Netflix: plenty of pitfalls in the fine print

September 19, 2011: 3:54 PM ET

Netflix's bold move to split itself into two business is being heralded by many. That doesn't mean it won't be fraught with difficulties.

FORTUNE -- In applauding Reed Hastings' decision to split Netflix (NFLX) into two separate companies, one for streaming and one (to be called Qwikster) for the "legacy" DVD business, several commentators have cited The Innovator's Dilemma, Clayton Christensen's much heralded 1997 book about how to deal with fundamental changes to existing markets wrought by technological innovation. Hastings is a genius, these commentators have declared, in recognizing that the future of video rental lies in streaming.

They might be right, but there are a few huge caveats. The most immediate one being that people sitting at home trying to rent and watch videos probably aren't thinking much about disruptive technologies and innovators' dilemmas. They just want to watch a movie, as cheaply and conveniently as possible. The loud backlash that ensued after Netflix split its pricing plan in two is being turned up several notches today as customers wonder how this latest move will affect them. Mainly, they see it as only making their hassles worse, on top of the price increases many of them are already coping with.

More fundamentally, though, while spitting the business in two (this is a real split – the businesses will be run separately, operate on separate Web sites, and customers of both will get two separate billing statements) probably makes sense in the long-term, it poses serious immediate risks to Netflix's streaming business.

This is because copyright law applies very differently to Netflix's DVDs and streaming videos. With DVDs, Netflix can rent whatever it wants thanks to the First Sale Doctrine. Once Netflix owns a DVD, it has the rights to rent it to whomever it wants, at whatever price it wants to charge. Unfortunately, that's not the case with streaming video. There, the rights stay with the owner of the content, and those owners are charging more in licensing fees, and might be charging way more very soon. They also decide which videos can and cannot be streamed. DVD rentals, despite the relative inconvenience of rental by mail, might look like a bargain by comparison for many customers.

Furthermore, Netflix until now had the option of giving customers access to DVDs if the company couldn't get streaming rights to a particular video. That gave media companies a further incentive to allow Netflix to stream their videos. That incentive is now mostly gone, because if Netflix can't get streaming rights, it will have to shunt customers off to a completely different company (albeit one wholly owned by Netflix) to get the DVD.

Not that this is an easy problem. DVDs will eventually fade from the scene as streaming replaces it. It's true, as Hastings wrote in his "apology" to customers, that "streaming and DVD by mail are becoming two quite different businesses, with very different cost structures, different benefits that need to be marketed differently, and we need to let each grow and operate independently."

The important word there is "becoming." If there were just as many good movies available via streaming as there are on DVD, at the same cost, it would make sense for Netflix to not merely spin-off the DVD business, but to drop it altogether. Unfortunately for Netflix and for its customers, the market is a total mess, with lots of titles not available for streaming and with future pricing highly uncertain. And it's unclear what will happen when movies do become more widely available via streaming. Will Netflix even be a major player at that point? Nobody can say for sure.

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