Netflix and DVDs, Still Together

Shipping disks by mail is a declining business, but still quite a profitable one

The wave of the past.

Photographer: Andrew Harrer/Bloomberg

Remember how, back in 2011, Netflix was going to spin off its DVD-by-mail service and call it Qwikster? And how, in the face of furious customer opposition, Chief Executive Officer Reed Hastings had to walk it back, New-Coke style, saying he had made “a mistake in underestimating the depth of emotional attachment to Netflix”?

Ah, those were the days. Yesterday, when the company reported fourth-quarter earnings and subscriber growth that got investors very excited, DVDs barely rated a mention. Of the 2,500-odd words in the quarterly letter to shareholders, just 45 were devoted to plastic disks. In the 44-minute “earnings interview” that followed, the DVD business didn’t come up till the 41:33 mark. “It’s going to continue to decline, we don’t have any illusions on that,” Chief Financial Officer David Wells said. “But we think that for a lot of people in rural areas and cinephiles, the DVD makes sense for them.” (He failed to include “people who got a disk of ‘The Monuments Men’ in the mail two months ago and will probably send it back without ever watching,” the category to which my family belongs.)

The DVD also seems to make sense for Netflix. Here are the divergent trajectories for domestic streaming subscribers and DVD subscribers since 2011:

Netflix members

 Yes, it’s a huge and growing gap. When you look at the two businesses’ “contribution profit” (the company defines this as “revenues less cost of revenues and marketing expenses directly incurred by the segment”), though, DVDs look a lot more important:

Netflix profits

The contribution profit from DVDs in the fourth quarter ($88.6 million) more than offset the losses ($78.6 million) from streaming operations overseas. DVDs are a backwater, but also a cash cow, with a 49 percent contribution-profit margin (for domestic streaming it’s 28 percent).

 Why such huge margins? It’s because, in DVDs, Netflix has built up what Warren Buffett calls a “moat” -- a deep and crocodile-filled barrier against competitors. Its huge DVD library, its national network of super-efficient warehouses and its deep relationship with the U.S. Postal Service -- the kind of relationship you get when you’re the Post Office’s biggest customer -- probably will never be replicated. That, and Netflix can just buy DVDs on the open market and keep them as long as it wants.

In the streaming business, on the other hand, Netflix is just hoping to be one of the two or three biggest players (HBO and Amazon are the most obvious rivals, although there are others).  It also faces regular bidding wars for content, and sometimes contentious relations with content providers that see themselves as competitors as well as suppliers. Its distributors, the cable companies and telcos, are also rivals more than allies. The streaming business is growing, while the DVD business is shrinking, so of course Netflix was right to shift its emphasis to streaming. But by this point one has to think that its executives are pretty glad they held on to the DVDs, too.

“Most companies that are great at something -- like AOL dialup or Borders bookstores -- do not become great at new things people want (streaming for us) because they are afraid to hurt their initial business,” Hastings wrote in 2011 to explain the Qwikster spinoff. It was a legitimate concern, and Hastings was surely right that “streaming and DVD by mail are becoming two quite different businesses, with very different cost structures.”

At least as far as the Netflix’s financial statements go, though, they’ve turned out to be nicely complementary businesses. DVDs have thrown off cash that the company has been able to put into its ambitious international expansion. And while DVD subscriber numbers have been dropping at a rate of about 4 percent a quarter for the past couple of years, the DVD contribution profit fell less than 1 percent in the final quarter of 2014.

This can’t go on forever. At some point the company won’t be able to keep shrinking its distribution network, as it has been quietly doing for the past few years, and still deliver DVDs quickly. There’s also the risk that U.S. Postal Service cutbacks will make quick delivery impossible even before then. Until that moment, though, DVDs remain a happy, profitable reminder of Netflix’s origins and its biggest misstep -- just not one that gets much attention in an earnings report. 

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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