Summary:

For CEO Reed Hastings and his team, consumer behavior provided the sign that it was time for Netflix (NSDQ: NFLX) to shift from a hybrid str…

Netflix CEO Reed Hastings
photo: Getty Images / Jason Kempin

For CEO Reed Hastings and his team, consumer behavior provided the sign that it was time for Netflix (NSDQ: NFLX) to shift from a hybrid strategy to separating streaming and DVD: 75 percent of the new subs in Q2 opted for streaming only despite the option to add DVDs for only $2 a month. Never mind that DVD subs churn less, spend more and will still be in the majority. The future of Netflix is streaming — and that transition’s making for a rocky present.

The cost Monday when Netflix reported earnings along with guidance that Q3 subscriber growth wouldn’t make up for the lost customers: roughly 10 percent of the company’s market cap as the share price dropped by nearly $29 in after-hours trading.

That’s because Hastings opted for major surgery to separate the two, literally putting the U.S. DVD business in its own division while the rest of Netflix focuses on its global streaming future in the U.S., Canada and beyond. Subscription plans were split into streaming and DVD, each for $7.99, and the price to take both went up 60 percent to $15.98. DVD plans for more than one title at a time went up, too.

The outcry was immediate and loud — but, Hastings told investors and analysts on the Q2 call, “believe it or not the noise level is actually less than we expected given a 60 percent price increase for some subscribers.” Unlike the usual kind of price increases due to costs, this one was more about strategy: “We didn’t approach it as what percent price increase should one do. And I think if we had, we probably wouldn’t have gone to 60 percent. … We really approached it on that we should separate the businesses and the plans because streaming only was going to become a global offering.”

They’re banking that separating the two now — and taking the reverb now from customers who opt out of the new pricing and try competitors — will pay off in increased revenue to out towards more streaming content, currently considerably outmatched by DVDs, and that, in turn, will bring in more streaming-only subscribers. Says Hastings: “We got convinced that we can thrive on streaming only — and with the great new content we’re going to be able to get with this pricing change, the best timing was now.”

In the shareholders’ letter issues Monday with the quarter’s results, Hastings and CFO David Wells said they thought DVD subscriptions likely had peaked. What about streaming in the U.S.? Wells said on the call: “I don’t think there’s any implication that we’re nearing the peak in that … We’re expecting Q3 to be a quarter where we have subscribers choosing where they want to land.” They also expect to go back to domestic growth mode in Q4 and project it could be the company’s first $1 billion quarter.

So far, Wells added, “most people are taking the hybrid offering.” The two were responding to e-mailed questions grouped together by investor relations.

Netflix expects the Q3 shakeout to wind up roughly like this: 10 million streaming only, 3 million DVD only and 12 million with both. Put another way, that would be 15 million total DVD subs and 22 million total streaming.

Going global: Netflix expanded north last year; this fall, it heads south to Mexico, Latin America and the Caribbean. Netflix plans to go overseas in early 2012, and in the Q2 shareholder letter, said “depending on content licensing discussions underway, we may launch one or more new countries in Q1.”

The most likely markets are the UK and Spain, as Variety reported recently and we’ve confirmed. Unlike Latin America, where most deals cover all 43 countries included in the Netflix expansion, Europe and the UK take separate agreements per country.

That sounds like a lot of expansion all at once in Latin America but Hastings says it would be “inefficient to arbitrarily not allow the service to be in certain countries when we’ve essentially paid for the content for those countries anyway.” He expects to launch with more content than in Canada but to slower adoption.

On competition: Hastings said the recent CBS (NYSE: CBS) deal with Amazon (NSDQ: AMZN) doesn’t change the content landscape or challenge Netflix strategy — and he doesn’t see the e-tailer as a threat. “We haven’t been able to detect any effect from the Amazon Prime bundling,” Hastings said. (What didn’t come up: how that equation might change once Amazon expands access to the service, which is part of a $79 annual fee for shipping privileges, to portable devices like the tablets it’s expected to have out in the fall.)

Any other competition? “We haven’t seen anything that’s an alternative service. HBO GO is a very impressive application. It doesn’t have any of the content that we have, and we don’t have any of the content that it has. … It comes back to my metaphor of baseball and football competing for some of the same dollars and time, but (with) really different offerings.” No mention of Hulu Plus, which came up in the shareholders’ letter: “We invest much more than Hulu Plus in content, in marketing, and in R&D.” Hulu Plus is on track to hit one million subs this summer, a solid start but not close to Netflix.

On DVDs: Hastings and Wells insist splitting the business should be better for DVDs. Said Hastings: “What we do know is that we’re going to maximize whatever opportunity is there.” Investing now in the DVD business should mean it will “shrink slowly as opposed to rapidly.”

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