The Real Cost of Netflix Streaming is the Movie, Not the Bandwidth

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Everyone knows that Netflix’s future is in streaming, and as a result, the company is investing heavily in titles for its Watch Instantly service. But a closer look at Netflix’s financials underscore how the Internet has changed the movie distribution business, and how it is capitalizing on that trend. Netflix is spending its more money than ever on streaming video, in part because it costs less to deliver that content online than by mail.

According to its 10-K filing, Netflix spent $66 million in the second quarter 2010 to license streaming titles for its Watch Instantly service, compared with just $9 million that was spent in the prior-year period. (Hat tip to CNET) The acquisition of new and better content has helped drive its subscriber numbers up 42 percent over the past year, with 15 million subscribers at the end of the second quarter, compared with 10.6 million a year earlier. In addition, those subscribers are watching more streaming content than ever, with 61 percent using the service, compared to just 37 percent a year earlier.

But despite a huge increase in the amount of video streams it’s serving up through Watch Instantly, Netflix’s streaming costs haven’t increased proportionally. In the second quarter, the company said costs associated with delivery over third-party CDN networks only increased by $1 million versus the previous quarter. Netflix is benefiting from bandwidth costs continuing to fall exponentially as it grows its streaming business.

So the real cost of running its streaming business is in acquiring the content, not delivering it.

On the DVD side of the business, just the opposite is true. Netflix spent $24 million on DVDs last quarter, compared to $43 million during the previous year’s second quarter. For the first six months of 2010, the company shelled out $61 million on DVDs, which is down from $89 million during the first half of 2009.

But expenses associated with DVD delivery offset its reduction in purchase costs. According to Netflix, the costs of its DVD-by-mail business increased by $23.1 million in the second quarter. Due to the vast increase in its subscriber base, the number of discs shipped grew 9.3 percent, despite a 20 percent decrease in the number of DVDs per sub. Those costs could increase even further next year, as the U.S. Postal Service has announced plans to increase postage rates (again).

The good news is that Netflix’s streaming strategy appears to be working. It seems to have entered into a virtuous cycle in which it is able to sign up subscribers who are attracted to its streaming service, which enables it to reduce its spend on DVDs and put more cash toward acquiring streaming content, which will pull in even more subscribers.

Related content on GigaOM Pro: Three Reasons Hulu Plus is No Threat to Netflix (subscription required)

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