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Stream This!: Netflix's Streaming Costs
While Netflix doesn't give out much information on its streaming delivery costs, it is possible to estimate those numbers with a little number-crunching.
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While Netflix is not yet giving out a lot of details on the costs associated with its streaming video service, the company has given out enough data for us to have a pretty good idea of its streaming delivery costs for the Xbox 360 and other devices. Here’s what we do and don’t know, and how it all breaks down.

We know that the average encoding rate for video streamed to the Xbox 360 is about 2,000Kbps. That means one person watching a 2-hour movie would transfer roughly 1.8GB of data. For HD movies, the average encoding bitrate is around 3,200Kbps, and one user would transfer about 3GB of data. Based on the high volume of movies Netflix is streaming each month, it is getting a very good rate in the market. I estimate the company is paying, on average, about 3 cents per gigabyte delivered across Limelight and Level 3, and it could potentially have a slightly lower rate.

Based on the 3-cents-per-gigabyte assumption, it would cost Netflix about 6 cents to deliver one SD movie and 9 cents to deliver one HD movie. Those numbers would be about 25% lower if the length of the movie were 90 minutes instead of 2 hours. It would also be a little lower or higher depending on the exact bitrate, since some movies are streamed higher and some lower, and Netflix only has about 400 movies available in HD. Taking all that into consideration, the average cost to Netflix to stream to the Xbox 360 is about 5 cents per movie. Streaming to the PC is a lot cheaper—about half that cost—as the bitrates are much lower.

License to Stream
Based on those numbers, Netflix’s streaming offering looks like it would save the company tons of money and make it much more profitable since it spends about 78 cents out and back for standard, presort, first-class mailing of its DVDs. But the one problem is that these streaming costs do not yet include the licensing costs from the content owners. It’s the costs associated with licensing the content that really make or break Netflix’s streaming service, not the cost of bandwidth.

I don’t know what Netflix is paying to license content, and many of its licensing deals are at different prices. In other online video offerings, I have seen content owners charge a one-time flat fee per video, a fee each time the video has been watched, a one-time licensing charge for a specific number of plays, or many other licensing models. I’ve seen licensing costs as high as $4 per movie per play, and I’ve seen pricing on the other end of the spectrum at a few pennies per play. That’s why many of the content licensing deals Netflix has in place are a one-time cost no matter how many movies are watched. While that works great for Netflix today, most of those licensing deals are not with major studios for first-run content. It’s also interesting to note that Netflix’s recommendation algorithm takes into account which movies have a cheaper licensing cost and makes those movies show up as recommendations more often.

One of the major reasons that Netflix does not have a lot of new content in its streaming offering is the fact that the licensing costs for new content are so high. Studios are still greedy, and Netflix simply can’t afford to pay the costs associated with first-run movies. Netflix’s CEO has said many times that they are going to spend a lot of money this year to license content where the costs are "reasonable." That comment goes to show that much of the newer content is simply out of reach for Netflix, as well as others, and that studios simply want too much cash. Over time, you would think the studios would get on board with this and license some newer content faster, but so far, they don’t seem to want to. At some point, one of the major studios is going to break from the pack and make it affordable for Netflix to offer some newer, first-run content to test the waters. But right now, the studios think they don’t need Netflix.

I would not agree with that, but looking at the penetration rate Netflix has, it is very small. Netflix has 10 million subscribers, and while the company and Microsoft said last month that "1 million Xbox LIVE Gold members have downloaded and activated the groundbreaking Xbox LIVE application from Netflix," they didn’t say if those are paying Netflix members. With 48-hour free trial cards showing up in Xbox 360 games, we don’t truly know how many paying customers are using the service. And as of January of this year, Microsoft had sold 11.2 million Xbox 360 consoles in North America, according to the NPD Group. So if the penetration rate is only 1 mllion today, it’s going to take years before it truly scales. And that’s really what the movie studios care about: a large audience. I think it is short-sighted thinking on the studios’ part, but I don’t think anyone would disagree with me if I said it’s not the first time the studios didn’t get it.

The Numbers Game
But the question remains: What is the total cost to Netflix to stream a movie? For some content Netflix has today, it’s clearly cheaper than mailing out a DVD, but for other content, it’s still more expensive based on the licensing costs. And with all the talk lately of Netflix wanting to some day offer a streaming-only service, probably this year, running the numbers for such a service does not make a lot of economical sense. Let’s say the average cost to stream and license a movie is 50 cents. All it takes is one user streaming 10 movies a month and Netflix’s cost is $5. And with its cheapest DVD plus unlimited streaming offering being $8.99 a month, how much can Netflix realistically charge for a streaming-only service? Maybe $5.99? So far, the economics of a streaming-only service don’t work unless Netflix can get very good licensing terms and hope that users who don’t stream a ton of movies each month make up for the ones that do. At this point, it’s a guessing game, although Netflix is already compiling some great data on what users are doing with streaming and what their consumption habits are.

For now and some time to come, Netflix’s streaming service is not going to generate revenue. Yes, Netflix does expect it to help retain customers, and if that is all it does, that alone is worth the cost. With Netflix’s churn being 4% last quarter, anything that helps keep churn down from the company’s core business is very valuable and can generate a return. While Netflix said it spent around $40 million for its online video offering in 2007, and most folks I spoke to said they thought the company spent twice that last year, clearly it appears as if Netflix is ramping up to spend close to $100 million in 2009.

A Promising Future
The key thing that I think people are missing is that Netflix’s streaming service is not a substitute for its DVD business; it’s a complement to it. Many years from now, when broadband-enabled TVs and Blu-ray players get some install base, things may change. But for the next few years, Netflix is not going to make money from its streaming service unless the financial benefit comes as a result to the company’s core business.

That said, what Netflix is doing is exciting, and I love the streaming service on my Xbox 360. Netflix is laying the groundwork for the future, and it’s going to be really fun to see where the company takes this service a few years from now. We’re all keeping a close eye on the financial impact streaming movies could have on Netflix’s overall business. Studios, give them a chance! License some decent content already.

[The above article is featured on Dan Rayburn’s Business of Video blog and has been slightly edited from its original form. —Ed.]