Netflix: Qwik, Let's Dump All the DVDs and Tick Off the Customers

Netflix (NFLX) CEO Reed Hastings announced the split-off of the DVD rental business that made the company a household name. The new division, Qwikster, will continue the DVD business and also add console game rentals.

Some thought it was a hoax until they read his blog post or got the email sent to customers. Couched as an apology over how the company delivered the price hike news, it was actually a marketing announcement of a step that was obviously long in the planning. The question is whether avoiding one strategic trap -- putting too much emphasis an endangered business model -- will put the company in the cross hairs of another: getting on the wrong side of customers.

Gotta dump the DVDs
Even as a pricing strategy, the conceptual split between streaming and DVD rentals was smart. Netflix will likely make more money, even with a projected loss of 1 million customers, while reducing licensing fees to Hollywood. But that's not the only advantage.

Netflix's stock price tumbled as Wall Street freaked out over the loss of subscribers, apparently not understanding that ridding yourself of the least profitable customers can be a smart strategy. By treating DVD and streaming businesses separately, the company sets a strategy to woo back investors.

The large costs of buying, storing, handling, and shipping inventory are now pulled out of the Netflix business and put entirely on Qwikster. Suddenly, Netflix will be able to show a big profit jump on streaming films, which is a move calculated to make Wall Street happy.

Step right up, getcher Qwikster here
With the DVD (and now gaming) rental business wrapped up in an attractive and tidy bundle, it's all set to sell off to another company. As Dish Networks bought Blockbuster, maybe DirecTV will buy Qwikster. Or, possibly, a Sony (SNE) or other entertainment biggie that has a vested interest in seeing DVD sales and rentals continue.

Perhaps the buyer would be a private equity firm. Or AOL -- hey, desperate is as desperate does. Sell the business while DVD demand is still strong and you extract the value for existing investors while freeing cash for important things going forward, like maybe buying Hulu or otherwise ensuring access to more streaming material.

Even more importantly, Hastings has taken a smart step to avoid the Innovator's Dilemma. That's where a company gets overwhelmed by challengers because it can't afford to drop an older and profitable line of business, even though new technology could make it obsolete.

Warning: angry customers ahead
But as important as the Innovator's Dilemma can be, it's not the only business principle at work here. Another critical one is brand permission. As Laura Ries, daughter and partner of her father, marketing expert Al Ries, points out, brands aren't necessarily extensible. FedEx made a huge mistake when it bought and renamed Kinko's, as UPS did with Mail Boxes Etc.
A company needs customers' permission to do something different with the brand name. Clorox was unable to extend into the detergent category in the early 1990s because consumers associated it with bleach, so were worried about possibly wrecking their clothes. Kentucky Fried Chicken couldn't expand into other types of food successfully until it moved the brand name to KFC.

Hastings knows that the Netflix brand is associated with DVD rentals. If he is to avoid being dogged by little disks, he has to create the new brand and slowly transfer the DVD identification to it, while cementing the Netflix name with streaming.

Just one problem: He's already ticked off a lot of customers. By making the split between the services, he is making their lives more complex. As a friend and colleague, irritated with the change, wrote me, "The email is like a message from your dentist that says he's raising his fees to pay for new operating equipment that will make your visits more uncomfortable." And she wasn't the only one I heard from expressing a similar sentiment.

Thus, what we should call the Netflix Dilemma: Even though you may badly need to do something with your brand to protect your business, it's tough to get customers' permission when you've ticked them off. Hastings may have to do considerably more to get consumers to put this behind him.

Related:

• Why Wall Street Is Wrong About Netflix
• Microsoft and Sony Were Right: Game Consoles Are the Future of Entertainment
• Hulu Starts to Kick Its TV Studio Dependence
• Netflix Earnings: Taking on Cable Costs a Whole Lot
• Thanks to Hollywood, Netflix Is Pricing Itself Out of a Business
• Google Likes Hulu, but Really Lusts After Its Network Backers