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Netflix's Letter to Customers Is a Panic Move

The company's questionable decision to demarcate DVD and streaming is now formalized by a business split.

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 Netflix (NFLX) sent a letter to customers Monday announcing a formal split of the DVD and streaming video business. At first glance, this seems like a panic move by the company. The DVD business will be named Qwikster and have a separate website; customers who receive both DVDs and streaming will get two separate bills. The Qwikster service will also have a subscription tier that allows customers to access video game titles in addition to video content. By highlighting the two separate charges on credit card statements, ironically, more subscribers could opt to drop the plan that delivers the least value. We continue to believe the shares are overvalued, but much less than before their sharp price decline last week.

We've never really understood the company's decision to demarcate the DVD and streaming business in the first place. There is room to invest in the streaming business and use DVDs to keep customers satisfied at the same time. We think the July price increase was necessary to help Netflix invest more in the streaming business, but it was a mistake to not offer a discounted price to customers taking both DVDs and streaming. The company had a competitive advantage in the DVD rental business, but as we've stated repeatedly, streaming is a whole different ballgame, as deep-pocketed competitors like  Amazon (AMZN),  Apple (AAPL), and  Google (GOOG) are viable threats. We think the company's best strategy would be to use the combined streaming and DVD offering as a comprehensive plan for customers. While the streaming content offering is limited, customers could use the deep library from the DVD service to fill the void. While waiting for a DVD in the mail, customers could satisfy instantaneous demand with online viewing.

On the video game side, the market for subscriptions has never taken off, as the leading industry player, GameFly, only commands about half a million subscribers, and Blockbuster has had limited success establishing a large presence within this market. In the past, Netflix management has commented about the difficulties of creating a video game subscription service and has dismissed its potential entrance into this market, so we find it curious that the firm would choose to enter now, given the impending impact of digital distribution and increased competition in this market (Amazon,  Best Buy (BBY), and  Wal-Mart (WMT) have all made various inroads into the video game market recently).

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Michael Corty does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.