NetFlix 2005 Annual Report Download - page 28

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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. Future
enhancements and modifications to our proprietary technology could consume considerable resources. 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 or disruptions caused by inclement weather, natural disasters, labor
activism, health epidemics or bioterrorism. 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 recently increased the rate for first class postage
on January 8, 2006 by 2 cents, from 37 cents to 39 cents. In addition, the U.S. Congress has been considering
postal reform legislation which would provide the U.S. Postal Service with more flexibility in establishing postal
rates. The U.S. Postal Service continues to focus on 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 or higher breakage for our DVDs and our gross margin could be affected adversely.
Also, if the U.S. Postal Service curtails its services, such as by closing facilities or 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 HD-DVDs and 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 DVDs may rise materially which would depress gross margins and profitability and adversely affect
free cash flow.
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