4 Reasons Netflix Shouldn't Kill DVD Rentals

Netflix (NFLX 4.17%) 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.

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 (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 (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 (AMZN 1.30%), 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.