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Netflix (NFLX) is a leading entertainment content provider that specializes in Internet streaming and DVD mailing. A federal appeals court unanimously ruled on Friday that the U.S. Postal Service discriminated against GameFly Inc. (pdf) by providing Netflix with special treatment. Specifically, Netflix's DVDs were handled by hand at no additional cost (no wonder the USPS is insolvent) to prevent damage. Not only is this ruling a significant victory for GameFly but this could have a notable impact on Netflix's performance. Many will dismiss this ruling as irrelevant, reasoning that DVDs are the past and Internet streaming is the future.

Not so fast: the DVD business is keeping Netflix afloat thanks to its high margins and profits. As of Q3 2012, Netflix had 8.47M paid DVD subscribers with revenue of $271M and a contribution margin of 48.2%. In contrast, the global streaming business has 27.49M paid subscribers with revenue of $634M and a negative contribution margin. As you can clearly see, the DVD business is currently accounting for virtually all of Netflix's profitability.

There are two broad categories of outcomes from this litigation involving the USPS: (1) Gamefly will receive the same preferential treatment that Netflix receives or (2) Netflix will stop receiving preferential treatment and will have to face the same cost structure as Gamefly. In reality, I expect some sort of compromise in the middle.

Gamefly has been subjected to the following additional costs above the basic $0.44 per DVD due to Netflix's preferential treatment:

  • $0.44 extra per DVD surcharge for one-ounce First-Class letter versus the First-Class flat rate
  • $0.20 extra per DVD surcharge for weight associated with protective cardboard inserts

This calculation ignores the additional cost associated with damaged discs and the related customer dissatisfaction as they are difficult to measure.

At a worst case, Netflix would face an additional $0.64 per DVD shipment, or $1.28 per round-trip. Netflix's base subscription allows customers to rent one DVD at a time but have unlimited rentals per month. With a $7.99 monthly subscription and elevated $2.16 round-trip mailing cost, Netflix would actually lose money if subscribers rented a reasonable one DVD per week (actual break-even at 3.7 discs per month). Netflix is one of the largest DVD mailers in the United States and mails a significant number of DVDs to its 8.5M customers every day. Even a small increase in the postage rate can have a large impact on the company's profitability. Is a DVD plan price increase inevitable? After the Qwikster disaster in late 2011, Netflix has to be very careful to not alienate any additional customers but also needs to keep its only real profit source alive.

As I have stated in the past, the number one reason why you cannot own Netflix is because of its misguided international expansion but any weakness in the cash cow DVD business is important to monitor. If Netflix is forced to increase the subscription price for the DVD plan then it could lose many subscribers. Netflix discloses that more than two-thirds of DVD subscribers also have the streaming plan, thus its customers would likely be very price sensitive to a DVD price hike. For example, even if Netflix increases by two dollars per month, if you already have Netflix Internet streaming you are more likely to cancel than if the DVD plan is your only source of entertainment. I have been bearish on Netflix's prospects, notably arguing that Disney's (DIS) content will not save Netflix and here is yet another argument in favor of a short case against the stock. The stock has rallied nearly 60 percent in the past three months and I believe that we will see $80 per share before we see $120 per share.

Netflix reports Q4 2012 earnings on January 23, 2013.

Source: Is Netflix's Cash Cow Dead?