The slow but inevitable decline of Netflix’s DVD business

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.

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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.

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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.

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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.