Netflix Faces "The Innovator's Dilemma"

At Digimart yesterday, Peter Broderick interviewed Ted Sarandos, the Chief Content Officer at Netflix. The big news from the discussion was that Sarandos said that Netflix will "announce where we're going with electronic distribution" in early 2007. (I can't tell if that means they'll simply announce what their plans are, or unveil a download service.)

But Sarandos' big news raised a big question for me: why hasn't Netflix already introduced a digital download service?

During the conversation with Peter (and in a short conversation with me afterward), Sarandos said that he and others Netflix have been inspired by the book `The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail' as they built the company. `The Innovator's Dilemma,' as far as I'm concerned, is one of the best books ever written about technological revolutions -- why some companies take advantage of them and establish new markets, and why other companies (often the incumbents) stumble.

The author, Clay Christensen (a Harvard Business School prof), defines two kinds of companies in the book: entrant firms, the newcomers in a market, who don't have a large business to protect, and established firms, who tend to be more conservative. Christensen's thesis is that it's much harder for established firms -- who often have been innovators in the past -- to catch the next important wave in technology.

Sarandos made the case (and I agree) that Netflix, as an entrant firm in the late 1990s, saw an opportunity to create a subscription DVD-by-mail business when established firms, like Blockbuster or Hollywood Video, didn't.

But now, I think Netflix has become an established firm itself. The company is publicly-traded. Revenues for 2005 were $682 million. They have five million paying customers. (I'm one of them -- and I love the service.) Their motivation is to keep those subscribers happy, and attract more subscribers in a cost-effective way.

Now, ever since I first interviewed Reed Hastings in 2001, he has been talking about eventually shifting the company to digital delivery; they don't expect the DVD to always be the most convenient delivery channel for movies. (Here's a CinemaTech interview with Reed from last year.) Netflix boasts that it invests one to two percent of its revenues in R&D, building a system for eventual electronic delivery of movies.

But the company has sat on the sidelines as Movielink, CinemaNow, Vongo, Amazon.com, Apple, GreenCine, EZTakes, Guba.com, and a few others have launched their digital movie download services. (Even Wal-Mart, which tried and failed to copy Netflix's rental-by-mail business, will likely launch a download service before Netflix does.)

Sarandos, speaking at Digimart, was critical of this first generation of services. The quality isn't as good as a DVD. Not many consumers want to buy movies in digital form right now. The download process can be flukey. Electronic delivery, he said, is "a very interesting new space." But, he continued, "DVD has a very long life."

Sarandos is, of course, correct in his criticisms. But `The Innovator's Dilemma' points out that every important new technology doesn't work well at first. It doesn't satisfy the highest-end users (IE, cinephiles who want DVDs or even high-def DVDs.) The market is small, and revenues insignificant.

The problem is that when a new market (like digital downloads of movies) takes off, it's hard to catch up; it's far easier to get on a train while it's stopped in the station, or even when it has just started pulling out, than when it is tearing across the countryside at top speed. Even though Sarandos freely admits that it took Netflx a year or two of being in business before the company discovered the subscription DVD delivery model that works, for some odd reason, Netflix isn't interested in getting into digital delivery early, and learning the do's and don'ts.

One impediment to Netflix is that the studios may not want to license their movies to the company for digital rental or electronic sell-through (also called download-to-own). Studios may worry about Netflix dominating digital rental and sale the way they've come to dominate DVD rental.

But I'd still make the case that the company should be building a digital download service with any content that it can license -- indie movies, old TV shows, classic sporting events, whatever -- simply for the opportunity to make some early mistakes, and learn how to do it right. (GreenCine, EZTakes, and others are already taking this tack.)

Instead, Netflix, once a hard-charging entrant into the traditional video rental business, is now the establishment, unable to make a risky leap to the next technology.

Netflix's only hope for overcoming its `Innovator's Dilemma' situation is that it can throw a "Hail Mary" pass, and beat all of the other players already offering downloadable movies. I am not betting on this.

But the company does have two things going for it: its ability to design an easy-to-use online service, and its intelligent recommendation software, which has a sophisticated understanding of each user's taste in movies. Problem is, both Apple and Amazon do those things well, too.

Sometimes, there is a situation where a company can catch the technological train once it has left the station. Apple's a good example; dozens of companies made MP3 players before Apple introduced the iPod in 2001, and now it is the industry-leading product, with nearly 80 percent market share.

Can Netflix do the same? I'm interested in hearing your take.