Netflix’s return envelopes in a jam

With 70% processed manually, retailer may have to change or pay more to U.S.P.S.

By Ned Randolph -- Video Business, 12/5/2007

DEC. 5 | A recent audit by the Office of Inspector General, U.S. Postal Service has determined that Netflix return envelopes jam automatic sorters, costing the agency millions of dollars in manual labor costs and could result in a 17¢ surcharge per envelope for the company.

Netflix ships 1.6 million DVDs daily and 416 million a year. An imposed surcharge without adjustments would reduce Netflix’s monthly operating income by 67%, from $1.05 per customer to 35¢, said Citibank analysts Tony Wible and Mark Mahaney, who downgraded Netflix’s stock Tuesday.

“Given the magnitude of this risk, we believe Netflix will work toward resolving this issue by redesigning its mailers. If the U.S.P.S. forges head with a rate increase, Netflix has more exposure to the change and is less able than Blockbuster to offset any increases with cost savings,” they said in an analyst note to clients. “A price hike would exacerbate the risks we see in Netflix’s business model as aggressive pricing, maturity concerns and higher costs prevail.”

The Postal Service uses automated sorters for its “Permit Reply Mail” program and imposes surcharges on companies whose mailers are not “machine compatible.” This applies to all mailers of DVDs and CDs, not just Netflix.

Apparently, the Netflix return mailers most often jam automatic sorters, however, because their hard leading edge is torn off when the disc is removed by the customer, creating a “floppy leading edge” for the return trip. The postal Inspector’s report does not refer to Netflix by name, but it does reference a “large DVD rental company” and describes brightly-colored mail pieces and the 1.6 million pieces a day that the company posts.

The inspector general audit, initiated on charges of favoritism for Netflix, found that postal employees manually sort 70% of Netflix’s return envelopes, costing the agency $42 million in labor costs in the last two years. The labor costs are expected to increase to $61.5 million over the next two years, the report says.

The audit recommends a 17¢ surcharge per item unless Netflix redesigns its mailers.

Netflix estimates that the company saves the U.S.P.S. $100 million a year by picking up its mail at U.S.P.S. distribution centers rather than having it delivered all the way to its fulfillment centers, according to a spokesman.

“The mailer is in compliance with the U.S.P.S. currently,” he said. That is born out by the postal Inspector’s report, which confirms Netflix was told its envelopes are machinable. Because in practice they are not, the Inspector is recommending a change in the criteria for automated processing, which Netflix would then have to meet, or pay the additional postage.

The Netflix spokesman said the company has made about 40 modifications to its mailers over the years and will make further modifications if ordered to do so.

The Citibank analysts downgraded Netflix stock to a target price of $18.50 with a sell rating and issued a buy rating for Blockbuster, with a target price of $8 per share.

“While Blockbuster would also be hurt by a postal increase, it is better positioned to absorb the blow since its online business represents a much smaller portion of revenue (roughly 12% of revenue) and as Blockbuster has many near term opportunities to fuel growth...”

They added: “We would note that based on our conversations with Blockbuster, their mail envelopes appear to already be in compliance with the U.S.P.S. processing and do not jam the automated sorting machines.”

Netflix closed Wednesday at $23.93, and Blockbuster closed as $3.18.