Netflix’s Innovator’s Dilemma

July 18th, 2012

CNET’s Greg Sandoval wrote a very good profile of Netflix’s ill-fated attempt to spinoff their DVD rental business into a separate company. Sandoval writes:

Hastings has an unwavering belief that streaming video represented the future of home entertainment. He argued that in times of technological advancement companies that had succeeded at one business often clung too tightly to tradition and to what had made them successful. And then they were toast. He didn’t want that to happen to Netflix.

Netflix’s CEO and co-founder, Reed Hastings, wanted to separate the DVD rental business because he believes online streaming is the future of video and wants to focus on the company’s future. His logic is sound; resources spent on the DVD rental business are resources that can’t be used for their streaming business and internal processes for the two businesses are very different. Worse, by allowing rentals to remain a central part of the company and therefore its culture, Netflix’s ability to move forward with streaming and innovate based on it is threatened. A company whose resources, processes and culture are focused on a dying business could die with it.

Hastings intended to separate the two businesses as quickly as possible so Netflix could begin focusing on its future. Because Netflix offered a subscription plan with unlimited DVD rentals and unlimited streaming, doing so meant breaking these plans into two separate subscriptions. Netflix broke the existing, $10 per month plan into two $7.99 plans. As a result, if customers wanted to retain rentals and streaming, they would have to pay nearly $16 per month—a 60% increase in price.

Customers, understandably, were enraged. Netflix lost 800,000 customers as a result and their stock collapsed. Just 3 weeks after announcing the spinoff plan, Netflix scuttled it.

Netflix ran head-first into the innovator’s dilemma: their existing customers, and their own processes and culture, make it very difficult to adopt innovations which will disrupt their existing business. In this case, Netflix is in a bit of an interesting position, because they are involved in both the existing and disruptive businesses. Customers revolted because streaming doesn’t meet their needs—streaming can’t compete with DVD rentals on its terms because there isn’t a large enough selection to do so.

Netflix’s larger strategy for streaming is to expand selection, but also to offer exclusive television shows. This strategy is sound, because it offers different value than DVD rentals and thus can stand on its own. There’s less need to compete directly with DVD rentals—something it cannot yet do—if Netflix streaming is the only way to watch several excellent television shows. By doing so, and continuing to grow their subscribers, Netflix should be able to demand more content from studios. This creates a process where the service becomes increasingly comparable to DVD rentals, and at some point, will become good enough and can replace it.

I don’t think Hastings’ error was in attempting to separate the two businesses and separate the subscription plans. Rather, I think he made two mistakes. First, publicly separating the businesses into two separate companies so soon was a mistake. Netflix would have been better served by separating the two businesses internally and making the DVD rental business a more or less autonomous unit so management could focus on streaming.

Second, and most damaging, I believe Hastings separated the subscription plans too hastily and underestimated how angry customers would be. He knew they would be angry, but figured it would be temporary; what he didn’t realize is that because streaming could not compete with rentals on its own terms, customers felt forced to choose between a substantial price hike or losing a service they were used to. Choosing streaming-only was not an option for most people. And then, just a couple months later, Netflix lost Starz, and with it, a substantial amount of their important streaming selection. This was extraordinarily bad timing; customers had to choose between a price hike and degraded service, and then the service became even worse just a couple months later. Extraordinarily bad timing that could have been avoided.

Instead, Netflix could have waited until next year to break apart the subscriptions, after their original television shows premiered. This has the advantage of separating them when the streaming service offers unique value to customers. Rather than choose between paying more and degraded service, customers would rather be choosing between DVD rentals (watch anything and everything, but deal with discs and the mail), and streaming (watch it immediately, and watch excellent television shows that you can’t watch anywhere else). That’s a fairer fight, and one where customers aren’t going to feel as screwed, because streaming now has its own value.

Of course, customers would still be angry, and many would still leave. That’s inevitable, because Netflix is at a juncture between the past and future. But by breaking them apart after streaming becomes a truly disruptive innovation (when it’s coupled with exclusive content), Netflix could begin growing its streaming subscribers with future customers, rather than past customers. The people who will subscribe to streaming are going to be largely different than the people who subscribed to DVD rentals. People who subscribed to DVD rentals largely did so in addition to a cable subscription, but the people who will subscribe to Netflix in the future (they hope) will do so to replace cable subscriptions.

In other words, by timing it with when their streaming service becomes something truly unique, Netflix could also begin separating their subscribers into two different groups, past and future, which should have been one of their goals from the beginning of this failed transition.

This wouldn’t have solved the problem, of course. Indeed, the same result might have occurred; Netflix is in a very difficult predicament, because it’s stuck between its past and future, with customers, processes and culture all working against it. It’s not easy disrupting yourself.