Why Netflix is Moving our Cheese

Last week, Netflix announced new pricing structure to split online streaming and DVD delivery into separate plans. So instead of paying a minimum $10 per month for both, users will pay at least $8 per plan, for a total of $16 to keep both plans. Netflix’s 60% price increase has sent shock waves through its user community. To date, there are over 5000 comments on Netflix’s official blog, over 70000 comments (including multiple comments from same users) on its Facebook page, with plenty of complaints going around.

Netflix’s response is cool and almost indifferent. “We knew there would be some people who would be upset,” said company spokesman Steve Swasey, when commenting to MSNBC. “To most people, it’s a latte or two.”

Netflix is profitable, its stock price has also sky rocketed in recent years. There seems to be no urgent need to “fix what’s not broken”. So why the sudden change? Why risk alienating its most valued asset – its customers? And why now? Many questions remain. One answer is clear – Netflix does not stand still. It does not wait for change to happen; it simply brings change to the world. And in doing so, Netflix writes its own rules for the game. The dramatic increase is indicative of Netflix’s ambition and its bold business strategies. Whether successful or not, it’s a gutsy move.

To see why Netflix can afford to make such a widely unpopular move, let’s first let’s look at why Netflix can increase prices. The numbers are important here. Netflix has 23.6 million subscribers as of Q1 2011, representing a 21% penetration rate. More impressively, it has enjoyed a churn rate of less than 4%. People love Netflix because it is simply the best deal out there. Even after the price increase, Netflix still delivers the best value for home entertainment dollars. We know it, Netflix knows it. Even if it loses a quarter of its user base, it will still come out far ahead in turns of revenue and profit.

Secondly, the price increase may not hurt as much as it sounds. The price is very inexpensive to start with. The relative number here (60%) causes more outrage than the absolute number which is $6 per month. Most cancellation cries are more emotional than economical. After some cooling off, subscribers on tighter budget are more likely to keep one of the plans.

Timing is also important here. Angry users rushing to cancel service quick found there is a big problem: there just isn’t a better alternative out there. Blockbuster’s DVD plan is more expensive and doesn’t include streaming. Amazon’s streaming plan is cheaper but has a much smaller selection. Netflix couldn’t have picked a better time to minimize users defecting to its nearest competitor, as Hulu is rumored to have been put up for sale. Redbox is a potential winner here, as more Netflix users are expected to keep online streaming, and use Redbox as a complimentary DVD service. Redbox is never a threat to Netflix though. Again, a rational analysis by most consumers can lead to only one conclusion: keep Netflix.

There is nothing more strategically important for Netflix than its continued ability to acquire better and more content. The price increase is designed to further propel Netflix forward in the race to become the nine hundred pound gorilla in home entertainment. With its current content offering, it will only be a matter of time before the next competitor catches up. Hulu is getting there. Amazon, Google and Apple all have deeper pockets to get there. Only with a higher per subscriber revenue stream, can Netflix afford to upgrade its service offering, both in terms of content and infrastructure quality. While Netflix expects to lose a percentage of its user base, it hopes to gain more in the future, by value of its offerings.

Technically, the move is a welcoming one. With its rapidly increasing user base, Netflix’s quality has often suffered as infrastructure struggles to keep up. The lower cost of current pricing model also meant Netflix has to limit per user spending to remain profitable. With the temporary slowdown, Netflix can focus on servicing a slightly smaller customer base better, leading to better user experience and high quality services. Separating streaming from DVD also makes business sense, as the infrastructure cost is totally different. Other than content, DVD cost is mostly postage, which is linear. Streaming cost, on the other hand, requires capital investment in infrastructure, as well as long term financial contract with CDN vendors. Over time, Netflix is more likely to allocate more resources to streaming which is a much more lucrative growth market.

The initial reaction is probably as expected. The revelation will come on Sept 1st, when the price increase becomes effective for current subscribers. Netflix must be watching numbers by the day, if not by the hour. Netflix will probably consider this move successful if it loses less than 10% of its user base as a result of the price increase. Netflix may be taking one step back now, but it is hoping to take many steps forward in the future. While consumers may be upset, a year from now, we may find our cheese still has the familiar red label on it.