What’s Really Behind The Netflix/Qwikster Split?

The decision to split Netflix into two companies makes no sense. Unless you look behind the scenes.

Doug Mataconis · · 17 comments

As I note in a comment to James Joyner’s post, part of what Netflix/Qwikster is doing here seems to be related to the ongoing battle being waged by the Hollywood studios over online streaming:

Hollywood is a unique place, and understanding “business” in Silicon Valley leaves you ill-prepared to understand what makes Hollywood tick (for more on this see: When It Comes To Television Content, Affiliate Fees Make The World Go ‘Round). Very few people understand the key underpinning of the Netflix “original” business model — a 1908 Supreme Court Ruling known as “first sale doctrine.” From Wikipedia: “The doctrine allows the purchaser to transfer (i.e., sell, lend or give away) a particular lawfully made copy of the copyrighted work without permission once it has been obtained.” Because of the first-sale doctrine, any DVD reseller, including Netflix, can basically buy a DVD at WalMart, and turn around and rent it to someone else the very same day. The content owners have absolutely no control over whether the copy can be resold or rented. Period. As such, Netflix has the ability to rent (via DVD) any movie which has ever been sold on DVD, and its costs are relatively fixed as a result of the retail price of the actual DVD. In some ways, it is a perfect storm. Fast forward to digital streaming and all bets are off. More specifically, the first-sale doctrine does not apply. That’s right. For DVDs, Netflix’s rights are unlimited and its costs are constrained. For digital, its rights are constrained and its costs are unlimited. In the absence of the first-sale doctrine, Netflix must negotiate each and every title, and the price of the right to stream that digital title is up to the whim of the content owner. For many titiles, you cannot even obtain digital rights, because they can’t find all the people the need to release the rights to do so. So here is what I think happened with Netflix’s recent price change (for the record, I have no inside data here, this is just an educated guess). Netflix has for the past several years been negotiating with Hollywood for the digital rights to stream movies and TV series as a single price subscription to users. Their first few deals were simply $X million dollars for one year of rights to stream this particular library of films. As the years passed, the deals became more elaborate, and the studios began to ask for a % of the revenues. This likely started with a “percentage-rake” type discussion, but then evolved into a simple $/user discussion (just like the cable business). Hollywood wanted a price/month/user. This is the point where Netflix tried to argue that you should only count users that actually connect digitally and actually watch a film. While they originally offered digital streaming bundled with DVD rental, many of the rural customers likely never actually “connect” to the digital product. This argument may have worked for a while, but eventually Hollywood said, “No way. Here is how it is going to work. You will pay us a $/user/month for anyone that has the ‘right’ to connect to our content – regardless of whether they view it or not.” This was the term that changed Netflix pricing. With this new term, Netflix could not afford to pay for digital content for someone who wasn’t watching it. This forced the separation, so that the digital business model would exist on it’s own free and clear. Could Netflix have simply paid the digital fee for all its customers (those that watched and not)? One has to believe they modeled this scenario, and it looked worse financially than the model they chose.

If this is what’s going on behind the scenes, then most of what’s been going on with Netflix over the past several months starts to make a lot more sense. The pricing changes that caused so much controversy when they occurred were likely Netflix’s attempt to narrow down its population of streaming customers to only those that are actually using the service (since that’s how the studios are charging them). And splitting the company into DVD and streaming-only independent operations brings that population down even further. Some people will probably sign up for both services, but only the ones that are really interested in using the streaming service, thus reducing the total costs Netflix incurs with the studios. Netflix could have explained all of this better, I think. Heck, if they really wanted to, they could have made the studios out to be the bad guys. I imagine that the only reason they didn’t is that because, in the end, the content owners are in a far better position to dictate terms and without the content, the streaming service is meaningless.

Of course, much of this could be fixed, to the benefit not just of the business model of Netflix, Amazon (which offers its own online streaming service), and the cable companies, but also consumers. Congress could step in and clarify how online streaming applies to the copyright issues that this brings up, perhaps by applying a version of the First Sale doctrine to online streaming. Congress, though, seems firmly in the pocket of the big studios (the AMPAS lobbying operation in Washington in one of the most sophisticated) so it seems unlikely that anything will happen there. The original First Sale Doctrine came about because of a Supreme Court case, but I’m not at all sure how a case could be developed to challenge the studios here. For the reasons noted above, I doubt Netflix would be willing to roll the dice on litigation. That’s bad for consumers, and it’s bad for the innovation that would be created by opening up the massive online libraries of the movie studios to the world of online streaming.

This Netflix issue isn’t just about a business decision, then. It’s about how our Copyright Laws, which are authorized under Congressional authority to “promote science and the useful arts” are holding back technology yet again thanks to the lobbying strength of copyright holders.