So here's the deal. Hollywood studios have been increasing unhappy about the decline in DVD sales. One might paraphrase the Oscar-winning Network and say they are mad as heck, and can't take it anymore. In the first half of 2009, U.S. retail sales of DVDs dropped 13.5%, while DVD rentals rose by 8.3%. People are being non-committal with their televised entertainment, preferring to watch once and ship back rather than purchase for their permanent collection.

The studios' solution? Delay their audience's gratification, making new releases available only for purchase for the first few weeks. People counting on seeing new flicks on Netflix (NFLX) or via Coinstar's (CSTR) Redbox service would just have to wait ... or buy the movie, which is what studios are hoping for.

Netflix (NASDAQ: NFLX) released its Q2 report on Thursday after the bell. You had to like what you saw. Revenues increased 21%. Total subscribers went up 26%. Growth in net subscribers on a year-over-year basis was impressive, as was the increase observed in the gross margin. Free cash flow was up. And now for the final piece of the performance puzzle: adjusted earnings per share increased 29% to 58 cents. Very good.

Consumers have really taken to the Netflix model. They love getting DVDs by mail. And Netflix has really done a job on its major competitor, Blockbuster (NYSE: BBI). No doubt about it, I'm sure a lot of Blockbuster shareholders are wishing they were invested in Netflix.

Netflix, Inc.'s (NASDAQ: NFLX) continues to be the dominant DVD rental company in the U.S. when it comes to rentals by mail, but the U.S. Post Office is probably not happy about it. Why? The adhesive on Netflix's return mailers keeps jamming its automated mail sorting machines, causing costly manual sorting of the Netflix envelopes.

That sounds like a small problem, but considering Netflix has seven million customers and is sending and receiving hundreds of thousands of DVDs every month, the need to manually sort all those special DVD envelopes is costing the USPS an estimated $21 million in labor costs per year. Don't think for a second that the federal mail agency is not about to place a surcharge on every Netflix mailer sent through its national network.

Want numbers? Citigroup analyst Tony Wible estimates that a surcharge could change the monthly operating income per Netflix subscriber from an existing $1.05 to $0.35. That's a 66% drop based on faulty mailers alone. Competitor Blockbuster, Inc. (NYSE: BBI) studied this issue before it became one for them, so that company is not experiencing a similar problem.

It's hard to imagine that a simple adhesive is creating such a mess for Netflix, but it is. Going back to the envelope drawing board may be the only solution (from what I have seen, Netflix envelopes have not changed in years). Until then, this problem will be hanging over the company's head, and it's financial prospects in the next few quarters and beyond.

The Associated Press interviewed James Keyes, who became CEO of beleaguered rental chain Blockbuster Inc. (NYSE: BBI) in July. Not surprisingly, Keyes is optimistic about the future. The company is investing aggressively to move into the digital age and become relevant, and Mr. Keyes predicts that someday, customers will head to Blockbuster to download movies onto their cell phones, or burn them onto CDs.

But there's just one problem: what exactly is Blockbuster's competitive advantage? The large stores that the company has are more of a headache than anything else. If they really were a valuable means of moving the company into the new era, competitors like Netflix (NASDAQ NFLX) would be gunning to establish a brick and mortar presence, but they're not. Blockbuster is trying to spin its retail presence into an asset. But the $4 billion that the company lost from 2002 to 2005 exposes the stores for what they really are: a liability.

And what of Blockbuster's technological investments? They're great, but any other company can invest in new technology; and a lot of companies with much stronger balance sheets are. I'm reminded of Warren Buffett's decision to close the Berkshire Hathaway mills in 1958. The mills were antiquated and unable to compete on costs with lower-cost producers overseas. Buffett was shown plans to modernize the mills through aggressive investment, but ultimately passed. He explained the decision by saying that anyone else could modernize too, and that the cost savings would filter down to the consumer, not revive the New England textile industry. Of course, Buffett was right, and a lot of less prescient operators who did move to modernize lost their shirts.

Faced with increased competition from Blockbuster Inc. (NYSE: BBI) and other online download movie distributors like Amazon.com Inc.'s (NASDAQ: AMZN) Unbox service, Netflix Inc. (NASDAQ: NFLX) has said that is lowering the monthly price of two of its most popular DVD rental subscriptions. If a customer keeps three DVDs rented at a time, the price will now be $16.99 per month, with $8.99 as the cost for a single DVD rented out at any given time. Both plans were previously $1 higher in price.

Will this cause more customer loyalty among the online DVD rental faithful? I'm not sure a single dollar is what is needed here as anybody can compete on price. Can Netflix really absorb these price cuts, anyway? These two plans, which are used by a majority of the company's 6.8 million subscribers, will have an immediate impact on Netflix's revenue starting today. As always with price cuts, the strategy will need to make up the loss in revenue with more revenue coming from subscriptions (new or existing). Netflix will really need to recruit new customers. Not to mention these are not new pricing schemes -- competitor Blockbuster already has them.

What Netflix may need is some kind of other competitive advantage. How will Netflix differentiate itself? It must find an angle if it wants to increase that all-important subscriber rank. With NFLX shares down 24% this year and indicating down over 8% in premarket trading this morning (9:00 a.m.), this may be the most important decision it makes all year.

Netflix also reports Q2 numbers today, so this subscription announcement was probably carefully planned timing-wise (Friday) although it didn't seem to soothe shareholder fear. The competition is not slowing down a bit.

The VHS tape had a pretty spectacular run -- over 20 years in the mainstream consumer electronics arena. With the advent of popular and cheap DVD players in the late 1990s, VHS started losing its appeal for most consumers. With $150 DVD recorders now in the mainstream, there is very little reason to own a VCR these days. But with the advent of digital files that just fly from Internet servers to iPods and other devices, are DVDs destined to live a shorter life than the VHS tape?

Although recent standards like HD-DVD and Blu-Ray will only find a niche audience most likely (DVDs look so good to the rest of us, you know), it's hard to imagine that a physical medium like the DVD will go away. DVD players are everywhere, and even recent moves from companies like Apple -- and even the agreement Apple has with Wal-Mart that will let Wal-Mart shoppers buy "digital movie tickets" that can be redeemed for online movie purchases and downloads -- won't cause DVD sales to just plummet overnight.

I agree with this article that states the need for a physical medium will almost always exist. The experience a DVD provides is first rate these days (except that too much non-control is given to the customer, argh), and duplicating that on a streaming platform of download does not exist. Sure, there will be large niche audiences that want to embrace non-DVD entertainment -- but for the rest of us who share DVDs, don't have a huge movie library on demand from our cable, Internet or satellite provider or course, the DVD and the DVD rental store still fit the bill quite nicely -- and will for quite a while.