The recent announcement and subsequent u-turn by Netflix reflects a wider crisis facing Hollywood.
Before the 1950s Hollywood studios made their money renting their movies to cinemas and then splitting the profits.
When televison became a popular medium in the 1950s, it was a time of panic but eventually became another revenue stream as studios could monetise their libraries by selling them to a new emerging medium.
In the 1970s when Sony invented the Betamax format, which allowed viewers to record programming on videocassettes, it spurred a worried Hollywood into adopting a rival format (VHS), which ultimately created a new home entertainment revenue stream.
The video rental boom of the 1980s also gradually turned into a retail one as consumers bought videos of their favourite films.
When the DVD format was introduced in the late 1990s, consumers upgraded to the format in the same way they had replaced their analogue vinyl records and tapes with digital CDs.
Home video innovations that the studios thought would destroy them, actually turned out to be their salvation.
From 1998 until 2004 there was a DVD boom which saw profits pour into studio coffers, as consumers embraced the format as DVDs were often availble to buy and rent on the same day.
But dark clouds began to form in 2005 as the industry debated about what would be the high definition successor to DVD.
After a costly format war between Sony’s Blu-ray and Toshiba’s HD-DVD, the former won in February 2008 partly due to the fact that they owned a movie studio and could put Blu-ray drives in the PS3 console (10 million PS3s outnumbered the million HD-DVD players in the market).
By early 2008 things looked to have stabilised for the manufacturers and studios as there was now one format which they could all get behind.
However, there were still some major challenges:
- Consumer upgrade costs: The jump from DVD to Blu-ray was much more costly that VHS to DVD as it involved the cost of getting a new TV and player and at this stage costs of equipment and discs were unattractively high (even though they would later come down).
- The Recession: The financial crisis of 2008 had many wide-ranging consequences as the world went into a global recession. For the entertainment industry the subsequent drop in consumer spending meant that people weren’t willing to replace their DVDs with Blu-rays.
- Netflix and Digital Downloads: Over the last decade US service Netflix saw explosive growth in subscriptions, which has eaten away at the traditional DVD model as the company movies towards streaming.
Studios and retailers dealt with the cost issue by dropping prices and with many major titles folding in the Blu-ray and digital copy with the DVD release (sometimes known as a Triple play).
The recession poses a much greater problem, particularly as online retailers like Amazon can undercut traditional shops (thus reducing studio profits) and streaming services make consumers indulge in cheaper alternatives.
What are those alternatives?
Until recently Netflix subscribers in the US could gorge on an incredible back catalogue of films for a cheap monthly fee, whilst the price of back catalogue DVDs is ridiculously low.
So the last few years have seen a volatile environment emerge in which DVD profits have been eroded and Hollywood executives concerned about their balance sheets.
Michael Lynton of Sony Pictures Entertainment reflected this concern, saying to The Guardian in 2009:
“This has become a major issue for the movie business,” says Sony Pictures Entertainment chairman and CEO Michael Lynton. “Over the past decade, the DVD business has been perhaps the most important profit centre for the industry. But now it isn’t just contracting, it’s become more volatile and unpredictable than it used to be. And that very volatility is what makes your decision-making more difficult, because when you don’t really know why a lot of titles aren’t performing, the only rational response is to become more cautious when you’re deciding what movies to make.”
Another factor that Guardian article points out is that studios clouded their DVD profits in complexity:
The problem is that studios have invested years in obfuscating their DVD profits, fearful that A-list actors and filmmakers would get wind of how much money was pouring in and want a bigger piece of the action. By Sunday, everyone knows what movies made in cinemas – it’s a carefully monitored cash business.
DVD has little of that transparency, especially with some DVDs being rentals while others are purchases, making the numbers more difficult to quantify. When studios announce their opening-day DVD numbers, they aren’t actual sales figures – the numbers represent the amount of DVDs shipped to stores. The DVDs that don’t sell get shipped back to the studio. The industry abounds with stories of studios who have warehouses full to the ceiling with DVDs that went unsold and were shipped back, left to rot in storage.
Isn’t this a little similar to the financial industry embracing obscure instruments and loans which almost brought the world economy down?
Earlier this year, the problem has become something of a crisis with the Digital Entertainment Group reporting that DVD sales had plunged in the first quarter of 2011.
Retail sales had dropped 19% and high-street rentals had fallen by 36%, whilst video chain Blockbuster was in Chapter 11 bankruptcy (meaning essentially that it’s on the business equivalent of life support).
In the UK, retailers like Woolworths, Borders and Zavvi have closed down and even a once iconic chain like HMV is facing a major challenge to stay afloat in the era of online options.
Although digital downloads and streaming have grown rapidly in recent years, there is a major shortfall as viewing habits are split between discs and streams and downloads.
On a more fundamental level the shift to rental from retail is proving problematic as the studios don’t make as much from consumers who use services like Netflix than they do from ones who buy physical discs.
Netflix is at the forefront of this problem, as for a monthly fee users can get DVDs through the post or stream films direct to their TVs or laptop at no extra charge.
This meant the company has seen explosive growth, with subscribers rising from 8 million users in 2008 to over 23 million this April.
The UK equivalent is LOVEFiLM, which has the same basic model, and that was recently bought by Amazon, presumably with an eye to where consumer habits are going.
Netflix has been incredibly successful in a relatively short period of time, with reports that it accounts for 20% of non-mobile internet traffic in America during the evenings.
Although studios still have the crucial bargaining chip of their movie and TV libraries, they are still probably concerned that Netflix have accrued so much dominance in so little time.
The Economist recently quoted Kevin Tsujihara, the head of home entertainment at Warner Bros, and analysed the current deals the studio system is negotiating with Netflix:
I have nothing against $1 rentals—at some point,” explains He just doesn’t want cheap rentals competing with disc sales. So last year Warner Bros, Fox and Universal Studios struck deals with Netflix. The service would keep its hands off their movies for 28 days, to give them a chance to sell in shops and in high-street video stores—in effect creating a new window. In return, the studios allow Netflix to stream more old films and television shows. Sony keeps big-budget films out of Netflix’s hands for 28 days but not smaller films.
This brings us on to the issue of the release window, which sees studios open films in cinemas first and then stagger the opening over different platforms (DVD/Blu-ray/VOD, pay TV, free-to-air TV) in order to make money each time it hits them.
Studios are split on what the precise nature of these windows should be: Warner Bros and Fox feel that holding releases back from cheaper online platforms sees a bump in disc sales and rentals, whilst Sony don’t think that consumers care that much about a window.
In a recession, many people are probably prepared to wait a month for the price of a film to come down as opposed to buy it when it comes out.
Disney has another approach. With a huge merchandise division they can afford to try and get their films on as many platforms as possible and they have pushed for a shortening of windows, both video and theatrical.
When Alice in Wonderland came out last year, UK cinema chains almost pulled it from release because of Disney’s plans to release it on Blu-Ray and DVD earlier than was usual.
That particular spat was resolved but it highligthed the different ways in which studios want to monetise their assets in an uncertain digital age.
Back in April at Cinema Con, the annual convention of cinema owners in Las Vegas, four of the major studios (Warner Bros, Fox, Sony and Uniersal) shocked the conference by announcing a premium VOD service.
This reflects a shift towards the idea that the release window is not fit for the digital age and that audiences should be able to legally access films via download or pay-per-view sooner rather than later.
Paramount sided with the theater owners, citing piracy as a major concern (e.g. digital copies can leak sooner) and some observers feel it is a case of Hollywood shooting itself in the foot.
But what the row highlighted was the larger cultural and technological changes going on as consumers want greater control over their viewing experience and studios want to cut costs by moving to a digital distribution system.
Which brings us back to Netflix.
It seems odd that such a realtively new and successful company could be experiencing problems but recently they faced their own digital dilemma: do they focus on streaming or DVD?
The company decided to split its operations so that customers had to decide whether they wanted to pay for online streams, DVDs by mail, or both.
For users that currently pay $9.99 for the combined streaming-plus-one-DVD plan the hike to $15.98 per month felt like a major increase.
In addition, Netflix made the bizarre decision to eliminate customer profiles from their website.
All this led to a furious backlash from Netflix users and an apologetic blog post from CEO Reed Hastings where he said:
“I messed up. I owe everyone an explanation. It is clear from the feedback over the past two months that 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.”
Why were loyal customers angry?
Partly it was the way it was handled, as although Netflix could see the business logic of raising subscription fees , it was a tone-deaf move during a recession.
This was compounded by the fact that one of the reason subscribers have traditionally loved Netflix is that they feel they get great value from the service.
That perception – for some – was wiped out overnight.
But why would Netflix do this?
The answer lies in what Hastings announced in the same post: that they would be spinning off their DVD-by-mail service into a separate service called Qwikster, whilst Netflix would be dedicated to streaming.
They clearly realise that streaming is the future because of the lower costs and greater technical flexibility across viewing devices.
Robert Cringely wrote this week about how Hastings has always seen digital delivery via the Internet as the goal of the company and that he would’ve done it sooner if he could:
I first met Netflix co-founder Reed Hastings in 2001 at a Maxtor event where I was the dinner speaker. He explained then that the company had always intended to deliver movies over the Internet (hence the name Netflix) but was starting with DVDs because the network infrastructure simply wasn’t ready for digital delivery. They’d eventually drop the DVD deliveries, though I think his estimate of when that would happen was around 2007, not 2011 as the company announced this week.
However, the problem they face is that discs still form a huge part of their business and making people shift from this is going to be difficult when the overall media landscape is in a state of flux.
What happens when one part of your customer base wants DVDs by mail, another wants streaming and yet another wants both?
If you stay still your company could slow down and be overtaken by a rival and if you make necessary changes then you are bound to upset some users.
Even for a company as modern and data driven as Netflix, it’s difficult to adjust a stable business model to fit around shifting customer habits.
In a sense their dilemma represents the wider problems faced by the studios, who are struggling to adjust their business models in an era of rapid technological and social change.
But if the studios can’t make up the shortfall in profits caused in part by digital delivery systems, then how can they continue to fund the very films we watch over them?