NetFlix 2004 Annual Report Download - page 47

We rely heavily on our proprietary technology to process deliveries and returns of our DVDs and to
manage other aspects of our operations, and the failure of this technology to operate effectively could
adversely affect our business.
We use complex proprietary software to process deliveries and returns of our DVDs and to manage other
aspects of our operations. Our proprietary technology is intended to allow our nationwide network of shipping
centers to be operated on an integrated basis. We continually enhance or modify the software used for our
distribution operations. We cannot be sure that any enhancements or other modifications we make to our
distribution operations will achieve the intended results or otherwise be of value to our subscribers. If we are
unable to maintain and enhance our technology to manage the processing of DVDs among our shipping centers
in a timely and efficient manner, our ability to retain existing subscribers and to add new subscribers may be
impaired.
If we experience delivery problems or if our subscribers or potential subscribers lose confidence in the
U.S. mail system, we could lose subscribers, which could adversely affect our operating results.
We rely exclusively on the U.S. Postal Service to deliver DVDs from our shipping centers and to return
DVDs to us from our subscribers. We are subject to risks associated with using the public mail system to meet
our shipping needs, including delays caused by bioterrorism, potential labor activism and inclement weather. For
example, in the fall of 2001 terrorists used the U.S. Postal Service to deliver envelopes containing Anthrax,
following which mail deliveries around the United States experienced significant delays. Our DVDs are also
subject to risks of breakage during delivery and handling by the U.S. Postal Service. The risk of breakage is also
impacted by the materials and methods used to replicate our DVDs. If the entities replicating our DVDs use
materials and methods more likely to break during delivery and handling or we fail to timely deliver DVDs to
our subscribers, our subscribers could become dissatisfied and cancel our service, which could adversely affect
our operating results. In addition, increased breakage rates for our DVDs will increase our cost of acquiring titles.
Increases in the cost of delivering DVDs could adversely affect our gross profit and marketing expenses.
Increases in postage delivery rates will adversely affect our gross profit if we elect not to raise our
subscription fees to offset the increase. The U.S. Postal Service has announced that it will seek an increase in the
rate for first class postage in 2006. The extent of this rate increase is not yet known. In addition, the U.S. Postal
Service has announced long-term plans to reduce its costs and make its service more efficient. If the U.S. Postal
Service were to change any policies relative to the requirements of first-class mail, including changes in size,
weight or machinability qualifications of our DVD envelopes, such changes could result in increased shipping
costs for our DVDs and our gross margin could be affected adversely. Also, if the U.S. Postal Service curtails its
services, such as discontinuing or reducing Saturday delivery service, our ability to timely deliver DVDs could
diminish, and our subscriber satisfaction could be affected adversely.
Currently, most filmed entertainment is packaged on a single lightweight DVD. Our delivery process is
designed to accommodate the delivery of one DVD to fulfill a selection. Because of the lightweight nature of a
DVD, we generally mail one envelope containing a title using standard U.S. postage. Studios occasionally
provide additional content on a second DVD or may package a title on two DVDs. In addition, the studios have
recently announced plans to release certain films in high definition format on either HD-DVD’s or BluRay
DVDs. These new DVDs have characteristics that are different than those currently in circulation. These high-
definition format DVDs may be heavier and/or more fragile than current DVDs. If packaging of filmed
entertainment on multiple DVDs were to become more prevalent, if the weight of DVDs were to increase, or the
durability of DVDs deteriorate, our costs of delivery and fulfillment processing would increase and our costs of
replacing damaged DVD’s may rise materially which would depress gross margins and profitability and
adversely affect free cash flow.
If we are unable to effectively utilize our recommendation service, our business may suffer.
Based on proprietary algorithms, our recommendation service enables us to predict and recommend titles
and effectively merchandize our library to our subscribers. We believe that in order for our recommendation
31