Tilting the Netflix windmill

My friend, [Andrei][Andrei], [points out][Andrei link dump] [an article][abovethecrowd article] as possible counter point to my [observation][first article] and [ridicule][second article].

It is [an interesting article][abovethecrowd article] for those not familiar with the legal basis created by the Right of First Sale or the Betamax case (though the application is not **literally** true in the case of Netflix. [Netflix revenue shares][hacking netflix], and has used similar deals [to bargain with in early streaming contracts][netflix warner]).

But, despite those good points, here is why this article is actually pretty terrible…

[hacking netflix]: http://www.hackingnetflix.com/2009/09/netflix-pays-a-revenue-share-on-about-half-of-rentals.html “Netflix Pays a Revenue Share on About Half of Rentals—Hacking Netflix.com”
[netflix warner]: http://articles.latimes.com/2010/jan/07/business/la-fi-ct-netflix7-2010jan07 “Netflix agrees to delay in renting out Warner movies—LA Times”
[abovethecrowd article]: http://abovethecrowd.com/2011/09/18/understanding-why-netflix-changed-pricing/ “Understanding Why Netflix Changed Pricing—AboveTheCrowd”
[Andrei]: http://zmievski.org/
[Andrei link dump]: http://terrychay.com/article/dvds-by-mail.shtml/comment-page-1#comment-682857
[first article]: http://terrychay.com/article/dvds-by-mail.shtml “DVDs By Mail”
[second article]: http://terrychay.com/article/translation-from-asshole-speak-to-english-of-selected-portions-of-netflix-ceo-reed-hastingss-e-mail-to-netflixs-entire-customer-base.shtml “Translation from PR-Speak to English of Selected Portions of Netflix CEO Reed Hastings’s E-Mail to Netflix’s Entire Customer Base”
[second article]: http://terrychay.com/article/translation-from-asshole-speak-to-english-of-selected-portions-of-netflix-ceo-reed-hastingss-e-mail-to-netflixs-entire-customer-base.shtml “Translation from PR-Speak to English of Selected Portions of Netflix CEO Reed Hastings’s E-Mail to Netflix’s Entire Customer Base”

### The obviousness argument ###

If Bill Gurley’s argument is true, then why didn’t Reed Hastings, Silicon Valley CEO extraordinare, make this in his e-mail? A gajillion people, including PR flacks, probably vetted that e-mail at Netflix (and his previous announcement in July). None of them predicted the huge fallout from the one in July? None of them seem to have predicted the current fallout of this one? Hmm, so much for being “one of the best CEO’s Silicon Valley has ever seen.”

In reality, there are a lot of things going on here more than simple contract changes with the copyright holders that he implies, I linked them as “from the real reasons” in [my article][second article]. Among the issues are:

1. The first and second major streaming content losses (Sony pictures and Disney) turned out to be quite a bit more noticeable than anticipated.
2. A recently projected one million subscriber loss as fallout from the price hike announcement in July.
3. The impending loss of the Starz content from the streaming.
4. The USPS, under attack from the Right Wing, is raising prices and possibly eliminated Saturday delivery—both would have a huge hit on DVDs-by-Mail part of the business.

Now in this non-apology apology has Reed Hastings addressed a **single** one of these? One can assume his omission is intentional. Which means that either to they are **not** mitigating to the customer (the one being addressed in the e-mail), or that announcing such factors would have knee-capped the company with respect to the content owners and Netflix’s actual financial position is much more perilous than represented in the article.

(I, personally, think it’s both.)

### Starting with a straw man ###

The worst part of the article is it is premised on a [straw man][straw man] argument. Bill Gurley is trying to defend Netflix from attacks, but he doesn’t actually do it against specific attacks—only his misread version of attacks he makes up.

For instance, let’s take [my "attack."][first article] Basically my premise is that Netflix, normally a well-managed company with great vision, has recently made two business/PR blunders and has paid/will pay the price for them: a minor one made in July and a major one made yesterday.

1. The minor business error was to announce both a price increase and a separation of the streaming component *at the same time*. I have never had a problem with the price increase; I have a problem with the optics of the timing. Putting them together alienates your existing customer base for an as-yet-unrealized future one.
2. The major error is a choice to split the company in two during the middle of a pivot. I don’t know off to top of my head a single company that split themselves in two and did well because of it (Palm Computing? :-D), but I know a lot of companies that successfully parlayed one temporary advantage into another more lasting one without breaking themselves up (Apple, Microsoft, and Amazon are the [examples I gave][first article]).

Nothing in his article actually address my particular version of why the July and September e-mails constitute a “bad strategic move.” Instead he flips, like Reed does, interchangeably between the price increase, the streaming subscription, the apology, and the split company, cherry-picking each as to make his core argument: that Netflix had no choice and Reed Hastings, CEO of Netflix, is brilliant..

And please ignore the fact that the latter two events are occurring in an e-mail that is billed as an apology to the customers. ;-)

### Fallacy 1: Lead time ###

Next look at the internal inconsistencies inherent in his own argument. For instance, he claims that:

> 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.

Then he states that:

> With this new term, Netflix could not afford to pay for digital content for someone who wasn’t watching it. This forced the separation, so that the digital business model would exist on it’s own free and clear.

And because of this

> …the price move was not a “decision,” so much as a “reality” presented to Netflix from the content owners in Hollywood.

Do you see the fallacy? In the first part he basically states that the price to stream content is negotiated a **year** in advance. Therefore, Netflix has had a year to project out these costs (and the computation is trivial in his example, they are a fixed percentage with respect to subscriber count), and roll out a new business model in anticipation for any changes (surely the trend line in the contract negotiations is obvious to even a casual observer?).

When you’ve had a year to crunch these numbers, why then bundle a price increase with a separation in such an abrupt manner? Why not do it in stages?

In any case, these unprofitable deals weren’t exactly sprung on Netflix out of whole cloth at the 11th hour as the article implies. With a year to move, this was the best rollout strategy they could come up with? Reed, seriously consider firing your entire PR and business team. :-)

### Fallacy 2: the DVD customer is always righthopefully a tool. ###

He continues:

> While they originally offered digital streaming bundled with DVD rental, many of the rural customers likely never actually “connect” to the digital product. 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 argument—in fact the entire article—assumes that the primary customer Netflix is worried about is the DVDs-by-Mail customer who has no broadband connection. I don’t buy that.

If you prioritized your existing customers, then why not roll out the price change first, wait a bit, and then split the services so there is a perceived savings (or cost neutral) for the customers *across the board*, instead of a few instances? Or, better yet, do it in the reverse order and take a financial hit now so you don’t lose so many (irate) customers down the road (which is what happened anyway)—one million customers is a lot of revenue.

In either case, everyone knows that users don’t like the perception of being charged for something they think of as “free”—not expecting to take a sizable hit when you charge a price for a free service is failing B-School 101. This reality was hammered in, oh, like 1000 times in the book, [Predictably Irrational][Dan Areilly].

Also, if the “DVDs-by-mail” is the important business, then why not continue to name that part “Netflix,” and the new company “Streemster”? (Heck, if you paid more than $5 for the domain name, name the streaming company Qwixter—streaming is a hell lot more quicker than the US Postal Service!) Clearly with the naming convention, Netflix is signalling which customer they think has value and which one they don’t give two shits about. (If you haven’t gathered yet, they care about the rich urban tech-savvy VC like Mr. Gurley, not this hypothetical rural customer who has no broadband connection, and is apparently a cheapskate to boot.)

Look, if you are have a business reality that you have to split your services and increase your prices, fine. But don’t paint the shit red and tell me that it smells like a bed of roses. As Reed clichéd in his e-mail, “Actions speak louder than words,” and his actions say he doesn’t care about his most loyal customers.

Don’t act so surprised that they’re acting all butt-hurt.

### Fallacy 3: (not so) Brilliant projections ###

Bill goes on to hypothesize:

> Could Netflix have simply paid the digital fee for all its customers (those that watched and not)? One has to believe they modeled this scenario, and it looked worse financially (implied severe gross margin erosion) than the model they chose. It is what it is.

In [the second article][second article], I linked [one that points out on September 15th][price hike], the company revised their estimates of subscribers **downward** one million people. This was outside of a quarterly earnings estimate, in direct response to the July announcement, and based on just a half-month under the new price regime. They wouldn’t be revising their numbers if they hadn’t been egregiously wrong with the way they modeled the scenarios, Neh?

Furthermore, what is with this “not a decision,” “whim of the content owner,” “No Way,” “Perfect Storm,” “It is what it is”—all loaded linguistic terms? Ignoring the terribly bad clichés here, I thought VC like him were gliberatian [IGMFY][IGMFY] with utter faith in the magic of free market? Content holders are messing with the subscription pricing because of the law of supply and demand. In other words, the price has gone up because the supply (the content) is [inelastic][elasticity] while the demand (companies who want to stream the content) has gone up in a huge way. Whereas before the only customer was Netflix, now it also includes Amazon, Yahoo, Apple, Microsoft, Sony, Comcast, Blockbuster/DISH network, Hulu, etc.—almost all of which a have far more money (and more desperation) to crack open this business model. Since they’re willing to pay more for the content, Netflix’s stranglehold on the distribution mechanism is eroding fast.

Netflix is being bitch slapped by the invisible hand of capitalism, and now Bill Gurley is going to cry about it because the one who benefits is Hollywood and not Silicon Valley? Cry me a river, and then wipe away the tears with hundred dollar bills.

### Fallacy 4: (not so) Brilliant CEO ###

Finally, the article concludes:

> Netflix is an amazing company, and Reed Hastings is one of the best CEO’s[sic] Silicon Valley has ever seen. That said, at age fourteen, the digital world is forcing Netflix to execute a pivot. And the world they are entering is radically different from the world they are leaving. There is no longer a first-sale doctrine to keep things neat and tidy.

In fact, I alluded to that same salient strength of Reed Hastings: the ability to predict changes long before they occur. There is no doubt he’s an amazing “vision guy.” [I mentioned][first article] a vignette about Reed at least as early as 2005, when he stated that they never wanted to be a DVDs-by-mail business—if that was the case, they’d have called themselves DVDsByMail.com and not Netflix.com.

But, with the goal to do internet streaming from the start, they shouldn’t be surprised that they have to execute a “pivot.” They’ve been preparing for this day for over a decade now. No, what is surprising is after 14 years to prepare, they’ve bungled it up so bad.

### Fallacy 5: Success at one thing, doesn’t mean success at everything ###

How bad? Unlike the author, I don’t believe talent in one area (vision) translates into success in another (execution).

If you were Stephen Covey, you could say Reed practices a lot of habit 2: “Begin with the End in Mind,” and the thing he seems weak at habit 3: “Put First Things First.” Being good at the former, doesn’t mean you’re good at the latter, and yet, a company needs both leadership (habit 2) and management (habit 3)—it needs to know where it needs to go, and it needs to be able to get there.

(I once worked at a company where the CEO was a pretty good manager but a terrible leader and the Executive VP (effectively the COO) was great at vision, but terrible at managing. Their skills were backwards from their job description. Now that was a disaster!)

To give a specific example of how a strength in one area doesn’t hide a weakness in another: there is little doubt Steve P. Jobs is a world changer. And yet, despite his vision and his reality-distorting salesmanship, it is pretty obvious (to me, at least) he displayed the same weakness on at least three major occassions during his career (he made the exact same business mistake, each was a watershed moment in the anals of business):

1. He oversold the potential of the Macintosh way (graphical operating system, mouse pointing device, windowing operating system, desktop metaphor, etc.) to Bill Gates at Microsoft which would go on to create Windows.
2. In order to secure money for feature-length movies, he oversold the potentila of Pixar’s 3D animation to Disney Motion Picture Chairman, Jeff Katzenberg, who would later go on to found Dreamworks Animation Studios.
3. He oversold the iPhone’s guerilla strategy of domainating smartphones to board member Eric Schmidt, who also happened to be CEO of Google, the creator of the Android platform.

If Steve Jobs, someone who actually **was** “one of the best CEOs Silicon Valley has ever seen,” could have a weakness, then maybe something similar can be found in Reed Hastings?

I think that brings us to what appears to be a singular problem of Mr. Hastings’s management and public face: the need to confound two things together because they seem to be related in his mind, when they are clearly not related in the customers.

### Confound it! ###

The first time it was separating out the streaming subscription **while** hiking up the price. It can certainly be argued that bundling the streaming as free with the DVD was necessary to pivot the userbase to a streaming one, and that idea showed great vision. However, for business reasons, streaming-only subscriptions and a price hike should have been made distinct to the customer, irrespective of any financial reasoning that they might be related.

The second confusion was apologizing for the previous faux pas **while** spinning out those same core customers into a separate business unit. This optics on this one is especially egregious, and why I teased it mercilessly in [my “translation” post][second article]. As someone [recently put it][rape analogy]: his e-mail is like saying, “I’m sorry I screwed your sister, and I’m going to make up for it by raping your mom too.”

Think about it: if you are going to defend Netflix’s actions here as brilliant and necessary, you are fighting an unnecessary uphill battle on multiple fronts. I, personally, would not bother tilting that windmill.

### Update: Answering questions ###

By the way, here are my guesses to the multiple questions raised. Note that unlike Bill and Reed, I can keep them distinct in my head.

1. Why did Netflix create a separate streaming subscription? I think Bill is right here, contracts with content providers were forcing Netflix to pay for all their subscribers, not just the ones who streamed. Creating a separate streaming subscription saves money on those that never stream.

2. Why did Netflix raise rates? There are probably a number of things going on. The first is that the USPS is raising rates and Netflix’s core business depends on this publicly funded infrastructure to work. This is bad because Netflix used and planned to continue to use the core DVDs-by-Mail business in order to build up capital for the pivot. The second is that competition from other content streaming services did two things that Netflix didn’t properly anticipate: it drove up prices for the content, and it eroded their market position much faster than expected. At the rate it was going, without a price increase (some estimate that even now, Netflix’s streaming revenue is 1/3 of costs), Netflix would be deep in the red soon on the streaming side.

3. Why did Netflix do (1) and (2) at the same time? Because they were blind to the “predictably irrational” optics of this. My guess is there was a “do-no-wrong” attitude in the company with respect to the CEO’s decisions—kind of like how Star Wars Episode 1 was a total disaster.

4. Why did Netflix issue an apology? Because they lost 1 million subscribers, much more than their models predicted. This meant that the “pivot” that they were preparing for was in deep danger of failing.

5. Why did Netflix split the company in two? I think there are two reasons: one operational and one business. The operational reason was that Netflix had lost two streaming content providers and is going to lose a third. In each of the cases, the lack of content is glaring because of the fact their the DVD catalog is nearly complete (in other words, any idiot on Netflix can see they have far less streaming content than they did). If you don’t show what the customer can’t stream, then maybe the customer doesn’t realize the content loss. The business reason is that they are trying to set up the streaming business for a merger and acquisition exit. The DVD-by-Mail business has no value to any of the possible acquirers (Amazon, Yahoo, or Microsoft being the among the more prominent possibles). So they cut it lose but kept the high value pieces like the brand name (c.f. Blockbuster) in the streaming business. They plan for the DVD-by-Mail business arm to die a slow, gradual death as its business gets disrupted.

6. Why do (4) and (5) at the same time? I honestly don’t know, it was beyond stupid to do that. My guess is the 1M subscriber loss caused Netflix to rush the timetable on things and they fucked up bad. In any case, they’re now the butt of an awful lot of jokes made at their expense. (c.f. [The Joy Of Tech][joyoftech netflix] and [The Oatmeal][oatmeal netflix] via [John Gruber][daring fireball]).

The nice thing about my answers is I may be wrong, but at least my explanations live up to Occam’s Razor.

[daring fireball]: http://daringfireball.net/ “Daring Fireball”
[joyoftech netflix]: http://www.geekculture.com/joyoftech/joyarchives/1593.html “Reed Hastings explains the recent Netflix changes—The Joy of Tech”
[oatmeal netflix]: http://theoatmeal.com/comics/netflix “Why Netflix is splittingitself in two—The Oatmeal”
[rape analogy]: http://www.balloon-juice.com/2011/09/19/odd-man-out-again/#comment-2785804
[straw man]: http://en.wikipedia.org/wiki/Straw_man “Straw Man—Wikipedia”
[Dan Areilly]: http://danariely.com/ “Dan Areilly”
[price hike]: http://paidcontent.org/article/419-netflix-says-one-million-customers-expected-to-depart-after-price-hike/ “Netflix Says One Million Customers Expected To Depart After Price Hike—paidContent”
[IGMFY]: http://www.urbandictionary.com/define.php?term=IGMFY “I Got Mine Fuck You—Urban Dictionary”
[elasticity]: http://en.wikipedia.org/wiki/Elasticity_(economics) “Elasticity (economics)—Wikipedia. A really fancy way of saying the price is supply amount is (nearly) fixed”

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