Netflix Redux: Is It Ever OK to Fire Your Customers?

Editor’s Note: This is a guest post by Mark Suster (@msuster), a 2x entrepreneur, now VC at GRP Partners. Read more about Suster at his Startup BlogBothSidesoftheTable.

A month ago I applauded Reed Hasting’s bold decision to split his business into two components. Today he’s announcing that they’re backing out of this decision.

Netflix as a service has always prided itself on movie recommendations that are tailored specifically to you, plus user ratings on the quality of films. So let me use their ratings system to judge their actions to date and explain how I think things will break in the future and why.

The big price increase: 5 out of 5 stars. The remainder of this article will deal with this decision but it comes down to the different economics of DVD rentals due to “the first sale doctrine,” which gives Netflix a complete library of films and the fact that the first-sale doctrine doesn’t apply to digital downloads. This makes their business types very different. Some customer segments value the DVD business and these may be more price sensitive. Some customer segments value the convenience of instantly available films. They might be willing to pay higher prices (and perhaps not an “all you can eat” price but a “pay as you go” price per film). They are potentially different business models. Netflix needs to segment their customers and charge each what is appropriate.

The decision to split the businesses: 3 out of 5 stars. I really like the clarity of two business units—whatever you name them. Each with its own head, its own financial reporting and its own content strategy, pricing strategy and marketing strategy. Did they need to be separate legal entities? No, probably not. But creating better visibility for investors of the profitability of each unit and accountability for bosses of each to perform well according to differnet metrics is a good & important idea. Perhaps they should have just created business units called: Netflix DVD & Netflix Streaming. Or take a play out of Coca Cola and called them Netflix Classic & Netflix Digital (note: in the future they may want to have downloads and not just streaming so I like “digital” more than “streaming.”)

The handling of the announcement to split the businesses: 1 out of 5 stars. Netflix announced the changes to its company via a blog post. A blog post! While I loved the sentiment of what was written in the post, the lack of the human touch made it DOA. Netflix needs to borrow the marketing prowess of You need to plan big announcements. You need some showmanship. You need to invite the press, talk to them, let them ask questions. You don’t handle major announcements via a blog post and no touch points. Of course the press is going to roast you. Duh. They don’t understand the complexities of your business. They need to grill you with questions and look in your eyes as you respond.  Not a freakin’ blog post. So how will consumers react? Basically their reaction is heavily correlated with the press coverage of your rollout. Here’s a brilliant post that they *might have* written but didn’t.

The name Qwikster: 1 out of 5 stars. I was asked by a journalist at the NYT if I thought it was a clever name since it was perhaps intentionally retro. I responded, “no, it’s not clever. They thought about it for 5 minutes. Probably the 5 minutes before they wrote their blog post. What is my evidence? They didn’t even bother to get the Twitter handle for it. A quick read of the Qwikster Tweet stream talks about “bible studies” and the like. I, for one, read the Tweet stream right after Qwikster was announced. I can assure you that it was most certainly not about bible studies. It was filled with profanity and pretty dirty commentary. Much of this has been deleted, me thinks. That’s not how you handle a major announcement in your company. WWMBD?

The decision to have two IT systems for Netflix & Qwikster: 1 out of 5 stars. One of the biggest things that came up in the 255 comments to my original post was how disappointed people were in having to have two separate IT systems for Netflix & Qwikster. Two separate rating systems, two separate queues, etc. Yeah, I thought that was pretty dumb, too. Again, I think nobody had really given much thought to what customers would want in the rollout. I stated in the comments that I felt that even with separate legal entities they could have had APIs between the IT systems that allowed for reviews, queues, billing info, etc. to be synchronized. This is the main reason the tech elite roasted them. Dumb, da-dumb, dumb, dumb.

The decision to back-out of the splitting of the business: 3 out of 5. Given how badly the announcement of the splitting went and their inability to control the PR cycle (or their stock price!) I guess it’s not the end of the world to unwind their decision. Right? Well at least this time they’ll handle the announcement of the change more carefully. Or …

The announcement of the decision to back-out of the business: 0 out of 5. JFC. Really? Major change by blog post again? How’d that work out for you last time?

Fan Summary of Netflix Redux, the movie: 2 out of 5. Netflix is a great business. I use it all the time. I’m a 99% streaming guy so I do want a bigger library. There are some films I find on iTunes or NVOD that aren’t on Netflix. I pay for them separately. I’m in the convenience “I want it NOW!” customer segment. But they sure need somebody at the top handling their marketing and PR better. Maybe the person that runs this is tremendously talented and Reed Hastings is setting the agenda. Or maybe they need to hire somebody with more gravitas / experience. But if I were on the board that’s what I’d be complaining about more than the changes to the business, the separation of business units, the loss of some customers, etc. Because poorly run marketing can negatively affect a company. And it ain’t rocket science.

So with that out of the way …

Is it ever ok to fire your customers?

Netflix increased prices by 60%. They are projected 1 million losses of customers beyond what they had expected: 200,000 from streaming and 800,000 from their traditional DVD mailing business.

Is this suicide? Is it ever a good idea to “fire” your customers?

Before answering let me preface with the following to take them off the table in the debate:

Customer Segmentation
I’m sure you’ve all heard of customer segmentation before. In case you haven’t there’s a primer here. It basically means that you split your customers into “like groups” that can then be analyzed as a constituency and different groups. An example of how a customer segment discussion inside your business could take place is in this post I wrote on Customer Segmentation (“Elephants, Deer & Rabbits”).

Each customer segment of your business needs to be analyzed to determine whether they are profitable enough given ongoing costs to serve them relative to the revenue you would receive and the retention money you’d have to spend to keep them with your service.

Once you’ve run profitability analysis on each of your customer segments you need to decide whether you have the operating model that allows you to serve each segment profitably and even if you do whether you want to divert management attention to serving these customers.

In Netflix’s case, I’ll bet that there are a large number of DVD customers who don’t want to pay for streaming. They’re the “cost conscious” segment and perhaps overlapping with the “technology laggard” segment. The problem with this segment for Netflix is that they may not be profitable at the current price points and at a minimum servicing them isn’t pointing at where Neflix knows its future will be. Netflix estimates that only 10% of its 24 million customers would be “DVD only.” If this is right then some of these 2.4 million customers might have actually gotten a price decrease. If they were on the $9.99 all-you-can-eat DVD + Streaming plan they can now pay just $7.99 for DVD only. A 20% savings for a cost conscious consumer.

If you’re cost conscious and want “streaming only” service you can get that also for $7.99 / month. If you’re like me, the “convenience customers” I don’t mind paying $6 extra per month for the right to have DVDs and a broader library even though I never seem to use it. If that segment is 25% of their users then they’ll rake in a cool $432,000,000 extra per year with very little additional costs. That extra profit will go a long way toward buying content rights for streaming plus making up for the lost customers who abort from Netflix altogether. So probably not a bad bet to fire the low end of their customers.

Here are some more examples of where businesses haven’t wanted certain customer segments:

1. Hypermarkets & convenience shoppers—In the local super market industry it would be heresy to not have a “quick check out” aisle for people with less than a certain number of items to purchase. The local residents who shop there expect to be able to come by frequently for items such as milk, bread or diapers. They don’t want to wait alongside those with their weekly shopping basket.

But did you know that many “hypermarkets” intentionally don’t have convenience lanes? Yes, customers complain. By the hypermarket business is based on turning over large volumes of product and making money on the number of “turns” that each product has and on the banking “float” (when you get paid versus when you have to pay your suppliers). They price cheap, stack ’em high and want to move a ton of product.

As a result they’re often crowded. They don’t want to discourage their $700 shoppers with $10 shoppers buying milk. “But if they built a new lane then they could serve both customer segments, right?” Not necessarily. The high-volume merchant is built on a different model. They don’t want that $700 customer not shopping because they can’t find a parking spot taken by a $10 shopper. Yes, there is an economic cost to parking space scarcity.

They have security personnel that check you out as you leave. They don’t want to increase the volume of people flowing through this queue.  And so on.

A customer is not a customer.

2. Magazines—Magazines make their money through a combination of subscription or purchase revenue vs. ad revenue. Each mag has a different mix. I once had a discussion with an industry insider who told me of times in the past where magazines intentionally raised prices in order to dissuade more readers. What? Not possible.

He explained that much of their revenue was advertising based and they relied upon high-minded advertisers. As their subscribers started to move downmarket they started losing important advertisers. By raising prices they could control their customer segments and therefore drive higher ad revenues.

3. Apparel—You’d think that all retail brands would want to maximize the amount of product that they sell. Not true. Many apparel brands and cosmetic companies will actively fight against discount channels like Ross carrying their products. The moment you see lower-end customers wearing your products it loses cache for the upper end segments. I personally find this all a bit Sneetch-ish but it’s basic human nature. So in order to keep prices & profits high they spend serious money trying to fire the lower-end segments of their market.

I know of at least one major high-end cosmetic & fashion brand that actively limits stock of its most sought after product to even their best customers. They create limited availability in their most exclusive brands to segment even the upper-end tier of their most loyal customers. Strange, I know. But that’s the way the world works.

My argument isn’t to stay focused on the most exclusive customer segments. Sometimes that is the best strategy, sometimes it is not. But you need to understand your segments, choose which ones to serve, figure out an effective operating model to serve them, be careful not to divert your management attention to every segment and be willing to fire your customers if they’re taking you in the wrong direction.