 800,000 subscribers and a great deal of market valuation. Those are outcomes, and even good strategies get bad outcomes from time to time. Plus, many strategies require more than a few weeks to achieve their desired effects. (See also Who Did Best?)

Whether Netflix chose a good strategy is knowable because it is analyzable. I know it is because I’ve performed such analyses on other businesses, and because other people have too.

Such an analysis for Netflix would not look like gap analysis or financial analysis (too narrow) or like trend analysis or benchmarks (little or no relevant past). It would not rely on anecdotes or arbitrary performance targets. (See also All About Models.)

Rather, it would delve into exactly the points, all of them, raised by the fourteen reasons why Netflix was wrong, or not.

Judgment

Dear reader, if you are a pundit or guru who wants to pronounce lurid and/or definitive judgment on Netflix’s goodness and smartness, then you must be sorely disappointed in this essay. I’m afraid it’s not going to get any better for you. But if you are not such a pundit or guru then you will, I hope, join me in three [updated: four] conclusions.

First, we cannot, and therefore should not, gauge the rightness or wrongness of a strategy merely by noticing whether we feel joy at its outcomes at this very moment. We should gauge the quality of the strategists’ decision and decision-making.

Second, it is useful to debate the rightness or wrongness of a strategy. Debate surfaces and clarifies important issues to analyze.

And finally, whether Netflix has gone vile or smile (sorry, my best rhyme at this time), they deserve kudos for their efforts to avoid the pitfalls of those who came before. Think about this: Blockbuster could have been Netflix if only they’d strategized differently.

Really finally, the most important conclusion is to note the question that conventional analysis and conventional analysts are not even asking, let alone answering: given that streaming is supplanting rentals, what’s the long-term alternative for Netflix? Netflix’s stock price may have gone down a lot, but it would go down further (yes, we can spell “Blockbuster”) if it stuck to rentals while the world moves to streaming.

Update, October 28, 2013. As of today, Netflix’s stock price closed at $314. And we note that Amazon is raising prices by increasing the threshold required for free shipping. Its share price went up.

Update, April 28, 2013. Netflix’s stock closed at $215 on April 26, far above the low it hit after its strategic “mistake.” CEO Reed Hastings apologized for having “screwed up” a while ago but that doesn’t mean he made a mistake. For example, we note that he has not reversed the price increases at the core of Netflix’s strategy. (See The New York Times, “Netflix Chief Looks Back on Its Near-Death Spiral.”) Remember how horrible the loss of 800,000 customers in one quarter looked with that strategy? Netflix added 3 million customers globally in the first quarter of this year.

Update, February 4, 2013. Netflix’s stock closed at $175 today, according to Yahoo Finance. That’s below its historic high but it’s double its price after the move people had decried as disastrous. A bit over a week ago it reported a profit (analysts had expected a loss) and that its subscribers to its streaming service had grown to 27 million. The New York Times: “A Resurgent Netflix Beats Projections, Even Its Own.” “It’s risesn from the ashes,” said a senior analyst at Lazard Capital Markets in the Times article. Ashes? What ashes? I told you so.

Update, June 25, 2012. “Netflix Subscriber Numbers Up, but Streaming Still Short on Profits,” on Wired.com. Netflix making most of its profits from DVD rentals seems to suggest that raising prices was a bad idea… or does that show it was good? Profits high because they lost the low-margin renters, because slowdown in subscribers means buying fewer DVDs, because they simply have higher prices?  In 2011, $194M profit on $370M revenue on rentals. Meanwhile, profits on streaming are much lower ($52M on $475M in revenue). How much does that reflect building the business (non-recurring expenses) versus high prices to license content (recurring expenses)? The difficulty of evaluating a strategy that is still in progress, and will be for a while.

Update, May 24, 2012. “Ted Sarandos’ High-Stakes Gamble to Save Netflix,” in Newsweek. I interpret “save” to mean preventing Netflix from suffering Blockbuster’s fate; in other words, further evidence that Netflix is being proactive, innovative, and bold. “There is no comparison between that which is lost by not succeeding and that lost by not trying.” — Sir Francis Bacon (1561-1626)

Update, February 21, 2012. “Comcast to start ‘Streampix’ Video Service,” in The New York Times.

Update, January 26, 2012. Netflix reported 4th quarter 2011 results. Profits beat “expectations,” despite dropping 13.5%. Its subscriber base grew and sales went up 47%. Its stock surged, but perhaps for reasons not related to its strategy.  See CNNMoney, “What’s behind Netflix’s 20% spike?” So, with the passage of a near eternity — oh, six months or so — did Netflix go vile?

Update, January 26, 2012. See also “Netflix Will Rebound Faster than You Think,” by Annika Olson and Eddie Yoon of The Cambridge Group, writing in the HBR Blog Network.

Update, December 25, 2011. Netflix CEO Reed Hastings, speaking about the Qwikster move, was quoted by CNN. “‘We berate ourselves tremendously for that lack of insight because it didn’t need to be that way,'” CEO Reed Hastings admitted recently at a conference. “But you know, in three or five years, we aren’t going to remember it. It’s going to be, `’Did we succeed at streaming?”‘” Worth noting too: CNN pronounced Netflix’s move “dumb” purely on the basis of the short-term loss of subscribers and value in the stock price. Hastings may yet turn out to be wrong, but he’s obviously playing for the long term. For more on judging strategies, which isn’t such an easy business, see Who Did Best?.

Update, November 22, 2011. For more on the financial and competitive maze Netflix has to navigate, see “Netflix warns of losses for all of 2012.”