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Netflix is the big loser in Postal Service changes

In the face of naysayers who have long predicted its demise, Netflix has had a remarkable few years.
Image: Netflix envelopes
Affordability and speed of delivery are hallmarks of Netflix. Changes that the post office may force it to pick one.Paul Sakuma / AP
/ Source: The Big Money

In the face of naysayers who have long predicted its demise, Netflix has had a remarkable few years. In 2005, the Los Gatos, Calif.-based DVD rental service boasted 4.2 million subscribers and enjoyed net earnings of $41.9 million. Last year, the company netted $115.9 million, and its bright red envelopes made their way into the homes of 12.3 million subscribers nationwide. The company's NASDAQ-listed stock price tripled in that period.

2010 is shaping up to be another stellar year. On Feb. 25 of this year, Netflix enjoyed a red-envelope day of sorts: It surpassed former industry leader Blockbuster in movie rental revenue for the first time. Meanwhile, as mom-and-pop rental stores close up shop and Blockbuster enters a period of major retrenchment (the Dallas-based company recently announced plans to close 500 stores), Netflix's subscriber base looks set to expand.

Netflix is in many ways the epitome of the 21st century company: It's based in Silicon Valley, it sells its services exclusively online, and it employs a hip bit of Web-speak in its name. But even as it boasts many of the trappings of a New Economy juggernaut, Netflix is still almost entirely reliant on that most 19th century of institutions: the United States Postal Service. Indeed, Netflix is the Postal Service’s biggest corporate customer.

And sadly for Netflix, its big partner is also in the red — the Postal Service lost $3.8 billion last year. In an effort to stop the bleeding, on Wednesday, the USPS took the first step toward eliminating Saturday mail delivery — it asked the Postal Regulatory Commission for an opinion on the matter. (Congress still has to approve the change.) The USPS says it hopes to implement the change in fiscal year 2011. In addition to eliminating Saturday delivery, the Postal Service has also said that it wants to raise postage fees. If these changes are implemented, Netflix's finely tuned business model could suffer a serious blow.

Among other things, Netflix's success relies on its remarkable efficiency and its affordability. The least costly subscription plan, which allows a subscriber to rent one movie at a time, costs only $8.99, and the most expensive, which allows the subscriber to have four movies out simultaneously, tops out at $23.99. And delivery really is remarkably fast: The company generally delivers in just one business day, and has 58 warehouses nationwide, meaning that you rarely stray far from one. A subscriber can expect that if he sends back a DVD on a Monday afternoon, he will receive a replacement on Wednesday. To maintain these speeds, Netflix warehouse employees are expected to process a minimum of 650 discs per hour.

Slower and costlier mail service could put an end to that. The elimination of Saturday delivery would mean that Netflix subscribers will have to endure two consecutive days of no service — nothing to scoff at in a time when consumers have come to expect high speeds and (nearly) instant gratification. And Saturday is a big movie day; the blogger who runs the online bible for Netflix fanatics, Hacking Netflix, said via telephone that many subscribers have come to expect to receive movies on Saturdays and may be very disappointed. On the plus side for Netflix’s balance sheet, the blogger did note that the elimination of Saturday delivery could mean lower labor costs as warehouse shifts are eliminated. However, as the USPS claims that mail would still be transported and that post offices would still be open on Saturdays, it is not clear if this is the case.

Higher postage costs will pose another serious problem. Postage costs have already increased four times in the past five years. To combat these cost increases, the company has simply continued to fine-tune its automation and squeeze costs out of its warehouse and distribution network. The company has also slapped on costs for premium services, such as a $1-per-month fee on Blu-Ray discs. This has eased the cost pressure somewhat, but it’s a precarious balance. As far back as 2008, Netflix said publicly that it was considering raising subscription prices. Right now, Netflix needs to collect $2 per rented DVD in order to maintain profitability and is said to spend roughly 78 cents on postage for each rented DVD.

In total, Netflix estimates that it will spend $600 million on postage in 2010. A rise in postal rates will obviously skew this formula, and generate pressure on the bottom line. If Netflix can’t mitigate these higher costs through yet more automation, the company will face two options. It could slow down turnaround time, and therefore reduce the number of DVDs that it sends each month: That is, it could sacrifice speed for affordability. Alternatively, Netflix could instead elect to sacrifice affordability for speed and raise subscription prices to compensate for higher postage fees — a gambit that the company would be loath to attempt in this economy. Either way, Netflix may have to give up one of its hallmarks: bargain-basement prices or light speeds. And these reduced speeds, of course, will come in addition to the elimination of Saturday delivery.

And don't look to the Internet to save this Internet company, either. In recent years, Netflix has increased the availability of films that subscribers can stream instantly onto their personal computers, game consoles, Internet-enabled televisions, and soon iPhones. Currently, some 17,000 of Netflix’s roughly 100,000 titles are available for instant streaming. But while instantly streamed movies obviously eliminate postage costs, they are not a cost-free proposition for Netflix. Analysts suggest that the streaming technology itself is very cheap — it costs roughly five cents to stream 90 minutes of content — but the licensing fees can be exorbitant. Netflix won’t release the data on how much it pays for online licensing, but can apparently be quite expensive. Dan Rayburn, an analyst with Streaming Media, has said that he’s seen some streaming movies that cost as much as $4 per play.

Even if Netflix did wish to abandon mail delivery altogether, it wouldn’t be possible. Hollywood studios actively limit the number of films they allow to be streamed, because they want to avoid cannibalizing their highly profitable DVD businesses. (Studios collect about 80 percent of the sales of DVDs.) That’s a big reason why Reed Hastings, the founder, CEO, and chairman of the company, recently told Bloomberg News that he expects Netflix to continue mailing DVDs for 20 more years.

Ultimately, then, Netflix is going to be faced with higher postage costs and slower delivery speeds. Maybe your emphatically unsexy and oh-so-20th-century brick-and-mortar movie rental store isn't dead after all.