How Much Does Netflix Love DVD Rentals?

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Stop the presses! Netflix (Nasdaq: NFLX  ) just introduced a DVD-only plan! Sign up now, get a one-month free trial.

"Starting today, our DVD and Blu-ray loving audience can now easily sign up for a DVD only plan," blares a brand new official Netflix blog post. The key word here is "easy."

So, uh ... what's changed?
OK. This is only news if you had noticed that DVD-only signups haven't been available for a while. The new thing here is that Netflix once again makes it easy to sign up for a DVD-only trial. The fewer-clicks signup process went AWOL somewhere around the unpopular split between DVD and streaming plans, or perhaps the introduction of Qwikster.

This does not in any way diminish Netflix's desire to remove DVD rentals from the business mix. The default page for free trials still offers only a one-month streaming pass. There is no mention of DVD or Blu-ray products on that page. You need to enter a new address to get to the DVD deal.

Some observers are up in arms about this new emphasis on a streaming business that barely breaks even while DVD shipments carry the bulk of Netflix's profits. These are often the same people who complain that Netflix invests in expensive streaming license deals. Both complaints come down to a misunderstanding of fixed versus variable costs.

Running the numbers
The DVD business is simple enough to understand: buy discs, pay for stamps and a mostly automated handling process, reap the difference between these costs and the monthly $8 fees per single-disc customer. Add more customers, you also add more shipping costs and need to buy more DVDs. Margins here are pretty stable.

Not so in the streaming world. There's no shipping and handling. One digital copy from the studio is enough to seed the entire Netflix network. Because Hollywood is so used to negotiating content licenses with predictable cable and satellite broadcasters, nearly every license Netflix signs is a fixed cost. The company doesn't pay a single penny more to Walt Disney (NYSE: DIS  ) or Lions Gate Entertainment (NYSE: LGF  ) if you watch Tangled or The Expendables a million times (though your friends and family may question your sanity). Neither does Netflix get a break on license fees if a title on contract turns out to be a massive flop.

In this environment, the finances work out very differently. To cover the cost of expensive content, Netflix needs a lot of subscribers. Once the costs of content have been covered, every new subscriber is nearly pure profit. In DVD shipments, the costs of doing business will rise and fall with subscriber counts. In streaming, they are set when the company signs content deals. And right now, Netflix has enough domestic subscribers to stay about 11% above the content bets it made a couple of years ago.

Taking the boot off the customer-base accelerator at this point is tantamount to suicide. Firm content commitments of $3.9 billion are waiting to jump onto the balance sheet in the next couple of years. Those costs will be accounted for on coming income statements. Netflix is betting that this massive influx of more expensive -- and presumably more attractive -- content will keep subscribers coming back for more.

This is the same logic that makes Sirius XM (Nasdaq: SIRI  ) pay Howard Stern $500 million for five years of talk-radio service. With that cost set in stone, Sirius must then leverage that investment to sign up new subscribers -- hopefully enough of them to make Howard worth his while. Stern doesn't get paid a higher fee if Sirius snags another 5 million subscribers.

Or you can kick this model right back to Hollywood: Disney makes a movie to create a solid fixed cost. Then it's up to marketing and product quality to make the darn thing profitable -- actors and special-effects houses won't return their paychecks just because Cars 5 fails at the box office. It doesn't make sense to make expensive movies and then leave them without promotion support.

Makes sense now, boss
So that's why Netflix is so dead-set on becoming a pure streaming company. The DVD business already contributes less revenue to the total business than the domestic streaming operation, and that imbalance will only tip further as the international expansion gains traction.

Every subscriber here puts about $8 toward paying off the license deals while an $8 DVD subscriber puts only $4 in that bucket. I'd ask for more of the $8 payers, too. Expect an increasingly half-hearted effort to keep the DVD business alive. Ideally, the entire DVD catalog would eventually be available for streaming. Realistically, the DVD library will fill a niche role for customers with offbeat or fresh tastes for years to come -- but that's all.

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Fool contributor Anders Bylund owns shares of Netflix but holds no other position in any of the companies mentioned. Motley Fool newsletter services have recommended buying shares of Walt Disney and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Check out Anders' holdings and bio, or follow him on Twitter and Google+. Our disclosure policy wonders why people worry so much about delayed rental releases. Movies you want to see quickly surely passed through your local theater at some point.

Read/Post Comments (3) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 21, 2012, at 11:00 PM, MKArch wrote:

    I've got news for you Anders, Hastings is a lying about streaming content costs being fixed and you are nuts if you beleive otherwise. They may not scale directly with sub growth and stair step instead but they will scale with sub growth and Netflix dirt cheap all you can eat version of subscription stream will NEVER be anything more than marginally profitable at best. Hell with over 20M U.s. streaming subs or about 25% of the addressable market that business isn't profitable. The only hope for NFLX is if Steve Ballmer is stupid enough to spend another $8B to bail Hastings out.

  • Report this Comment On February 21, 2012, at 11:02 PM, MKArch wrote:

    BTW Comcast is now giving away the same content Netflix is charging for and it's just a matter of time before the other HSI providers follow suit. Stick a fork in em they're done.

  • Report this Comment On February 24, 2012, at 11:31 AM, JesseJamesFinn wrote:

    Netflix's software kicks the crap out of Hulu, Hulu beg's for a monthly subscription and plagues the user with lousy service and a substandard package of goods. Netflix's has the ability to regain plenty of growth, with different markets, just hog-tie their CEO from Blogging, and force him to stick with better content. The US Postage Service is in shambles, next year they plan on closing and regrouping another 230 facilities. Mail Order DVDs for the heavy users, is going to erode profits, with transport cost climbing.

    Can you imagine Fed-Ex or UPS trying to deliver NETFLIX, as the USPS struggles with "Fixed and Variable Cost" fuel, pension, lower bulk mail (thank spam and email) shipments. Interesting article and comments made on this subject. Cheers!

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