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Analysis: Disc Rental Profits Don’t Lie at Netflix

30 Jan, 2012 By: Erik Gruenwedel

On its way toward streaming dominance an interesting old school reality has emerged in Netflix’s bottom line.

DVD and Blu-ray Disc rentals are delivering five times the profit margins compared with streaming. In dollars, that amounted to $194 million in profit for disc (52%), compared with $52 million (11%) for subscription video-on-demand (SVOD) in Netflix’s most recent fourth quarter.

The discrepancy underscores an inconvenient truth for Netflix. Namely that while the future may belong to streaming, the present still is very much a disc-driven business, no matter how much management wants to spin it otherwise.

The notion of all-you-can-eat streaming access to movies and TV shows for $7.99 a month may be nirvana to consumers. It also is a double-edged sword to content holders and over-the-top providers such as Netflix and Hulu. Selling the concept of low-cost SVOD is not nearly as difficult as making a profit off of it.

For Netflix, its singular creation of a streaming business coupled with tech buzz and outrageous stock valuation have made it both foe and favorite to media companies. The media companies are concerned about SVOD’s impact on traditional distribution channels while at the same time lured by its incremental largess.

The profit imbalance might explain why Netflix wanted to spin off its disc business in the ill-fated Qwikster platform debacle last fall. If the company mantra revolves around the notion that streaming is the future (which it is), it’s kind of embarrassing when the original business plan (by-mail disc rentals) just won’t retreat into the shadows.

Indeed, in Q4 (ended Dec. 31, 2011), Los Gatos, Calif.-based Netflix generated $847 million in revenue, which included $476 million from SVOD and $370 million from disc. Yet, physical rentals delivered $17.32 in profit per subscriber, compared with $2.40 for each streaming sub, according to Erick Schonfeld, who dissected the numbers in a story for TechCrunch.com.

“The new business kind of sucks,” Schonfeld wrote.

Netflix ended the period with more than 21 million streaming subscribers and 11.2 million disc subs, which included 8.4 million hybrid disc-streaming members. It’s the latter group that’s key to the imbalance since hybrid subs pay $15.98 per month to rent one disc (out at a time) and unlimited streaming. This is the equivalent to two separate streaming or disc subs paying $7.99 each. In other words, those 8.4 million hybrid subs generate the same revenue as nearly 17 million streaming members but with half the operating costs.

Why? Disc rentals involve variable costs such as postage (which is not insignificant) and physical handling at numerous distribution centers around the country. While the former — including the specter of the elimination of Saturday mail delivery — cannot be ignored, distribution centers largely figure costs already amortized. More importantly, content-license rights paid to studios for discs typically feature umbrella agreements for numerous titles. This is not true for the millions Netflix is shelling out to content holders for exclusive SVOD rights — much of it on an à la carte basis per title.

Netflix CFO David Wells says streaming margins are greater than those of disc due to modest credit card fees and related bandwidth and content delivery charges.

“The contribution margin is almost twice what it is for a DVD subscriber,” Wells told analysts Jan. 25. “So that's the way we think about it.”

Meanwhile, the burgeoning value of SVOD content rights are no more magnified than next month’s ending agreement between Netflix and Starz Entertainment. Netflix was paying about $30 million a year for access to select Disney and Sony movies, among others. That agreement, which apparently won’t be renewed, now would cost Netflix about $300 million annually going forward, according to analysts.

With Netflix management predicting a loss throughout fiscal 2012 as the company expands into Latin America, the United Kingdom and Ireland, the service would appear to be behind the eight ball justifying its content spend vis-à-vis streaming subscriber growth.

“We don't feel great about the profit stream we have for this [first] quarter,” Hastings told analysts. “And for the content to grow, it shows up in our profit stream. We hope to mitigate that, obviously, as we grow the subscriber base over this year and return back to break even and continued rapid international expansion.”

Yet, Hastings & Co. continue to give short shrift to disc rentals, including coveted hybrid subscribers — many who abandoned the service last fall after Netflix imposed a 60% price increase. On fan site HackingNetflix.com, Netflix’s indifference toward discs elicited puzzlement from subscribers.

“DVD's are essential to my subscription,” wrote bobodod.

“Why abandon DVD’s at all … if they can still make money on it?” wrote Daniel L. “DVD's are good for movies that should be both viewed with the best possible quality and with the proper audio/subtitles. Streaming is good for watching season after season of older TV shows, and movies that aren't worth quite worth the investment of getting the DVD.”

“Given that Netflix has done the hard work on building the support infrastructure (and a first-rate one, as far as I can see) to support disc distribution, I think it would be foolish to dismantle it too quickly,” wrote moom. “It sounds like there [could] be profits made with physical discs for many years to come.”

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About the Author: Erik Gruenwedel

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