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Netflix Shouldn't Scale Down DVD

Thursday - 4/11/2013, 3:28pm  ET

With more than 8.2 million customers in place, Netflix’s  DVD by mail business has scaled down in recent years. It’s quite a decline from its earlier position as the company had close to 14 million subscribers back in 2011. As more and more consumers stream movies and TV Shows online via devices like Roku, Apple TV, XBox, PS3, etc. the business model of the company has rapidly evolved. However, there are a number of reasons why Netflix should hold onto its DVD customers tightly. 

Reducing Investments in DVD

In the U.S, Netflix offers DVD and which includes standard DVDs as well as high definition Blu-ray Discs. As the number of DVD-by-mail subscriptions declined substantially, the company's investments has also declined in the business segment. While the DVD business is unlikely to close shop anytime soon, there is clear evidence of Netflix trying to scale down and migrate its subscribers to the online streaming platform.

The amount of cash Netflix laid out for acquiring DVD content has spiraled down. The company spent cash $193 million in 2009 for acquiring DVD content, and this number has decreased every year sequentially and dropped to only $48 million in 2012. This reinforces the company’s own expectations of the DVD business going forward. However, keeping the DVD business in place has some major benefits for Netflix. 

1. Higher Margin Business

Netflix earns much more money from its DVD business than it does from its global Internet streaming platform. The company's contribution margin from its DVD business was roughly 47%, which is substantially much higher than the streaming business, which had a contribution margin of only 16% in 2012. The DVD business has been keeping the company afloat as the company signs expensive content deals and expands it footprint across the globe.

2. Demand for DVDs Exist

A lot of consumers still have an appetite for DVD rentals. Netflix's competitor in the DVD rentals space, Coinstar's  Redbox has been growing its DVD rentals in spite of secular forces firmly against it. Redbox has managed to increase the number of rentals by adding a lot of new kiosks, and was helped substantially by adding newer Blu-ray discs as well as, video game rentals. In addition, Redbox raised its prices in 2011, which helped it grow its revenues healthily, as a result, Redbox, managed to show same-store-sales growth of 10%.

In spite of secular headwinds, Coinstar's Redbox business segment has managed to grow its revenues and operating income rapidly in the last 5 years. In 2012, Redbox had an operating income margin of 12.5% on sales of $1.9 billion. And the operating margin has increased in each of the last three years for Redbox. Looking at Redbox's strategy of growing its DVD business, should encourage Netflix to grow its DVD segment. In recent years, Netflix has been focusing most of its marketing efforts towards streaming content, but can ramp up its marketing for DVD consumers, and try to add from the 8.2 million subscribers.

3. Good Package Deal for Many Customers

Netflix has a large number of customers who subscribe to both streaming and DVD subscriptions. The satisfaction of these 7 million+ customers will be negatively impacted, if Netflix scales down its DVD operations substantially. As these customers pay more, the incremental benefits to Netflix are substantial. If Netflix doesn't invest in adding more DVD content, they will be left to order pay-per-view content or go to DVD rental kiosks like Redbox.

One of the company's strongest rivals, Amazon  competes with Netflix for not only subscription offerings, but also for selling DVDs and also for video on demand. Amazon has more than 150,000 titles to purchase or rent, a large number of which are very recent and even includes day after TV. Amazon is a major online retailer of digital media content selection with over 23 million movies, TV shows, songs, books etc. In 2012, Amazon's media sales made up 33% of its total revenues of $61 billion. As a result, Amazon's media sales have been surging in part due to the success of its Kindle line of devices.

Netflix will end up losing a large number of DVD customers to the likes of Redbox, Amazon and even, other online entertainment stores like iTunes. And these customers will be very unhappy, as they will end up paying a lot more than the $8 a month they spend for the DVD subscription.

4. Paying for International Expansion and Originals

As Netflix has been laying out the foundation for its International Operations, the company's income statement has been feeling the heat. Losses from International have been rather heavy as Netflix racked up contribution losses of close to $500 million in the last 2 years. However, subscriber additions from International markets have been gaining momentum, and the operations are expected to lower their losses substantially in 2013.

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