Is Netflix As Dumb As It Seems?

The strange logic of the company’s decision to divide itself in half.

Not listening to customers may be Reed Hastings’ smartest move

Reed Hastings made his fortune with one exceedingly smart insight: People would pay a lot to escape video-store late fees. Ever since, the Netflix founder and CEO has devotedly sought out and implemented clever ideas for running a tech business. In 2006, he launched a $1 million prize to inspire computer scientists to improve Netflix’s movie recommendations algorithm. It was a great deal, giving Netflix the work of thousands of Ph.D.s for the equivalent of minimum wage. Or consider the company’s unusual work environment: Employees are allowed to take as much vacation as they want. In exchange for this freedom, Netflix employees are expected to be outstanding at their jobs. “We’re like a pro sports team, not a kid’s recreational team,” says an internal H.R. document. If your manager thinks you’re merely doing your job well, you will receive “a generous severance package.”

It’s this same enthusiasm for shaking up business as usual that’s at the center of Netflix’s recent troubles. In July, the company announced that it would raise the price of its combo DVD and streaming plan to $15.98 a month, from $9.99; its streaming-only plan would remain $7.99. The move angered customers, and last week Netflix lowered its latest subscriber forecast. The company’s stock tanked. Then, on Sunday, Hastings emailed an “apology” to users for the way he handled the price hike. But his remedy is worse than the original offense. Hastings is now going to separate Netflix’s DVD and streaming businesses into two different brands. The online half will be called Netflix, while the DVD-by-mail portion will be called Qwikster. The two services won’t share anything—your queues, ratings, and even your billing information will remain distinct on each site. In a sign of how hastily Netflix arrived at this idea, it seems to have forgotten to search for @qwikster on Twitter. That handle is owned by a person whose avatar is an image of Elmo smoking a joint.

Which raises the question: What is Reed Hastings smoking? As far as anyone can tell, he seems to have rolled up pages from The Innovator’s Dilemma, Clayton Christensen’s influential 1997 book about the ways that successful companies die at the hands of upstarts. Christensen, a professor at Harvard Business School, coined the term “disruptive technology,” which describes innovations that come out of nowhere to undercut a market leader’s dominant position. Christensen cited the way that Digital Equipment, the leader in 1970s-era corporate minicomputers, completely missed the 1980s boom in personal computers. But a better example may be Netflix itself—its all-you-can-eat business model disrupted, and eventually killed, the previously dominant Blockbuster model for movie rentals. Hastings is likely paranoid, then, that Netflix is vulnerable to the same kind of disruption. And that’s the logic behind the mail/streaming separation. Hastings would prefer to kill his own golden goose before anyone else beats him to it.

I think it’s an idiotic strategy. Most of Netflix’s customers subscribe to both DVDs and streaming, and if they’re like me, they like the service because it enables both not-so-picky instant gratification and well-considered delayed gratification. I use the DVD service to select movies that I really want to watch and am willing to wait for; I use the streaming service when I want to watch something—and pretty much anything—right now. I can keep doing this after the DVD plan is renamed Qwikster, but it will require more work. If I search for a movie on Qwikster, it won’t tell me that the movie can be seen for free, right now, on Netflix. If I search for a movie on Netflix and don’t find it, it won’t let me add it to my DVD queue. Say I watch a bunch of DVDs starring Kevin Spacey and then give them all a one-star rating. (I can’t stand Kevin Spacey.) Because the two services will have separate ratings databases, Netflix might just recommend that I watch a Spacey marathon.

And yet: It could work. In The Innovator’s Dilemma, Christensen argues that the companies that are most vulnerable to disruptive technologies are those that have really good management. The problem with good managers is that they tend to listen to customers. And the problem with customers is that they don’t always know what’s best for them. If you were a devoted Blockbuster customer in 2001, and if Blockbuster’s CEO sent you an email announcing he was closing all the company’s stores and switching to a DVD-by-mail service, you would have balked. From now on you’d have to wait three days for a movie? You’d have to choose your movie on your computer—how would you do that when you didn’t even have Internet service? You’d have to pay a monthly fee? What if you just watched one movie a month? All of this would have sounded like too much hassle.

As Christensen explains, disruptive technologies usually start out as inferior substitutes, proving attractive only to a small fringe of customers. For years, the people who ran Blockbuster saw Netflix as irrelevant. It’s easy to call them stupid now, but at the time they were mostly right. Blockbuster’s customers considered Blockbuster better than all the alternatives; if they didn’t, they wouldn’t have been Blockbuster customers. And Blockbuster’s managers were doing what good managers do—they were investing in the parts of the business that customers liked (opening more stores) rather than coming up with a whole new business that might alienate their current users.

The key advantage of Netflix’s new model is that it will give each side of the business—the DVD side and the streaming side—flexibility to manage its service in a way that pleases its own customers. As a combined service, any move to strengthen one side of the company over the other would have been perceived negatively by one group of customers. Netflix believes that its DVD shipments will peak in 2013; after that, as fewer and fewer people subscribe to DVDs, it’s going to have to raise prices to support the physical infrastructure needed to ship out the discs. Now it will be Qwikster that will suffer the negative reaction to all future price hikes—and Netflix that will benefit from the customers getting rid of their DVD plans.

This plan is also straight out of The Innovator’s Dilemma: “With few exceptions,” Christensen writes, “the only instances in which mainstream firms have successfully established a timely position in a disruptive technology were those in which the firms’ managers set up an autonomous organization charged with building a new and independent business around the disruptive technology.” Christensen argues that setting up a separate organization allows the disruptive side to ignore customers who like the mainstream side. “There are times at which it is right not to listen to customers,” he writes.

In other words, if you feel that Netflix’s new pricing and the company’s division into two entities is an alienating move, you’re completely right. That’s the whole point.