What will happen in the battle between incumbents and new players in the digital video / smart television space?  It is no secret that consumers are increasingly spending more time watching video from online sources, and cord-cutting has begun to concern many incumbents in the entertainment/media industry.  The widespread adoption of broadband internet and smartphones has enabled over-the-top video services, such as streaming video services, to grab a share of the time and money that consumers spend on entertainment.  Meanwhile, incumbents, such as broadcast networks and cable companies / multiple service operators have reacted by introducing on-demand services, “TV Everywhere” services, and their own streaming services, such as Hulu.  Both sides have realized that there is significant demand for a-la-carte / non-linear programming that can be accessed from any device, and the technology now exists for this service to be offered in many ways.  To navigate the increase in video entertainment choices afforded by online video streaming, tools such as recommendations from friends and algorithms based on past viewing behavior become key complements.  The end of all these trends appears to be smart television / entertainment.

As many players try to secure a slice of the smart television pie before the dust settles, the insights from disruptive online businesses can shed light on the potential trajectory of prevailing trends.

Content remains king

In the media industry, content is king and the source for substantial negotiating leverage, especially once its success has been proven.  With greater competition for content, content costs will continue to increase and the distribution platforms with the most resources will most likely win the licensing rights to the most appealing mainstream content.   Video streaming services, with the potential to grow a global subscriber base, are well-positioned to not only win licensing rights, but also eventually negotiate some degree of content exclusivity.  This year, Netflix, one of the leading providers of streaming video, outbid HBO to get exclusive rights to “House of Cards,” a series by David Fincher starring Kevin Spacey and Netflix’s first major push into premium original programming.

Due to competition for content, online video streaming is becoming a higher fixed cost business than most other online businesses.  Accordingly, an ad-supported business model does not seem sustainable in premium video streaming.  On 11/3/2011, CBS Corporation’s CEO, Leslie Moonves, was asked about doing streaming deals involving “success-based or non-guaranteed” payment, such as a split of advertising revenues.  In response, he said “[the company] frankly [doesn’t] believe in them…[and the company has] even been against joining Apple TV, which was an advertiser split.” Instead, CBS likes deals where it is getting guaranteed cash payment, as with Netflix and Amazon.

Are there network effects?

Yes.  The number of subscribers and the quality and size of a content library feed off of each other.  Moreover, video streaming businesses, like other online business, are not constrained by a physical network, and so their potential scale in terms of number of subscribers is beyond that of any broadcast network or cable operator.  These network effects are enhanced by the potential to drive subscriber growth through social media as well as minimize churn through subscriber data analysis and reviews.  Social media and data analysis / reviews are key steps on the way to smart television and can provide a competitive advantage.

Culture of innovation

Can the incumbents react with a video streaming service of their own?  Possibly.  Hulu is an example.  One of the key success factors in the growth and development of Hulu was its culture.  CEO Jason Kilar instilled a culture than emphasized meritocracy, frugality, and ownership, all tenets of many online startups.  For instance, rather than accepting a posh corner office, he preferred a relatively spartan office space full of whiteboards.  Hulu recently reached one million HuluPlus subscribers, doing so in shorter time than any other video streaming service.

Cost of pivoting

All incumbents have a lot to lose in order to successfully build a video streaming business.  The risk of impairing their existing advertising and cable subscriber revenue streams as well as the value of their physical broadcast and cable networks is significant.  Hence, the cost of pivoting is high for incumbents, providing smaller competitors, with less to lose, an opportunity to gain a foothold.  Netflix suffered the cost of pivoting, as well as the cost of making major PR mistakes along the way, with a 70% drop in its stock price this summer / fall.  The stock market’s reaction highlights the difficulty of pivoting and innovating as a public company, which is a condition that afflicts the largest media industry incumbents.

At Amazon.com, where I interned this past summer as a product manager, all employees live and die by the leadership principles (link: http://amzn.to/vRdUca). My personal favorite: Leaders Are Right, A Lot.  In a spectacular collision of bad decisions and heightened media coverage, Netflix’s Reed Hastings led his formerly untarnished brand through significant and, in my opinion, avoidable errors that led to multiple collapses of the stock price. Though the post-mortem has yet to be written (probably because the market thinks Reed may grace us with a few more foibles before this is over), I think there are a few lessons we can already take away from this mess.

#1 Simplify, don’t complicate

 In an age when every e-commerce site, search engine, grocery store, and lemonade stand spends lavishly on ways to simplify processes for their customers, Netflix went the opposite direction. Netflix used to be thought of as the simplest way to get your movies. First they came through the mail slot, and now some come streaming. Either way, for millions of Americans Netflix was (and still is) the portal to the world’s most impressive collection of movies and TV Shows.

On July 12, 2011, Netflix staff blogged that the company would “separate plans to better reflect the costs of each and to give our members a choice: a streaming only plan, a DVD only plan or the option to subscribe to both.” Customer satisfaction and retention rates were impressive before this moment, but Hastings chose to couple a price hike, which many consumers would have stomached, with a de-simplification of the beloved Netflix user experience. In the words of Julie Bogen, a customer responding to the announcement, “I was not even angry until I read that post; now I just want to throw things.” Customers understand that prices rise over time. But there’s no excuse for making their lives harder.

#2 Don’t tell your customers why they’re mad

Have you ever been in an argument where the other party tried to calm you down by telling you that they understand why you’re mad? BUT it turns out they had misjudged? Anger and disgust are two of the many feelings that people in this situation feel. Well Hastings did just that.

On September 19th Hastings sent out an email entitled “An Explanation and Some Reflection” in which he told users “many members felt we lacked respect and humility in the way we announced the separation of DVD and streaming and the price changes. That was certainly not our intent, and I offer my sincere apology.” The email was sent just after the market opened, and within a series of hours the stock lost 10% of its value.

Successful online e-commerce businesses deliver customer delight through a combination of price, selection, delivery, and user experience. “Respect and humility” relate to none of these. Customers perceived Hastings as being so incredibly out of touch with their feelings that funds, in mass, dumped Netflix’s stock.

#3 Sometimes the airlines know a thing or two

Reed can see the future. In a short period, physical DVDs will be relics. But that time is not now. A few years ago airlines started charging to have physical tickets mailed to your house. Mailed tickets are expensive, inefficient, and disrupt the complex boarding programs that airlines have implemented. Crusty users needing tickets mailed in an envelope were satisfied paying for the premium service, and the rest of us were happy not to be subsiding their archaic needs. Reed assumed we would see DVDs as antiquated and understand why we were being punished for still using them. The problem, of course, is that most content is not available via Netflix’s streaming service, so the punishment seemed uncalled for.

Wrap-up

Let me say, I’m bullish on Netflix. Despite the hoopla and avalanching stock price, Netflix is the only place to turn if, for still a tiny price, you want access to all the content the world has to offer. Their service is still a bargain, and no one is truly competing with them. Until the studios get their acts together and learn how to license their content to multiple services, mail order DVD services (of which Netflix is the unquestionable leader) will play a significant role in the delivery of one-stop-shop video content. When streaming content really hits the net, then this conversation gets more interesting. Until then, I hope Reed goes back to getting things right, a lot.

Who will buy Hulu? Or more importantly, what conditions will be attached to such a sale? Originally created as a joint venture between NBCUniversal, Fox, and Disney/ABC, Hulu’s on-demand streaming video service offers TV shows, movies, webisodes, and other content from over 260 media partners. The service has attracted a significant following, and in a blog post in April 2011, CEO Jason Kilar expected Hulu to reach $500 million in revenue in 2011 vs. $263 million in 2010. One would think that a sale of one of the dominant players in the red-hot online video space would almost certainly create a furious bidding war. But as the second round of bids come due, most sources expect a sale of Hulu to be unlikely. Why? Because it’s all about the content.

Ultimately, Hulu’s success is predicated on the content it is able to license from Hollywood studios and TV networks. Hulu itself is simply a distribution platform. Without the content, it is worthless. Knowing that they hold almost all the value, the studios and networks have all the leverage in any type of licensing deal with Hulu if it ends up being sold. Even worse, if the content companies decide to create a new Hulu competitor in the future, they could simply refuse to license any content to Hulu. Thus, it remains to be seen what combination of long-term licensing and perhaps non-compete agreements will come out of a sale, if it happens.

Similar issues exist in the streaming music space. New players such as Spotify and Rdio are attracting a lot of buzz. Consumers love the service because it gives them access to millions of songs for a low monthly fee. And for the record companies, it mostly eliminates the piracy issue that has dogged them since the invention of the mp3. However, the exact same problem looms over these new services. If the success of these services is predicated on licensing deals with record companies, won’t the record companies stand to extract almost all the value out of these ventures in the long run?

However, not all is lost in the streaming video and music worlds. The key to success will be how Hulu, Spotify, and similar businesses can create other value-added features for their users. Spotify has recently been emphasizing its social features, making it easy to share music with friends through Facebook and Twitter. Netflix has long invested in its proprietary rating system, which recommends new movies for you based on ones you’ve liked/rated in the past. There are also a number of independent startups in the content discovery space that may prove to be acquisition targets in the future. For example, Turntable.fm is a hot new startup that uses a unique DJ room format to facilitate music discovery. Combining this innovative service with the user base and licensing deals that Spotify has would make a lot of strategic sense. Features like these will be essential to increasing not only the amount of value delivered, but also the likelihood that users will remain loyal rather than skipping over to whichever service simply has the largest amount of content. As a result, content companies would no longer have all the leverage in licensing negotiations.

If Hulu does get sold, its new owners have a lot of work to do. Right now, the main reason Hulu is great is because of all the content it has. But like every other streaming service, it needs to make sure that content isn’t the only factor.

When Netflix announced that it was separating the subscription models of its Streaming and DVD services (eliminating the combination subscription package that offered a discount), there was a huge uproar from customers.  Months later, it then decided to further divide the two services by spinning off the DVD mailing service into a completely separate website and brand from its streaming service.  Again there was a huge amount of negative backlash from the customers that it is trying to better serve.

Why did Netflix choose to make these large changes in the first place?  Unfortunately, while Netflix (correctly) made these  organizational decisions in order to isolate what was increasingly becoming a company with diverging business models, they clearly didn’t think about the impact that the decisions would have on their customers (which just over half subscribe to both DVD and Streaming services).

Netflix has for some time seen that the future of their business is based in its streaming services, and has made many efforts to build that business by offering more and higher quality content.  This strategy has worked well, in conjunction with offering streaming access to current DVD subscribers for a small additional monthly fee.  However, as more studios began to closely guard the digital rights of their content, Netflix needed to change their strategy in order to keep bringing top tier content to their service.  The first step, while unpopular, was to make the pricing structures completely stand alone for both services (instead of the discounted or included offerings that existed previously) in order to understand the true value to its customers.  This step was necessary to understand what its customers were willing to pay, and in return be able to understand how much it could rationally spend on procuring new content.  While it was understandable given the increase in content costs, their price increase was too large to expect customers to understand without any visible increase in content provided.

The biggest mistake that Netflix made involved the belief that the roughly 12M customers who use both services would be ok with using two different websites, managing two different queues, and using two different ratings systems that Netflix utilizes to power its personalized recommendations.  Part of the appeal of using both services is that while looking for a certain movie on DVD, they would also see that they would have the ability to stream it immediately.  This type of convenience, along with the recommendation offerings, created a system of reinforcement that encouraged users to subscribe to both services.

What Netflix should have done, rather than creating a completely separate subsidiary and site, is to only internally separate its two businesses with both sides sharing the burden of maintain its website and marketing.   This failure to focus on the online user experience will likely result in a significant decrease in subscribers.   Instead, this move is going to increase the total costs to serve each customer while providing an overall negative user experience.

By: Matt Davidson

Network effects invite strategic blunders.Just as mobilizing many participants is necessary in order to deliver value, losing participants can destroy a company.

On July 13 this year, Netflix announced that it would separate its DVD-by-mail from its instant streaming video businesses into a new company, quirkily named Qwikster.Netflix also effectively doubled prices, from $7.99 for its traditional DVD+instant package to $7.99 for each, purchased via two separate billing systems on two distinct, nonintegrated Netflix and Qwikster sites.

During the following two months, the announcement ignited 17,000 comments on the company blog and Netflix reported that a million of its 25 million U.S. customers had dropped their subscriptions—only the second time in its history that it experienced a drop.Netflix’s stock price has fallen 52% since the announcement.

Of course, as we know from the eBay Partner Network, blog-based rally cries do not necessarily signal poor strategic judgment, and only time will tell whether Netflix’s decision was prescient or naïve.But it’s hard not to question Netflix’s decision in a context where network effects matter so much.

Netflix’s business is built into a two-sided market between content-viewing users and the entertainment studios that produce that content.Here, the value of Netflix’s service depends upon the number and identity of users and studios connected to the service.Users want more high-quality movies from more studios, and studios want more users to view their content, but links between users and the produced or not-yet-produced content they choose to watch are difficult to predict in advance.

When Netflix lost its 1 million users, it also lost the value those users had provided to the network.(If we try to apply Metcalfe’s Law to a two-sided network here, the company lost about 2 times its network coefficient.)

But, more interestingly, Netflix’s decision did not just weaken its network’s membership.Instead, it snapped apart and disaggregated one strong network into two more brittle networks—Netflix’s streaming video and Qwikster’s DVD-by-mail.

The combination of those products had been key to the company’s compelling value proposition, which Netflix readily admitted in its 2010 Annual Report:

The $305.6 million increase in our revenues was primarily a result of the 26.6% growth in the average number of paying subscribers arising from increased consumer awareness of the compelling value proposition of streaming and DVDs by mail for one low price . . . . (italics added)

Moreover, Netflix’s uniquely large library of DVD titles (currently over 100,000) attracted a loyal installed base (many early adopters of its introductory service in 1997), which motivated their use of the much more limited library of videos instantly available for streaming (currently 20,000, and dominated by less-frequented independent titles).Prior to the separation, users could search for a film in both databases at once, and then upon discovering how the content was available, select it into their DVD and/or instant queue(s).In a market where differentiation relies on the volume and quality of a library, the synergy between the instant and mail-order products, driven by Netflix’s format-agnostic aggregation of content, attracted users, which in turn attracted studios.

What do snapped networks mean for the users of the formerly integrated Netflix?

Now, without the magnetic force of its DVD library, the value proposition provided to the users, over which entertainment studios salivate, is compromised.

There are fewer users in each network (2.2m DVD-only subscribers, and 9.8m streaming-only subscribers, with 12m so-called “combination” subscribers choosing what to do next), and less content in each.More unfortunate, there is little backwards compatibility for current users, who will now have to pay for and manage two separate accounts for the two services.

Looking forward, disaggregating the businesses may also undercut the ability of each to collect and analyze data about each consumer’s consumption and to provide stronger predictive algorithms that formerly fueled Netflix’s powerful customer experience.

Netflix and Qwikster—standing alone—are less flexible in negotiating revenue sharing contracts with film studios via packaged offerings combining physical DVD and digital video distribution.Each network now proposes the new question: Which network would you like to join?, versus Will you join our network?

Perhaps Netflix will stand strong.Wal-Mart, Amazon, Apple and Hulu all compete with similar services to Netflix’s, although none have mastered complements, as Netflix has.Netflix earned its current ubiquitous monopoly on streaming content by orchestrating built-in integration with game consoles, blu-ray players, HDTVs, home theater systems, smartphones and tablets.

But this monopoly may not spring eternal.Earlier today, at it its “Stream Come True” conference, Dish Network (the lucky owner of once-giant Blockbuster) announced its entry into digital and mail-order video rentals.And it’s armed with a strategy to attack a strong two-sided market incumbent: easy, targeted switching for Netflix customers, entry through its Dish Network segment niche (at one low additional fee for customers), partnership with Blockbuster stores from which users can also rent at no additional cost, sexy get-people-in-the-door discount offers, and a viral distribution strategy that means business.For a flavor of Dish’s spirited attitude towards Netflix, consider the following Twitter posts and sponsored ads accessible by searching for “Qwikster:”

All this said, Netflix’s diminished subscriber base still represents a 37% increase from a year ago.The barrier to entry posed by Netflix’s hard lock on integrated complementary consumer electronics products remains significant, and if the company is correct that the DVD business is soon going under, the value provided by inevitably dwindling DVDs-by-mail consumers would expire anyway.

Asked about his vision for the company, Netflix’s CEO Reed Hastings reported in 2002 that his “dream 20 years from now [would be] to have a global entertainment distribution company that provided a unique channel for film producers and studios…. As Starbucks is for coffee, Netflix is for movies.”When strong network effects prevail, his dream hangs in peril.

By: Andrew Sternlight