Netflix: What is Driving It Out of the Mail?

Postalnews.com reported that Netflix stated in a filing with the Postal Regulatory Commission that a decision in GameFly’s favor could “result in reduced DVD shipment growth from Netflix as well as accelerate the ultimate decline of DVD shipments as Netflix would shift more resource to the digital delivery of content”.   In addition, Netflix is concerned about the Postal Regulatory Commission requiring the Postal Service to release confidential research conducted by Netflix that the Postal Service has that “certain changes in DVD design, manufacturing, packing and handling would enable GameFly to avoid DVD breakage from automated letter processing."

Netflix's assertion raises a couple of interesting question that are independent of whether GameFly's complaint has merit.  

• Does increased competition among entities providing a service using an old technology hasten the decline in the use of the old technology?  Currently only Blockbuster offers a competitive mail delivery movie service.   Netflix's other competitors are the remaining Blockbuster and other retail outlets, and kiosks operated by RedBox and Blockbuster.
  
  Competition from new technology is most likely to knock out the weakest competitors offering services using older technologies.   Blockbuster is likely to file for bankruptcy early this month which will allow it to jettison a significant number of its retail outlets.  The Los Angeles Times reports it plans to concentrate its business on its licensed arrangement for kiosks with NCR Corporation and developing an on-line operation. 
  
  
• Do lower costs for delivering and selling software for devices that can be used to stream movies affect the shift away from old technology?  All three of the major video game consoles (i.e. Nintendo Wii, Microsoft XBox 360, and Sony Playstation 3) have Wi-Fi capabilities that allow a viewer to stream Netflix's online content using the console.  Currently, there are over 60 million of these consoles in use.   If GameFly's service makes these consoles more attractive for potential buyers then it is possible that it creates a larger market for the consoles that are used for video streaming.   However given as a September 30, 2009, GameFly had 330,000 subscribers, it would appear unlikely that it has much impact on increasing the share of homes that have Wi-Fi capable game consoles.
  
  
• If the current Netflix Envelope permits Postal Service automation equipment to handle envelopes containing CD's and DVD's why did GameFly not reverse engineer or license the envelopes?  Unless Netflix holds a patent on the envelope  there would be nothing to prevent envelope manufacturers from reverse engineering the envelope Netflix uses and selling them to other firms that want to mail large quantities of CD's and DVD's by mail using the Postal Service's lowest cost processes. Similarly, GameFly could have paid for the reverse engineering themselves.   The proprietary study that GameFly wants would significantly cut the costs of this reverse engineering if it has not done this already.  
  
  Netflix holds a a patent on its envelope, patent #6,966,484.   The patent was issued in 2005 and and refrences versions of the envelope since 2001.  Netflix's patent has not prevented Blockbuster from having its own envelope as does GameFly.   However, it  is possible that the patented envelope design may allow the Postal Service to handle Netflix's discs more efficiently than the envelopes available to mailers who do not have access to the patent.  
  
  GameFly has two options in regards to the patent.  First, it could seek to license the patent.  However, Netflex may not want to relinquish any competitive advantages from its patent.  Second, it could reverse engineer the envelope with the goal of designing an envelope that that does not violate the Netflix patent  yet still can be handled on the Postal Service's automation equipment.   The proprietary study that GameFly wants would significantly cut the costs of this effort.  (Thanks to Brian Sheenan of postalnews.com for the patent information.)
  
  
• Why did the Postal Service not do the research on envelope design itself?  The Postal Service has always relied on private industry to design envelopes that meet its specifications.  Creative requirements of mailers often result in a cornucopia of designs designed to attract attention and increase the impact of mail.  In the case of Netflix, the Postal Service worked with Netflix's envelope designers to help design and test potential envelope designs that  Netflix developed that led to the envelope that was patented. movie by mail business.    
  
  An alternative approach may have developed if the Postal Service operated under a different business model and had more capital.  Under this model the Postal Service would have developed and patented the envelope itself and then licensed the design to all mailers that required an automation compatible self mailer with return envelope for CD's and DVD's.  This way the Postal Service could make money both on the patent and in the mail that uses the envelope. 
  
  
• Does the envelope issue raise questions about how the Postal Service manages its customer relationships and how the regulatory process influences these relationships?  The public fight between GameFly and the Postal Service appears to also be a fight between two of its customers.   The regulatory process forces the Postal Service to choose sides in a public battle between two of its customers rather than trying to find a way to privately maximize its return from both customers.  UPS does not have to figure out the impact on Walmart if it proposes a certain discount structure to Amazon. Why does it make sense for the the Postal Service to do this in public or for the Postal Regulatory Commission to have to make an evaluation of how rates charged to one corporate customer affect the business of a second corporate customer? 
  
  
• How is new competition from Apple, Amazon, Hulu and others affecting the pace that consumers are shifting from mailed to streamed video content?   Consumers now have the choice of a number of options for viewing video content streamed over the web including subscription, rental, and free services.    Both Apple and Amazon are offering streaming of offer streaming of individual TV shows and movies.  Both charge 99 cents for TV shows and 3.99 for movies.    Hulu also offers a large number of current television shows, a wide selection of older shows and many older movies free of charge with commercials  Hulu also offers the full season of shows on three broadcast networks for a $9.99 monthly fee.    CBS and Comedy Central currently have many of their current shows on line for free.  Many of the movies offered on-line by competitors for rent are not yet on Netflix's on demand service.
  
  Currently none of the services offering streaming content offer as easy an interface for selecting movies or as wide of  a selection of as the one Netflix has for viewing by mail.   Nor do they offer as wide a selection of movies for watching on line as Netflix.   In order for Netflix's on-line competitors to make a significant inroads into Netflix's business they will have to improve their interface, expand their selection, and reduce the risk that movies will be interrupted by network issues.  Given that these firms currently dominate sales of music mp3 files and sales of DVD's and CD's, they can be expected to make the neccessary changes to offer a competitive customer experience for selecting movies for streaming.
  

GameFly's complaint and the responses of Netflix and the Postal Service illustrate how the regulatory process perverts the process of negotiating rates between the Postal Service and its customers.  This complaint case and Netflix's response is similar to case filed before the Interstate Commerce Commission prior to trucking and rail deregulation where contracts had to be filed with the Commission and carriers were limited as to the number of contracts that they signed.   This prevented carriers from offering services that were price competitive and limited the growth of new and innovate ways to distribute goods in the United States.

I do not know whether GameFly's or Netflix's cases have merit.   I do know that both companies and the Postal Service would be better served if the companies were able to negotiate rates with the Postal Service without regulatory interference.  Shifting both companies to a negotiated contract model for rates would require the Postal Service to know nearly as much about GameFly's and Netflix's business and their distribution requirements as they know themselves.  The Postal Service would find it to be in its interest to try to find ways to use its assets to provide transportation and distribution services at a lower cost than these companies now do themselves.  

The potential benefits that exist for GameFly and Netflix are not unique.  All mailers would benefit from a Postal Service that had to know its customer's businesses as well as the customer in order to design its services and price its products.   However, the current regulatory process does not encourage this and instead creates the adversarial environment illustrated by the exigent rate case.   The future of the mailing industry, and the Postal Service itself requires this change.  The question is what would it take for Congress to recognize and act to make this change.

Leaving the Mailstream One Customer at a Time

In an interview with All Things Digital, Netflix CEO Reed Hastings stated that its DVD by mail business will continue until around 2030.  The importance of the mailed DVD will rapidly diminish over the next 20 years.  “Pretty soon, we’re going to be a streaming business that rents some DVDs,” Hastings told the All Things Digital reporter.  

There are numerous signs that the end of the mailed DVD is coming.   Netflix has already put the "Watch Instantly" tab first so to encourage Netflix to try the download service.   Netflix has announced that all three major game consoles, the Sony PlayStation 3, Microsoft Xbox 360 and Nintendo Wii, can all stream Netflix movies.  A limited number of Blue-ray disc players and HDTV's now have the capability of streaming Netflix content as well.   By next Christmas, this feature should become a standard feature in consumer electronics.  At the just concluded Consumer Electronics Show in Las Vegas, Netflix announced that nearly every manufacturer of high definition televisions and Blue Ray disc players will introduce integration of Netflix streaming functionality as a standard feature of their products.    Even store brands at Best Buy and brands sold at mass marketers like K Mart, Target, and WalMart will have this feature next year.

While Netflix Chairman announced 2030 as the year that mailed DVD service will end, it is clear that his projected date is but a rough estimate.   Consumer behavior could move that date forward or back by as much as a decade.  The key drivers include:

• Introduction of computer capabilities and wired and wireless network streaming in the living room.   Currently, streamed video exists to computers with broadband connections.   In most cases the content is streamed to a desktop or laptop computer for viewing by one person.   For family viewing, and in particular viewing on high quality HDTV's, a consumer most often needs to connect a networked computer to his audio and video entertainment center.   This is not a particularly elegant solution and often involves purchasing a computer with far greater capabilities than is required for high quality streaming of audio and video content.
  
  Netflix's deals with consumer electronics manufacturers should allow consumers to get streaming content to their audio and video entertainment centers at a much lower cost.  The speed at which consumers add streaming capable audio-video receivers, Blue ray players, game consoles, or HDTV's will depend on the life of the thousands of HDTV's and other devices just purchased in response to the introduction of digital television.   It is not unreasonable to think that it could take ten years for recent HDTV purchases to be replaced.  In the meantime, streaming Blue Ray players and game consoles costing well under $200 should be available by next Christmas to fill in the gap. 
  
• Improved reliability and speed in broadband service and in-home wireless speeds.   One of the annoying parts of using Netflix's streaming service is the problem that changing downloading speeds cause for viewing.  Movies can stop in the middle and a screen refresh is required to restart the film where it stopped.   There can be many causes of this interruption but two issues stand out, the quality of the broadband connection, and the quality of the home wireless or wired network.   Introduction of streaming video from hundreds of websites including websites that are dedicated to streaming content like YouTube and Hulu and sites that post both original and re-posted content puts great strain on the capacity of broadband networks. 
  
  Current cable, DSL, and satellite broadband networks were not designed to handle the volume of downloaded media content they are now handling.   New fiber-optic networks are just being installed and it will take between five to ten years until plans of private and public investments for this installation to be complete.   (Australia is spending $31 billion Australian to lay fiber-optic cable nationwide in a project that will take five years.)  Then the governments and companies that install the networks have to convince customers to replace existing land-line phone and broadband service with the new fiber-optic service, which will be an expensive and time intensive effort.
  
  At home, there is a similar problem.  With the exception of a limited number of new homes and major reconstruction, homes are not built to handle computer network wiring.   Using wireless networks solves the problem.   Most homes with wireless networks still have equipment using the wireless G standard which works find for most web-based activities.   However, heavy video streaming, like what is required when streaming movies may require more capabilities. The newer wireless N standard offers faster wireless speed and greater coverage, but requires purchasing and installing a new router, something that many homeowners find daunting.   While wireless N routers designed for streaming video are relatively inexpensive, under $150, the replacement cycle on routers is quite long and may be tied to decisions of homeowners regarding switches from one broadband supplier to another or their eventual purchase of fiber-optic telephone/broadband service.
  
  
• Expanded Choice and Capacity to Stream Movies.  Even Netflix has to deal with the challenge of streaming the thousands of movies that customers may want to watch.  It is possible that bottlenecks may exist in Netflix's computer and networking capability that causes problems in streaming video today.  Expanding the computer and networking capability to handle projected customer need will take time, but the switch from mailed DVDs to streaming videos will have less to do with Netflix staying a step ahead of customer demand than the other factors that currently retard steaming demand.      
  

Currently Netflix is one of the Postal Service's most important customers.  While First Class mail has declined for a decade, Netflix mail volumes have grown. The Chicago Tribune reported that in Netflix's Carol Stream warehouse processes 60,000 DVD's a day, producing 120,000 individual First Class mail pieces (1 piece in each direction.   With 58 similar warehouses, Netflix may generate around 2.5% of all First Class mail volume or 2 billion pieces annually.   The Postal Service can ill afford to lose this business but there is nothing it can do to stop the loss.

Netflix is not the only example of a customer abandoning the mail stream.   Info Week announced today that it is eliminating another 8 print editions and will produce 24 printed and 12 digital only editions this coming year.    The loss of mail volume from Info Week, and other trade journals should be a particular concern as most of the issues are delivered to high volume, and highly profitable stops at businesses and other non-households.   The lost revenue and volume from Netflix, Info Week and other customers is unlikely to be replaced by other letter or flat mail. 

The decline in business from Netflix and Info Week suggest that the Postal Service needs to better track demand of individual customers or customer segments in order to understand how secular, cyclical, and price trends, affect the rate at which the switch to electronic alternatives will occur.   The Postal Service has collected this information for a sufficent period to begin developing market segment or customer specific demand forecasts.  It may even be possible to use these forecasts to provide operating planners information on how the actions of specific customers will affect demand for sortation and transportation capacity at particular facilities or regions.  Finally, these customer and customer segment forecasts may help strengthen the Postal Service's understanding of how it can best use its pricing freedom to increase, revenue, volume, and net income through the use of sales, and incentive specific contracts that are designed for specifc customers or customer segments.      

The detailed forecasting effort described above is a much greater than the effort, developed and modified in 40 years of regulatory filings, that is now included as part of filings to the Postal Regulatory Commission and used in forecasts  presented to the Board of Governors and published in public presentations and reports.   Without this effort, the Board of Governors, Congress and others trying to ensure the future of the Postal Service and mail service in the United States will all find that they have too little information to make a credible plan for the future.  

The future of the Post in Delivering Movies

Both the Financial Times and the Wall Street Journal are reporting that Fox and Apple have reached an agreement to set up a movie rental service. In this service,users would download a movie from the iTunes store at a cost of $2.99 for one month's rental. This is cheaper than anything offered by Netflix or Blockbuster by mail and every video rental store. This service also offers the convenience of immediate delivery, even if the immediate delivery may take as much as two hours, and restrict the use of a home computer or home computer network during that period. (See Fortune article if others are innacessable.)

Movie rental services are not new, as four other services, including Amazon, have offered rental services since 2006. However, Apple is the dominant supplier of audio and video mp3 players, and has 70% of the worldwide and 80% of United States market share of purchased downloads of music. Apple's entry into the rental market opens download rentals to the largest established market of people already accustomed to downloading media. Also in 2009, when television broadcast goes high definition and the large installed base of standard definition televisions become obsolete, consumers will have substantial incentives to replace their television with a high definition television which will have inputs that allow easy connection to an iPod or computer.

Now what does this mean for the Postal Service? Netflix has been one of largest volume success stories introducing new volumes. While the new Fox - Apple agreement will not immediately affect volumes, the Postal Service could be a significant loser in this new technology. (For other winners and losers, see Silicon Alley Insider.)

In order to extend the life of the existing physical delivery model, both Netflix and the Postal Service will need to find ways to cut the costs of handling the Netflix product to keep Netflix competitive. It would appear that they have a year to find a way to do this. It is time to get started now.