Home > Uncategorized > Netflix Dividing Into Atoms and Bits: Smart Strategy, Dumb Execution

Netflix Dividing Into Atoms and Bits: Smart Strategy, Dumb Execution

Word broke yesterday (Sunday) on Reed Hasting’s blog and in an email to Netflix subscribers that Netflix is preparing to divide into atoms and bits businesses. Hastings has always said the long-term gameplan for Netflix was streaming, and this summer’s controversial and clumsy re-pricing and re-packaging foretold today’s announcement. What wasn’t clear was how the DVD/atoms business would continue to evolve while yoked to the relatively young and hugely ramping streaming/bits business.

No one in the industry can figure out how a guy as clued-in as Hastings could have overseen such a dumb roll-out of new positioning and long-term strategy. In less than a quarter Netflix has gone from a kick-ass logistics champ and new media giant pushing 30% of the Internet’s daily traffic to a gang that couldn’t shoot straight and can’t strike key deals with content providers.

The strategy for maximizing growth on either side of the equation is becoming more apparent. The DVD business continues to pump out cash, although the unexpected success of the disc rental kiosks (Red Box, et. al.) has slowed subscriber growth, now hovering over 14 million. Top-line, DVD is still a billion dollar business today for Netflix. The announcement included word that the disc company, Qwikster, will jump into game disc rentals for all the major gaming platforms (my kids will flip out at this). Lots of subscribers who had cut down to the one-disc plan will be persuaded to add another disc or two, particularly in homes with more than one game platform in active use (like mine). So ARPU is going to rise for Qwikster, and there will be at least a way to hold and add subscribers as well, starting Qwikster on its way to another billion in annual revenue. (Alternatively, as GigaOm’s Ryan Lawler wrote last night, Qwikster could already be too much of a legacy business and be harmed by being cut off from Netflix.)

The bits business: this is a little more uncertain. Phones, tablets, and game consoles are bringing lots of potential customers online and extending the availability of Netflix viewing to new times and places. Connected TVs are just barely registering in quarterly TV sales numbers but that will change in Q3 and Q4 2011 holiday season, and Netflix streaming is a default app on just about every Connected TV in North America. (Signing up for Netflix is still a laborious process on a Connected TV, but surely that won’t kill off subscriber growth via that channel.) So streaming subscriber growth drivers are firmly in place, and for certain categories of video content, there’s just no better service on the market (take that Hulu Plus).

But the trouble comes from the competitive pressures bearing down on the soon-to-be-streaming-only Netflix. Hulu hasn’t satisfied the revenue projections of its three-headed ownership group and will likely be divested in fire-sale fashion (if the latest rumors of low-ball bidding are true). Content providers will be looking elsewhere for the richest revenue for streaming and expecting Netflix to pay up. Amazon and Apple continue to hold the largest share of steaming VOD rental and have favorable retail-sales leverage with the content providers to give them price and exclusivity advantage over Netflix. And since there isn’t any sign of the apocalyptic cord-cutting that cable/payTV providers feared, that huge competitor still has subscriber and availability advantage over Netflix, also. Oh, and the networks and studios are all thinking they can cut out the Netflix middleman and stream directly to viewers, too.

What has to come next for the Netflix/bits business?

Higher ARPU through earlier/longer streaming availability deals. This must be item #1 on just about every agenda in the Netflix content group. Adding a premium priced service that gives users earlier access to current content, and keeps content available for longer time periods, is one obvious way to increase average revenue per user. As Netflix/bits subscribership grows, it becomes more attractive to content providers — but Starz walked away from the table, so somehow the numbers don’t add up yet. Netflix will keep negotiating and will find other content deals, but margins are going to be tighter than ever. Another lingering issue is charging extra for simultaneous streaming to more than one device per user account — but that’s another touchy issue that could go sideways, just as the earlier pricing did.

Other long-tail content. Netflix isn’t going head-to-head with Amazon and Apple on retail sales and VOD, so another option is finding other sources of long-tail content, and more capable and flexible search and recommendation technology to make it useful.

International. If the content providers are holding back North American availability of theatrical content in favor of their own possible streaming services, there might be opportunity to be the middleman for international streaming services, where someone will have to negotiate with multiple dozens of network providers.

UPDATE: Harvard Business Review is upbeat about Netflix’s chances in the 5-10 year timeframe. Time will smooth out the curve of frantic market dynamics in 2011-2012, says Adam Richardson, and Netflix’s ability to innovate into the next wave of high-bandwidth, low-latency, any-device video service will be the right yardstick to measure its performance through 2020.

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