Netflix Pays the Price for Free Streams

Netflix (Nasdaq: NFLX  ) may be thriving amid the recession, but one of its biggest draws could eventually become its Achilles heel.

The company's attractive pricing, home-delivered convenience, and "all-you-can-eat" subscription model have been just the ticket for homebound penny-pinchers. Netflix turned heads last month with the announcement that it topped the 10-million member mark, just weeks after closing out 2008 with 9.4 million subscribers. That's a rare feat these days for an entertainment company dependent on discretionary income.

A major driver of Netflix's growth is the DVD renter's welcome perk of offering subscribers to any Netflix unlimited plan the ability to stream movies online at no additional charge. That didn't seem like a big deal when the service was limited to awkward PC streaming. But it's a huge incentive now that you can stream more than 10,000 Netflix flicks into your living room through devices like TiVo (Nasdaq: TIVO  ) DVRs and Microsoft (Nasdaq: MSFT  ) Xbox 360 consoles.

Freebird as an encore
While Netflix offers Web streams at no additional cost to the subscriber, it's clearly footing some sort of bill itself. StreamingMedia.com decided to take a stab at nailing the bandwidth costs behind the streams this week.

It used the typical Xbox 360 video encoding rate, estimated the kind of pricing that content delivery networks Limelight (Nasdaq: LLNW  ) and Level 3 (Nasdaq: LVLT  ) are likely charging, and arrived at a price of $0.06 for a standard-definition movie and $0.09 for an average flick in HD.

That's a great rate compared to the company's bread-and-butter DVD-mailing business. Each movie shipped costs the company roughly $0.80 in postage alone, before we consider the mailer packaging costs and related distribution-center overhead. The comparison gets even better when you consider the wear and tear on physical DVDs, the amortized difference between what Netflix pays for a new DVD and what it ultimately unloads it for, and just the general inventory hassles that don't exist in digital delivery.

Slam dunk, right? Well, let's back up a bit. There is a physical limit for physical rentals. It takes, at best, two days to swap a viewed DVD for a new one. Online, a viewer is just seconds away from the next rental. The ability to stream content online may not necessarily slow the pace of physical DVD rental consumption.

Bow before royalty
We also haven't touched on royalties. The reason that new releases are rarely available through Netflix's streaming service is that studios can't afford to devalue their product that way. New flicks are available for streaming through companies like Apple (Nasdaq: AAPL  ) and Amazon.com (Nasdaq: AMZN  ) , but the studios are there to collect juicy royalties on every virtual rental.

"That's why many of the content licensing deals Netflix has in place are a one time cost no matter how many movies are watched," explains StreamingMedia.com.

Fair enough, but weren't most of these deals inked when Netflix was simply pumping catalog content into computers? Won't the studios of even cobwebbed content demand more in the future?

In just the first few months of Xbox 360 availability, Netflix and Microsoft announced that 1.5 billion minutes were consumed by more than a million Xbox 360 GOLD subscribers. It will be hard for filmmakers to accept small, one-time payments when a variable model is better suited for the explosive growth of online streaming.

Let the end credits roll
All of this, for now, is moot. Online streaming is helping grow the membership rolls at Netflix. The healthy income statements show that the company is effectively managing its costs. The wide disparity between streaming overhead and DVD rentals under today's cost structure probably make online streaming accretive to the bottom line.

That may not always be the case. What if more couch potatoes kill off their cable subscriptions, relying more on Netflix streams? There are already blogosphere whispers (thus far unsubstantiated) claiming that Netflix is throttling online users -- giving active streamers cheaper, lower-quality flicks. If it's true, that makes sense. A member watching a high-def flick through Netflix every night is costing the company nearly $3 every month on bandwidth alone.

Ultimately, Netflix may have to pull the unthinkable and actually cap streaming usage, the way it did when it initially rolled out the service. It will do everything possible to avoid that, I'm sure, since Watch Now streams are a great selling point for Netflix as a service.

However, there is a price to every stream -- even if it's included at no additional cost.

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Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and shareholder -- since 2002. He also owns shares in TiVo. He is part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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