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Netflix: Will Return Envelope Costs "Stamp" Company A Mess?

Wednesday, 5 Dec 2007 | 12:07 PM ET
Netflix
AP
Netflix

They revolutionized the way we rent movies; its TV commercials boast more than a billion rentals already. And while Netflix's stock has suffered a choppy performance through its history, the company has been enjoying a renaissance of sorts recently.

But a new report out from Citigroup this morning could put the brakes on Netflix's good cheer. Turns out, a new investigation by the Office of the Inspector General says Netflix has a good idea (return by mail DVDs), but it hasn't been executed it without cost. In fact, the OIG says Netflix and its return-envelopes have created a mail-sorting log jam, leading to enormous processing costs.

The OIG doesn't mention Netflix by name, but the implication is clear, and the findings suggest 70 percent of the envelopes get stuck and that means an additional $21 million in annual labor costs.

So, the OIG, worried about massive labor-cost overruns that could exceed $61.5 million over the next two years, is recommending a 17 cent surcharge on each mailer. "If Netflix has to bear the full brunt of this increase (without other cost offsets), monthly operating income per paying subscriber would fall 67% from $1.05 to $0.35," say analysts Tony Wible and Mark Mahaney at Citigroup.

"Netflix has told them that it's not sure the US Postal Service will accept the OIG's suggestions, and if no hikes occur, the impact would be limited," according to the Citigroup report. It's far more likely that Netflix will have to redesign those envelopes to be more compatible with the USPS systems. The costs of that are unknown, but could be meaningful.

Still, another thing to consider: while Netflix is saddled with this problem, it appears rival Blockbuster is not. Citigroup has determined that "Netflix has more exposure to the change and is less able than BBI to offset any increases with cost savings. A price hike would exacerbate the risks we see in NFLX's business model as aggressive pricing, maturity concerns, and higher costs prevail."

Citi is reiterating its SELL in NFLX shares (ouch!) And reiterating its BUY on Blockbuster, determining that its "mailers are not prone to the same issues." Something to consider when you rent from Netflix next; and whether you decide to become a shareholder or increase your position.

Amazing to me it took the Postal Service so long to come up with this finding--after a billion Netflix rentals. Rain, sleet, snow and dark of night, yes. Problematic envelopes? No.

Questions? Comments? TechCheck@cnbc.com

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