“I messed up and owe you an explanation.”

That’s the first line of an email that millions of Netflix customers received in their inboxes recently. Before then, not many customers even new who Reed Hastings, the co-founder of NetFlix, was.

For those that took the time to read the 671-word apology, they were likely disappointed, confused, or both.

Netflix’s decision to separate subscriptions between their DVD and streaming businesses over a month ago created a huge backlash from both customers and analysts. In order to continue their current DVD and streaming service, Netflix customers would incur a 60% monthly fee increase.

Many, including this author, decided to downgrade their service to streaming-only.

After apologizing for “the way we announced the separation of DVD and streaming and the price changes,” Mr. Hastings goes on to explain that they had found that there were two separate and distinct markets for DVDs and streaming.

To its credit, Netflix has recognized that video streaming, downloads and the $1/DVD/day supermarket Redbox are creating a significant disruption to the DVD industry, although in Hasting’s email, he only references streaming:

Most companies that are great at something — like AOL dialup or Borders bookstores — do not become great at new things people want (streaming for us)

There are many ways to succeed in the midst of an industry disruption, many of which are outlined in Christen’s eminal Innovator’s Solution. Spinning off or “firewalling” the disruptive business (as Netflix is doing with its streaming business) is one way. This allows the streaming business to execute and grow without the original DVD business acting like a creosote bush, killing off anything that grows underneath it.

Yet Netflix is just creating more confusion and complexity, with loads of negative publicity in the process. A disruptive innovation is disruptive because it is easier and/or simpler to use than the product or service it’s disrupting. Streaming is definitely easier to use than renting DVDs—no trips to the store needed. According to the NPD Group, DVDs are still about 75% of all US video sales, streaming and downloading have grown to 25% from nearly nothing a few years ago, and Netflix has 61 percent of that streaming market.

In order for a disruption to succeed, the business model, or how the product or service is delivered from supplier to customer, must also be disruptive. The iPod would not have had nearly as much success without iTunes. Nor would the iPhone and iPad have done so well without apps and the ease and low cost of accessing these apps.

Where Netflix screwed up:

  1. Not separating pricing for DVD and streaming earlier without increasing the price. This would have accomplished two things: first, it would have allowed them to test the price elasticity of both services. Second, it would have gotten their customers used to the idea that the two are really separate services.
  2. Completely separating the DVD and streaming business models. Sure, re-brand the DVD business if necessary, but keep the web interface and engine for DVD and streaming integrated. Many movies are not available for instant streaming. Before, if the movie wasn’t available for instant streaming, you could click one button and add the DVD to your queue.
  3. Not adding a streaming rental service. Apple iTunes, Amazon Instant, and Microsoft Zune all allow movie purchases and rentals. This could have provided a new revenue stream.

Netflix had the first-mover advantage with instant streaming. Their interface was seamless and easy-to-use. But they’ve made two major mis-steps with the poorly implemented price increase and now the complete decoupling of the two businesses. Unless they add a rental service and increase the availability of streaming content, these blows may have been fatal.