In analyses of Netflix (NASDAQ:NFLX), the DVD segment tends to get short shrift. All things considered, this isn't very surprising: Streaming is clearly the company's main focus, while the DVD-by-mail business is in permanent decline.
That said, the DVD segment still makes a critical contribution to Netflix's earnings. It is on pace to generate a contribution profit of $430 million to $435 million for 2013, down from $538 million in 2012. That's more than double the company's total pre-tax profit -- in other words, without the DVD-by-mail business, Netflix would have lost money in 2013.
So while the streaming business will drive significant long-term profit growth, the DVD segment's declining earnings power could still have a noticeable impact on companywide results. In fact, due to the ongoing membership decline and increasing postage costs, Netflix's DVD segment earnings are likely to fall very quickly in the next two to three years.
The trajectory of decline
The DVD segment began its decline immediately after Netflix's controversial pricing change and attempted spinoff of that business in 2011. Following the pricing change, Netflix had about 14 million DVD subscribers. That total has since dropped by half, with the vast majority of the subscriber losses coming in the first year.
Since early 2012, the DVD segment's decline has followed a relatively predictable pattern. Subscriber losses have been fastest in the second and third quarters. Meanwhile, the DVD contribution margin has tended to drop in the first quarter due to a seasonal uptick in usage and higher postage rates, before bouncing back over the course of the year.
The result of this pattern is that while the DVD segment's contribution to profit has declined every quarter for more than two years, most of the annual drop has occurred in the first quarter each year. A big jump in postal rates is likely to cause a repeat of this phenomenon in 2014.
Post office woes
In December, the Postal Regulatory Commission approved a U.S. Postal Service request to raise stamp prices by $0.03 later this month. Since Netflix sends out millions of its signature red envelopes each week, company management estimates that this will add $3 million to $4 million of quarterly expenses.
As a practical matter, Netflix can't recoup these costs from customers, because increasing prices would cause even more users to drop the DVD service. The increase in postal rates alone will reduce the DVD segment contribution margin by 1 to 2 percentage points.
However, an even bigger headwind could be looming on the horizon. The Postal Service, Netflix, and GameFly are wrangling over the service and pricing provided for DVD-by-mail delivery. The Postal Service is proposing to change the classification of DVD mailers so that it could charge extra for hand-sorting, a service that the USPS has historically provided to Netflix for free.
This dispute has been going on for a while, and right now the ball is in the Postal Regulatory Commission's court. However, there is a strong possibility that it will permit the USPS to raise prices for DVD mailings, causing Netflix's costs to go up even more in the near future.
Thus far, Netflix has done an admirable job of keeping its DVD contribution margin near 50% despite the rapid drop in subscriber numbers. To cut costs, Netflix has shut down many of its DVD distribution centers without having a major impact on service.
However, at some point this will become unsustainable. In 2006, when Netflix ended the year with 6.3 million DVD subscribers (slightly below the current level), the company reported a gross margin of 37.1%. That figure is roughly comparable to the contribution margin under the current accounting scheme. (Gross margin excludes marketing expenses, but these have become fairly negligible for the DVD segment.)
In other words, Netflix's DVD segment is more profitable today "on the way down" than it was at a similar size "on the way up." However, there is only so much room for Netflix to maintain its DVD margin in the face of eroding revenue. If Netflix closes too many distribution centers, service will suffer, exacerbating membership declines. If it doesn't cut enough, fixed costs will start to weigh more heavily on the DVD segment margin.
The tipping point
Last year, the DVD contribution margin dropped by 4 percentage points sequentially in the first quarter, even though the stamp price only went up by $0.01. With this year's larger increase, the margin drop is likely to be bigger.
For fourth-quarter 2013, Netflix may post DVD segment earnings of $106 million on revenue of $212 million, for a 50% contribution margin (author's estimate). A 5% decline in revenue and 5-percentage-point decline in contribution margin would lead to a first-quarter 2014 contribution profit of $91 million.
If 2014 follows the recent pattern, then Netflix might see slower contribution profit declines for the rest of the year. On the other hand, Netflix may reach a tipping point in 2014 where it can no longer offset second- and third-quarter subscriber declines with margin improvements. Just as it was able to achieve substantial margin growth while passing through the 6 million subscriber mark in 2006, Netflix may experience corresponding margin contraction when passing through that zone on the way down.
Permission for the post office to raise processing fees at some point in 2014 would add further pressure to Netflix's DVD contribution margin. The net result is that the DVD segment, which is still contributing more than $100 million in profit each quarter today, could see its earnings run rate drop by half (or more) by the end of next year.
Foolish final thoughts
Growth in Netflix's streaming business should be sufficient to more than offset disappearing profits from the DVD segment. That said, the DVD business has contributed more than $4 per share to Netflix's 2013 earnings per share, so the pace of decline will have a significant impact on total profitability.
The profit potential of Netflix's DVD business over the next few years will be determined by two factors: the post office's ability to raise rates for special processing of DVD mailers and the ability of Netflix to close more distribution centers without exacerbating the subscriber exodus. So far, the company has done a good job of keeping its profit margin intact despite heavy subscriber losses. That task is only going to get harder in 2014 and beyond.