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Posted on Harvard Business Review: January 27, 2012 2:54 PM
by Annika Olson and Eddie Yoon
Few companies faced bigger self-created challenges in 2011 than Netflix. Last summer the company tried to split itself in two, creating separate websites and pricing structures for its legacy DVD-by-mail business and its newer, growing streaming video service. Consumers and the media went nuts; company founder Reed Hastings was even parodied on Saturday Night Live. The company ultimately scrapped the dual-website plan but stuck with the price increase. In response, the company’s stock cratered, and some observers even wondered if the company would survive.
In fact, two new sets of data show that criticism over Netflix’s pricing moves has been overblown, and that the company is performing better than expected.
Netflix’s latest earnings data, out Jan. 25, shows that its pricing move didn’t hurt the company nearly as much as people thought. In the six months since the price increase, Netflix lost 405,000 domestic paid subscribers — not the 800,000 subscribers often touted, which included free subscribers trying the service out. This represents a 1.7% decrease in paid subscribers, which is meaningful if the trend continues but is not doom and gloom per se. Revenue per paid subscriber went up 11.9%. This was the first time revenue per paid subscriber went up since 2009, which is a good thing overall for the business. Quarterly revenue and contribution profit went up 10.0% and 15.4%, respectively, from Q2 to Q4 2011.
On the whole, the way to look at Netflix recent performance is that a more modest price increase (vs. the supposed 60%) led to double digit sales and profit growth with 1-2% volume loss. The most recent quarter actually showed a slight gain in domestic paid subscribers, reversing the negative trend.
One of the lessons of Netflix’s travails is that price increases are an exceedingly difficult process to manage. In a previous HBR blog post, we noted that nearly two thirds of categories/companies that raised prices recently saw sales and volume decline. This put Netflix’s pricing move near the top tier of category pricing moves out of more than 100 other categories. Most companies would declare this pricing action a success.
A second set of data shows more reason for optimism regarding Netflix. At the core of the pricing issue has been a simple question: Is its streaming product compelling enough to command premium pricing? If you’re hoping to watch recent, top-rated movies, then the Netflix streaming service is sorely disappointing. If, however, your demand for content is more for TV series (such as Mad Men or Lost) and you love viewing it on multiple platforms (online, iPhone, iPad, Xbox), then Netflix likely makes you happy.
The key question for Netflix is the size of the latter group, who should be thrilled with what it offers. In 2011, CBS, The Nielsen Company and The Cambridge Group collaborated on a study quantifying consumer demand for media, called “The Future is Now: In Pursuit of a More Efficient and Effective Media Strategy.”
It shows there are very different — yet not an infinite number — of media consumers, need states (viewing occasions) and media “palates” (programming preferences). The primary audience of the study was advertisers, and CBS has made the study public in the effort to help transform the media/advertising industry.
The data also provides powerful insights for other media players like Netflix. Importantly, it points out that while content is king, platform may very well be queen. The CBS work shows that two demand segments have high demand for multi-platform streaming content, and that 40 million households fit into these segments. Given that Netflix has 20MM paid streamers, it may still be in a category growth mode. In other words, Netflix has only tapped half of the existing market for viewers with demand for streaming content, and that market is presumably growing.
Netflix’s success in streaming will come down to a few things. Can it precisely understand the media and content demand of its current — and future — subscribers? Can Netflix estimate the pricing power the new content has? Can Netflix use precise demand insights and Moneyball principles to not overpay for content, especially as content costs escalate? Can they use them to know when to create their own content vs. buy it?
While these questions are keys to Netflix streaming, there is an even bigger question that will determine Netflix’s overall long-term viability. It’s hard to imagine streaming is the final end game given that its 11% profit margins are a fraction of the legacy mail DVD’s margins, which are nearly 5x higher. Netflix was a clear category creator with subscription-based DVDs by mail and again with subscription-based streaming. The question is: Can they do it again? What is the next new category creation opportunity for them? Might they jump on the digital trend of multi-channel (merging digital and bricks and mortar), by bringing its subscription-based media model to re-invent the local movie theater? Imagine for a fixed subscription price, you get to watch all the movies you want, as many times as you want, with your favorite drinks, candy and popcorn waiting for you at your reserved seat at your local theater.
One of the biggest sources of competitive advantage for all companies in the decade to come will be intellectual property. Streaming could be the near future for Netflix — or it could be the intellectual property engine for a new category of media delivery that Netflix has yet to create.
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