U.S. Postal Service to Netflix: You're killing us on labor

Netflix's return DVD mailers are apparently costing the U.S. Postal Service $21 million in annual labor costs. And the Postal Service wants some of its money back.

Simply put, Netflix's return DVDs clog the postal machinery and require manual sorting. When Netflix subscribers open their mailers the leading edge of the package is removed. On return, the same package comes back without the hard edge and plastic instead and jams the sorters.

According to Citi analysts Tony Wible and Mark Mahaney a potential 17 cent surcharge to Netflix's DVD return packages would crush the company's operating income per subscriber (Techmeme).

The analysts, who rate Netflix a “sell” and Blockbuster a “buy,” write:

If Netflix has to bear the full brunt of this increase (without other cost offsets), monthly operating income per paying subscriber would fall 67% from $1.05 to $0.35. NFLX questions whether the USPS will accept the OIG's suggestions, and if no hikes occur, the impact would be limited.

Here's the math:

The Inspector General audit at the Postal Service didn't mention Netflix specifically, but the hints in the report are pretty strong. Some excerpts from the audit report:

We initiated this audit based on concerns raised regarding potential preferential treatment given to a large digital versatile disc (DVD) mailer. Our objective was to determine whether PRM (permit reply mail) mailers' mailpieces are processed in accordance with their approved classification and pricing.

The Postal Service generally processes PRM mailpieces in accordance to their approved classification and pricing, as outlined in the Domestic Mail Manual (DMM). However, employees manually process approximately 70 percent of the approved First-Class two-way DVD return mailpieces from one DVD rental company because these mailpieces sustain damage, jam equipment and cause missorts during automated processing. Nonmachinable mailpieces are subject to a surcharge. However, the DMM does not currently address the characteristics of the mailer's two-way DVD return mailpiece that make it nonmachinable.

Because these mailpieces are not machinable, the Postal Service pays significant additional labor costs to manually process them. We estimate the additional labor costs to process these mailpieces were $41.9 million during the past 2 years, and will be $61.5 million over the next two years. We will report this monetary impact of $103.4 million in our Semiannual Report to Congress as $41.9 million in unrecoverable costs and $61.5 million in funds put to better use.

Add it up and you have the following takeaways:

• The Postal Service wants to add a 17 cent surcharge if Netflix doesn't redesign its mailers;
• Congress will love this tidbit;
• A surcharge would crush Netflix, which is under pricing pressure already;
• It's a safe bet that Netflix will redesign its mailers;
• The Postal Service is inefficient: Why did it take so long to even ponder a surcharge? A company would surely notice if a customer was increasing its labor costs.

On another note, Citi's analysts confirmed that Blockbuster's mailers don't clog the Postal Service's sorters.

As for that final takeaway, Wible and Mahaney reckon that the Postal Service may be looking to add surcharges to pay for other initiatives.

We are somewhat concerned that the USPS has singled out the rental by mail industry, which could allude to price increases despite any compliance with the mailers. To this point, the USPS proposed annual rate increase of $0.17 would provide $56.5 million in revenue and more than cover the estimated $31 million in annual manual labor costs, which implies that the USPS may be looking at online rental plans as a way to subsidize losses from other parts of its operations.

Netflix argues that it saves the Postal Service $100 million since it pays for first class postage both ways. But amid rising fuel costs and electronic delivery of mail and other promotions the Postal Service is likely to look to balance its budget somewhere.