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The slow but inevitable decline of Netflix’s DVD business

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When will Netflix (s NFLX) send out its last red envelope? The company is clearly focused on streaming, but executives have long maintained that DVDs, while declining, are going to be a part of its business for years to come. Still, there are some good reasons why Netflix might get out of the DVD business sooner rather than later.

Netflix’s DVD business by the numbers

Netflix will announce its third-quarter earnings Monday, and the attention of analysts and pundits alike will once again be squarely focused on the company’s streaming business. The number of customers who subscribe to Netflix’s streaming service in the U.S. was just shy of 30 million last at the end of the previous quarter. Analysts expect that the company could have added as many as 1.5 million additional U.S. subscribers in its third quarter, and there is going to be a lot of musing on how well the company’s continued investment in original content is paying off.

But there’s going to be another interesting story hiding on Monday’s earnings, one that barely gets any attention anymore these days. Around seven million customers still pay Netflix to send them DVDs of movies and TV shows via mail. Two years ago, that number was twice as high. Fast forward another two years, and there could be around four million customers left who get their red envelopes from Netflix. Or maybe even less.

From 58 distribution centers to 39, and counting

The number of DVD subscribers fell rapidly when Netflix decided to split up its two offerings in the summer of 2011, essentially asking people to pay $8 each for its DVD and streaming plans, whereas it had previously offered both for the same price (Netflix also offered both higher- and lower-priced DVD packages, but the $8 plan was the company’s best-promoted product.) In Q3 of 2011, Netflix had close to 14 million DVD subscribers. Half a year later, that number had dropped to 10 million. At that time, it looked like Netflix may be getting ready to close all of its shipping facilities within a year or two.

Since then, the decline has stabilized, but those shipping hubs are still closing. A Netflix spokesperson recently told the Montana Standard that it was closing “a handful” of its DVD distribution centers, with its facility in Butte, Mt. being one of them. According to the story, Netflix still maintains 39 distribution centers nationwide. The company declined to share any specific numbers around these closures with us, with a spokesperson only saying that “DVD continues to be important to Netflix and we want to offer our DVD customers the best possible service.” Previously, Netflix operated as many as 58 distribution centers.

DVDs used to be Netflix’s biggest cash cow. Not anymore.

There’s a reason Netflix has held on to its DVD business for so long: It’s incredibly profitable. 47 cents of every dollar Netflix customers spend on DVD subscription plans are pure profits. The contributing margin of streaming is far lower, largely due to the high costs of content licensing. That’s why Netflix has long used the money it has made from DVDs to build out its streaming biz: Physical discs first financed the growth of streaming in the U.S., and then bankrolled its international expansion into markets like Canada and Latin America.

But earlier this year, something interesting happened: During the first quarter, scale won over margins, and Netflix made for the first time more money with streaming to its U.S. customers than with DVD subscriptions. Since then, that gap has widened. DVDs still contributed $109 million to Netflix’s bottom line in Q2, but domestic streaming became the real cash cow, contributing $151 million.

Mind you, $109 million is still very significant, especially as Netflix is continuing to underwrite its growth in foreign markets, where it lost close to $66 million during the same quarter. But the writing is on the wall: Even from a financial perspective, DVDS are mattering less and less to Netflix.

Stamps are getting more expensive. Just like DVDs.

In an ideal world, Netflix could just scale down its DVD operations the same way it scaled them up, and continue to make at least some money until the last customer’s DVD player finally breaks. Realistically, the company is going to hit a few bumps in the road.

Customer satisfaction could be one issue, and not just because those closed shipping centers will have to slow down shipping eventually. Paradoxically, Netflix’s success in streaming could accelerate the decline of its DVD business. Up until now, some customers have still held on to both plans to fill holes in Netflix’s streaming catalog with DVDs. But as Netflix continues to invest into its streaming catalog, both with high-profile content deals and original productions, some customers may decide that they don’t need those extra DVDs anymore.

Will Netflix's originals help kill of its DVD business?
Will Netflix’s originals help kill off its DVD business?

Then there are other factors. On January 2014, the Postal Service is going to once again increase postage fees. Further increases in coming years are inevitable. Netflix can either decide to eat those extra pennies per envelope it sends out, thereby further decreasing the amount of money DVDs will contribute to the company’s profits. Or it could raise prices for DVD subscriptions, which could rapidly accelerate the subscriber exodus.

Finally, there’s industry politics. After being blindsided by the rapid decline of the home DVD business, Hollywood is trying to fix the floodgates and once again get consumers to value the ownership of its movies. Studios have begun to increase prices for digital rentals to make digital sales more attractive.

They’ve banded together to promote digital lockers that tie physical media to streaming access, and they’re trying to make it less profitable to undercut the sale of physical as well as digital media with cheap rentals. That’s why studios have forced new windows upon kiosk operators like Redbox, and that’s why Netflix increasingly has to strike deals with studios to get access to DVDs – something that the company pointed to in its most recent Q2 filing as a reason for DVDs being less profitable than they could have been under other circumstances.

When will Netflix pull the plug?

The numbers are clear: At some point, there’s an end of the line for Netflix’s DVD business. We just don’t quite know yet when that point will come. That’s why the development over the next couple of months, and in fact even Monday’s numbers, could be crucial: Will the decline in DVD subscribers follow trends from recent quarters? Will it accelerate? And how much of a hit will upcoming Postal Service rate increases pose for the company? All of this could decide when Netflix is going to pull that plug, and finally become an online-only company.

Image courtesy of Flickr user scottfeldstein.

21 Responses to “The slow but inevitable decline of Netflix’s DVD business”

  1. Bud Phyte

    These tech improvements invariably trade quality for convenience. What’s happened to music is appalling. I had better higher fidelity music forty plus years ago! We’ve got big screen HDTVs with 1080P and blu-ray players. Streaming video is below top video quality even if it’s HD. They don’t stream blu-ray and we’re not that close to having the infrastructure to do so. I need my BD rentals.

  2. dancenter

    Streaming is great if you want to watch Pirates of the Caribbean 5 or Fast and Furious 6. If you appreciate indie or foreign films you might be a little disappointed. That said, Netflix’s closing of the Butte, MT distribution center will now double the turnaround time for my movies, and brick and mortar movie rental stores are few and far between, so it may be time to find a new source of interesting movies. Any ideas?

  3. Adam Smith

    DVDs are an anachronism kept alive by differing legal treatment and seniors who don’t know how to deal with pure digital content. With today’s technology, getting movies through snail mail on a fragile optical disc is laughable. Unfortunately because Netflix has few good movies available for streaming due to legal and economic constraints, so I’m forced to have a DVD plan.

    • Streaming is for people who don’t care about picture and sound quality, not to mention all the playback issues that are common when streaming. Netflix “HD” streaming is what is truly laughable.

  4. As somebody who not only loves old, sometimes obscure films AND somebody for whom streaming video is not an option (limited bandwidth, slow connection), Netflix DVD service is awesome and I would be sorely disappointed to see it go anywhere. In the past few months, the deliveries have seemed to get slower – I assumed this was due to the fact that I moved to a different location, but now I suspect it’s a result of the loss of some local distribution centers.

    PS – lol @ redbox

  5. The day Netflix gets rid of its DVD content is the day I leave Netflix. I use the streaming service to make more room in my DVD queue. Redbox is not an option for me, I dont just watch new releases I also enjoy watching movies that I might not have gotten a chance to see in theaters from previous years.

      • what you don’t understand is that big business wants all digital streaming so noone ever really owns any movies and they’re only available at the whim of licensing decision makers and truly intelligent movie lovers will fight to own what they pay for. Digital is just plain flimsy as a form of property–in fact it’s actually nonexistant.

  6. Junk Podocalypse

    I still use and love my 3 DVD plan because there are so many great (and let’s face it, terrible) movies out there I want to watch. I work from home, so my motto is to never keep the DVD longer than 48 hours in my house – I think it’s rude to keep longer than that because it is a physical item and Netflix only has a set number of each disc (not talking about the big names but rather shows like Hana Yori Dango or movies like Bomb The System). I just let my queue get under 450 titles and about 50 of them are on “very long wait” and another 40 or so are on “long wait.” I know the fun thing about the service is that there are no late fees, it just burns me up waiting for a movie I have been waiting for for months and it’s still labeled as “very long wait” – and before anyone comments, I do know the trick on how to get that “very long wait” to turn into getting the DVD the following day, I just don’t like deleting my queue, that’s a lot to readd. A-hem…. sorry for my soap box rant, done.

    Like everyone else, I hope to see their entire catalog in streaming – but I know it’s a pipe dream because of all the legalities, ownerships and fees that have to come along with it. Janko, great article, thank you for all the information.

    Fellow comments, great comments! Wonderful points.

  7. The DVD business can never be too successful. It’s a leech on the main DVD business. In the past, DVD sales in stores like Walmart were big and so the studios were able to sell copies for a small amount. As Netflix flourished, though, they ate into these sales and the studios were forced to push up prices. Netflix’s DVD business doesn’t collect enough per viewer to pay for the development costs of the content it ships. THat means it must either sell old stuff with little value or cheaper new stuff or raise its prices.

  8. briggsbw

    I think this article ignores an elephant in the room – Redbox.For many families, Netflix is for streaming, Redbox is for DVDs. Unless you watch six or more DVDs per month, which I doubt many do, Redbox offers instant gratification and low cost.

    When newspapers sat unread for days, I cancelled my subscription. When DVDs sat for weeks without being watched, I did the same.

  9. I used to have a DVD plan with Netflix but cut back to just streaming because I wasn’t using it enough. Recently there was a DVD I needed and couldn’t get streaming so I signed up for the free 1-month DVD plan trial (which I was able to do even though I’d been a DVD subscriber in the past).

    I will watch this DVD, probably within the month, return it and cancel the DVD plan again…wonder how many people do that.

  10. I wonder how much of the scaling back of distribution centers is related to the USPS scaling back its processing centers??????

    I suspect it will be quite some time before they end the DVDs because: (1) There’s still a large number of people who don’t have broadband; (2) There’s still a large number of people who don’t have a streaming device hooked to their main TV set ; and (3) Even if it gets to the point of just breaking even, it would still be paying part of the overhead and be a hook to gaining more streaming customers.

  11. Once a paragon of operational innovation and user experience design, all one has to do is look at the DVD member experience to know that Netflix is spending as little as possible on the DVD side of things. The website is using graphics that are years old, same with the in-house mailer ads (which we design 4 years ago), etc. They’ve created a self-fulfilling prophecy of their DVD business declining. It will die and probably soon as it will cross the line for ROI.

    Getting to all streaming asap makes sense for a variety of business reasons (highlighted in the article above).

    And I’m with Paul, I don’t get why people don’t understand that Netflix doesn’t control what DVD content is available on streaming so asking for that is a non-starter.

  12. this story seems to ignore the plain fact that many movies CANNOT be streamed and as such, the only way to get them is via DVD. I tried to rent Indiana Jones and the Raiders of the lost Ark last nite, but it was not available for rent on any platform I could find. In fact, the only way to get it (besides on DVD) was to PURCHASE the 4 movies as a package.

    Again, until 75% or more of movies are available on streaming, Netflix will keep it’s DVD section. My guestimate is that less than 30% of all movies are streamable….but some nice facts as to this number would be nice to have…..

    I still don’t understand why so many people say dumb things like “when netflix provides their entire dvd library”…..its not up to netflix to offer movies via streaming, it’s up to the content providers to ALLOW streaming…..

  13. Sebastiaan vd Berg

    I hope Netflix will provide their entire DVD library to us streaming digital content. I mean I would love to see shows like The Big Bang Theory on Netflix but for now some of the greater movies / shows are dvd only which is ridiculous…

    • John Frier

      The problem with streaming with NetFlix is, all of sudden, they have started to edit and censor content. I watched a Swedish movie that had homosexual nudity involved and it was clearly edited out, i also watched a movie which I saw before and noticed they had edited it for a shorter time. That is why I canceled my streaming service, heaven knows how many movies I saw on stream that were “edited” for content and time. For some reason NetFlix is becoming just as bad as T.V editing, restricting and censoring content. That is why I am sticking with DVDs.