The Netflix Paradox: Are loyal customers sinking your stock?

Netflix made headlines recently when it was disclosed that it doesn’t treat all of its customers equally. As it turns out, some customers have to wait for popular DVD titles longer than other customers. Sometimes the leading online DVD rental company makes them wait a whole week longer.

It’s discrimination. But is it newsworthy? After all, differentiated service levels are the hallmark of every customer loyalty program under the sun. Reward loyal customers by showering them with perks and prizes. Penalize disloyal customers by withholding special privileges. Simple. Right?

But what happens when some loyal customers actually turn out to be a drain on corporate profits? That was the situation Netflix was facing. Heavy renters — those $17.99/month subscribers who ordered upwards of two-dozen DVDs per month — were causing the company to lose money. It’s not hard to fathom, considering that postage alone runs 78 cents per DVD.

Aware that the cost to serve these customers was exceeding the value derived from them, Netflix took decisive action. It deployed an analytics solution to ensure that new and light renters received shipping and inventory priority over old and heavy renters. In essence, the service’s most ardent users were now forced to go to the back of the line.

Many voiced anger, accusing Netflix of using an “unfair algorithm”. They called the practice “throttling”, and a class-action lawsuit was filed to try to end it. Netflix responded by revising its one-day-delivery-of-most-DVDs policy to explicitly state that certain customers do indeed receive preferential treatment and will continue to do so. Everyone else can please take a number.

The Netflix paradox speaks to the fact that not only can a company’s most loyal customers fail to contribute to corporate profitability, but they can even negatively impact shareholder value. A Harvard Business School study concluded that the least profitable 10 percent of a company’s customers can lose anywhere from 50 to 200 percent of its total profits. Larry Selden of Columbia University and Geoffrey Colvin of Fortune call the phenomenon “the growth illusion.” The more unprofitable customers a company adds, they note, the more value it destroys.

The profitability component is a key part of the value equation. Unfortunately, in their quest to drive customer retention through bigger and better loyalty programs, marketers sometimes lose sight of the fact that loyalty doesn’t always translate into profitability. They make the mistake of viewing “loyalty for loyalty’s sake” as a goal. In fact, the economic question they should always ask is: “What is the return on the cost of maintaining that loyalty?”

Netflix was smart to minimize the cost of serving unprofitable customers by essentially putting a cap on the number of DVD rentals they could make. That’s not to say the company did a good job of managing the decision to rescind its unlimited rental policy. In this age of transparency, Netflix might have been more forthcoming about its discriminatory practice from the get-go, and perhaps tried to migrate heavy renters into a new fee structure that makes economic sense. After all, from a customer perspective, it’s a bit like going to an all-you-can-eat buffet, only to find out that you’re actually allowed only two servings.

The fact that Netflix came through the controversy virtually unscathed is testament to the strength of its customer value proposition (the company added 1.6 million customers last year and enjoys high satisfaction ratings) rather than to the manner in which it handled the situation.

Unlike Netflix, which operates through a single channel, many companies still lack the ability to systematically identify unprofitable customers. In many cases, the problem is IT-related. It remains a huge challenge for many companies to connect their customer data silos across all of the different channels, product lines and geographies. Without doing so, however, it’s impossible to create a unified view of the customer relationship that reveals how much a customer spends with the company — and also how much it costs to serve that customer.

Another challenge relates to the traditional corporate mindset, which assumes that all customers are profitable. This explains why companies don’t have performance reviews for customers as they do for employees, and why “underperforming” customers aren’t subject to being “let go”. The fact that employees are viewed as a liability on the balance sheet while customers are viewed as an asset is one of the great follies of modern business.

Today companies need to follow Netflix’s example. They need to integrate their customer data and then use analytics to reappraise the value of their customers on an ongoing basis. Finally, they need to take appropriate action to either invest or divest in those relationships that are on the fence in terms of profitability.

Jeff Zabin is coauthor of “Precision Marketing” (Wiley, 2004) and a director in the Precision Marketing Group at Fair Isaac, a leading provider of marketing decision management solutions. He blogs at http://www.paretorules.com/.