Streaming Profits for Netflix from Sony PlayStation 3 Deal

Netflix announced in a press release that its video streaming service would be available to Sony PlayStation 3 owners next month. Although the DVD rental operator already has Internet distribution deals in place for a variety of consumer electronic devices, this latest partnering should help the company lower operating costs and overall churn rates in coming quarters.

The core strategy of Netflix is to meet the content needs of its subscription base by offering both DVD by mail and streaming services for one low monthly price, starting at $8.99 a month for the 1-out unlimited plan. Netflix’s Internet delivery of content is available on a range of devices, from Internet-ready TV sets (including Sony’s Bravia and LG Electronics), Blu-ray disc players (Samsung and Insignia, the exclusive brand of consumer electronic’s retailer Best Buy), and Roku and TiVo digital video players.

The distribution deal with Sony is important because it not only ends the lock Microsoft had on Netflix in the game console market — the Xbox 360 had previously been the exclusive videogame brand (the expiring agreement was recently extended to spring 2010 at Microsoft’s option) — but also because it broadens the number of TV sets already enabled to accept streaming Internet content. And, with about nine million PS3 users, Sony offers fertile ground from which it can grow its own subscriber base.

The largest U.S. movie-rental service provider ended the quarter with a subscriber base of approximately 11.1 million, representing 28 percent year-over-year growth, according to the third-quarter 10-Q regulatory filing with the SEC. Subscriber acquisition cost (SAC) for the quarter was $26.86 per gross subscriber addition compared with $32.21 in the year-ago period. The company attributed much of the customer growth and respective decline in SAC to incremental revenue gains from Xbox 360 gamer additions. Management expects the Sony deal to help in lowering SAC further in the next few quarters.

Despite the tough economy, the quarterly churn rate (customer cancellations) increased only 20 basis points to 4.4 percent, due in part to net subscriber gains of 510,000 in the quarter, compared with an increase of 261,000 a year earlier.

Notwithstanding Netflix’s investments and plans for Internet-delivered content, for now most customers still prefer to receive their videos by snail mail. Co-founder and chief executive officer Reed Hastings told analysts on the third-quarter earnings call that the company expected disk shipment volume to grow for several more years, in part due to successful capture of new customers from newly closed brick-and-morter video stores. The volume of DVDs mailed to paying subscribers increased year-on-year 20.6 percent.

The problem with mailing out more than two million videos a day is that the company remains captive to U.S. postage rate hikes. Gross profit improved in the quarter 80 basis points to 34.9 percent on higher sales, somewhat offset by the 4.8 percent increase (two cents) in first-class U.S. postage rates back in May. Netflix received good news on the postal front two weeks back when the Postal Service announced it would not raise rates in 2010.

Nonetheless, aggregate postal expenses will continue to climb in tandem with DVD volume shipment growth. CEO Hastings said on the conference call that the company forecasts total shipping costs of approximately $600 million in 2010, growing to more than $700 million in 2011. Longer-term, continued subscriber migration to online services would likely offset the adverse affect that conventional mail costs have on gross margin.

Although CEO Hastings envisions the company offering mail-order service until 2030, subscribers are getting more comfortable with its online offerings. In the third-quarter, 42 percent of Netflix subscribers streamed at least 15 minutes of TV or movie content, up from 22 percent in the prior year’s quarter. “We don’t see watching one TV show or movie in a quarter as sufficient,” Hastings said on the call, “but it’s a good start.”

Like power windows to car buyers, gamers will likely begin to view movie streaming as an expected option of any gaming platform. That said, in my opinion, it is only a matter of months before a similar deal is struck with the last holdout of the big three gaming hardware companies: Nintendo for its Wii gaming console. In addition, as Netflix looks to ward off competitive threats from other digital content providers (such as broadband cable), the search for sources of future organic growth will likely lead the company overseas — more than a combined 100 million units sold (of the latest consoles) are in homes worldwide. Can a deal with Apple’s 3G iPhone be far behind?