4 Reasons Netflix Shouldn't Kill DVD Rentals

Netflix (NASDAQ: NFLX  ) is quietly tiptoeing past an important milestone. The leading video service has sent out 4 billion DVDs since rolling out its original mail-based rental platform in 1999.

That's a lot of optical discs, but Netflix isn't shouting the milestone from the rooftops. There was no press release. There was no blog post. There was no questionable Facebook posting by CEO Reed Hastings.

Earlier this month, Netflix merely alerted what are now just 8.2 million disc-based subscribers of the milestone by slapping the achievement on its DVD mailers.

The small print reads: "We ship emotions ... 4 BILLION DVDS and counting. Thanks for helping us reach this milestone. Your love of TV shows & movies made it possible!"

To DVD or not to DVD
Netflix is mailing out fewer DVDs with every passing quarter, so the path from here to 5 billion will be longer than the one it took from 3 billion to get here. Since peaking two years ago, Netflix's pool of DVD renters has been shrinking sequentially at an alarming pace.

 Quarter

DVD Subs

Q3 2011

13.93 million

Q4 2011

11.17 million

Q1 2012

10.09 million

Q2 2012

9.24 million

Q3 2012

8.61 million

Q4 2012

8.22 million

Source: Netflix.

It's not just Netflix that's seeing waning interest in DVDs and Blu-ray discs. Studios have been suffering declining retail sales. DISH Network (NASDAQ: DISH  ) is closing far more Blockbuster video rental stores than it thought it would be shuttering since acquiring the chain out of bankruptcy two years ago, and it recently pulled out of the kiosk business when Coinstar's (NASDAQ: OUTR  ) Redbox took over the Blockbuster Express.

Redbox is the only name growing in DVD rentals, but that growth is padded by a late 2011 rate increase and the 2012 takeover of the Blockbuster Express machines. Analysts see revenue growth at Coinstar slowing to just 4% next year, when results will be more organic.

All of these moves seem to validate Netflix's shift away from optical discs. The bulk of its marketing is steering video buffs to its streaming smorgasbord, where Netflix doesn't have to worry about making subscribers wait for content or foot the bill for round-trip mail shipments.

The move has paid off. Over the past year, Netflix has seen its global streaming accounts climb from 23.5 million to 33.3 million as its disc-based subscribers have contracted by 3 million.

However, that doesn't mean Netflix should turn its back on the service that put the company on the map. Even in its shrinking state, DVDs remain a competitive strength at Netflix.

Let's go postal
Doing business by mail has never been ideal. DVDs get lost or damaged in transit. It takes subscribers at least two days to get a new rental after mailing one out. There are also some current developments that will make the process slower and more expensive -- namely, the move to eliminate Saturday deliveries and a recent move to increase first-class postage rates.

Shouldn't Netflix just shut down its disc-rental business? Maybe the move to spin that off as a standalone Qwikster service wasn't so crazy after all.

No! There are still plenty of good reasons for Netflix to keep its original DVD service going. If anything, Netflix should be more active in promoting the service.

  • For starters, nearly 7 million of Netflix's 8.2 million DVD accounts also subscribe to the streaming service. Put another way, a quarter of Netflix's growing domestic streaming business relies on Netflix for DVDs. Even if streaming is the future, Netflix doesn't want to upset those 7 million double-dippers who are Netflix's largest customers.
  • Streaming will also always be limited in selection. Even as Netflix spends 10 figures a year on digital content, there is a lot of content it will never get. Redbox just entered the digital market, and it makes fresh content available through its kiosks. Four nightly DVD credits are included in its monthly rate. Netflix's fiercest rival in streaming smorgasbords is Amazon.com (NASDAQ: AMZN  ) , and Amazon offers new releases as digital rentals a la carte. Netflix has stubbornly refused to go that route, so it needs to keep discs as a way for video buffs to get the hottest current content.
  • DVDs are also a more profitable business for Netflix, and not just because the company is losing money overseas. The contribution profit from its 8.2 million DVD accounts was greater than the profit generated by its 27.2 million domestic streaming accounts this past quarter. That trend will shift this quarter, but as a scalable model, Netflix should be promoting its DVD business to keep its highest-margin business steady.
  • Finally, we can't forget the ton of data that Netflix has amassed through DVD rental patterns. Netflix gets smarter with every billion DVDs it sends out, and not just in the way it can serve up more efficient recommendations. Keeping DVDs alive helps Netflix gauge the content that its streaming customers would want to access digitally. That helps Netflix prioritize licensing negotiations.

It will take Netflix a long time to get to 5 billion DVDs mailed out, but when it does, let's hope that this time it does shout from the rooftops.

Nothing but Netflix
The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why we've released a brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.


Read/Post Comments (5) | 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 March 09, 2013, at 5:21 PM, bubbler101 wrote:

    funny thing is , I keep hearing on the fool how dvd rentals are declining and all this, I agree from netflix they ARE! but I notice lines around the redbox kiosks all the time. I think the truth is that CSTR is starting to kick nflx ass. If you really want to know the truth, but you guys dont pump them because they actually have a low PE and a very sound business model. You guys have to pump these over inflated pigs like nflx in order to keep ignorant sheep buying this garbage stock.

  • Report this Comment On March 10, 2013, at 11:19 AM, jb757 wrote:

    Lines around the redbox kiosks? I've never seen that and I pass the kiosks every few days. It must be for kids. Never anything there worth the trouble of having to return the disk. They're only increasing revenue because they keep adding kiosks every year. NFLX is the professional and preferred movie rental service.

  • Report this Comment On March 10, 2013, at 10:42 PM, scfneon wrote:

    The fool used to be a great site, until they started getting story like this published on real stock sites it's really like they are trying to Manipulate the market with their opinions. I like Netflix and Coinstar both.

  • Report this Comment On March 11, 2013, at 11:34 AM, StartWolf wrote:

    Motley Fools used to be respectable source of the information in the past, but lately (with articles like this one) I can not distinguish them from Cramer's spam and mislead. In the past articles here used to say do your own due diligence because nobody knows what is going to happen, now they are just selling half baked lies as truth.

  • Report this Comment On March 11, 2013, at 10:36 PM, TMFBreakerRick wrote:

    StartWolf, please pick out the half-baked lies. I don't mind if fellow investors disagree with my opinions and conclusions -- there wouldn't be a market if we all saw things exactly the same way -- but when I'm accused of lying I take that seriously.

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