It’s not raising prices; it’s unbundling. And making sure it stays unbundled!

My thoughts on the Netflix pricing changes and the creation of Qwikster. 

Let me start by clarifying one thing – Netflix wasn’t trying to increase prices. The company was just unbundling its offerings to better target its customer segments. The creation of Qwikster – a DVD rental only company – further validates Netflix’s intention to segment their user base. This left some subscribers livid and as expected, Netflix lost a few subscribers. But has the exodus really begun? This CNN Money article seems to suggest it has. I think some customers will be happy to give up the DVD-by-mail option and stay with Netflix’s streaming plan. The customers that value the streaming and DVD service will begin using both Netflix and Qwikster, and pay more for those services. Some of them will leave the service entirely. That’s not necessarily a bad thing. Let me explain:

Netflix has carefully most of this past decade prepare itself and cultivate the market for video streaming – bundling it with DVDs to seed the market, building an ecosystem of hardware partners (mobile phones, game consoles and televisions). In November 2010, Netflix introduced a $7.99 for instant streaming offer and an additional $2 for a bundle of streaming plus 1 DVD. This bundle played an important role in introducing streaming to millions of DVD users, but it was most likely a loss leader. Given that the U.S. Postal Service increased the rate for first class postage in May, 2009 to 44 cents, it’s pretty clear that the $2 incremental revenue didn’t support the costs of postage for a heavy DVD user. Their DVD-by-mail business is one of the US Post Office’s largest customers. Netflix spent approximately $600m on USPS postage in 2010, 1.7% of all first-class mail revenue. In addition to postage costs are the cost of managing the fulfillment centers, replacing lost DVDs.  While much of the investment in this infrastructure can be looked at as a sunk cost and has been amortized over the years, supporting ongoing DVD operations isn’t a priority for Netflix. And given the scale of the business, it is a potential distraction for CEO Reed Hastings, who sees as a bigger opportunity – video delivery over the Internet. And he chose to deal with this potential distraction by spinning it off into its own company – Qwikster. As a result, Netflix will not have to serve these unprofitable DVD customers. Qwikster will be serving these customers now, but at a price point much higher than the $2 Netflix used to charge.

Netflix has seen a clear segmentation in its subscriber base and is pricing to maximize its future profit opportunity. If this pricing move to unbundle turns out to be a success, Netflix and Qwikster will see an expansion in their user bases, as well as increased profits from existing members. Qwikster will be able to profitably serve its high cost DVD rental subscribers, and Netflix can focus on reaping the profits from its high margin streaming business without any concerns about bearing the losses of the DVD mailings. With content providers threatening to take their business elsewhere, this increased profits will help Netflix build key partnerships – not just with studios and content providers, but also with hardware vendors and also fund innovation.

Companies can use price to do a number of things and signaling is one such function of price. With your prices, you can signal to your subscribers that you are a premium or low-cost provider, or you can make price changes to signal to competition that you are thinking aggressively about this market. Regardless of the final state of Netflix as a company, it’s important to note that by unbundling (and thereby increasing prices for some users), Netflix is signaling to the market that their focus will be on the video streaming segment, and will lend the Netflix brand to that segment.

At the heart of this restructuring by Netflix is a pricing decision. And pricing decisions always seem to directly impact the company’s bottom line. It will be interesting to see if the long-term profits from move will offset the short-term loss of revenue from lost subscribers.

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