NetFlix 2006 Annual Report Download - page 22

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 could adversely affect our gross profit if we elect not to raise our
subscription fees to offset the increase. The U.S. Postal Service increased the rate for first class postage on
January 8, 2006 by 2 cents, from 37 cents to 39 cents, and proposed another increase in the amount of 3 cents. If
approved, the increase is expected to take place in mid-2007. In addition, the U.S. Congress recently passed
postal reform legislation which provides the U.S. Postal Service with more flexibility in establishing postal rates.
It is unclear at this point the extent to which this new legislation may impact our operations and costs, but it does
appear that the expected 2007 increase in postage will take place. 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 adversely affected. 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 adversely affected.
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 DVD per envelope 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 begun 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.
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 merchandise our library to our subscribers. We believe that in order for our recommendation
service to function most effectively, it must access a large database of user ratings. We cannot assure you that the
proprietary algorithms in our recommendation service will continue to function effectively to predict and
recommend titles that our subscribers will enjoy, or that we will continue to be successful in enticing subscribers
to rate enough titles for our database to effectively predict and recommend new or existing titles.
We are continually refining our recommendation service in an effort to improve its predictive accuracy and
usefulness to our subscribers. For example, in 2006 we launched a contest intended to encourage the
development of algorithms that will significantly improve the predictive accuracy of our recommendation
service, and we intend to use the results of this contest to further refine its utility. We may experience difficulties
in implementing refinements. In addition, we cannot assure you that we will be able to continue to make and
implement meaningful refinements to our recommendation service.
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