By Michael Corty, CFA
) issued a press release on Sept. 1 that disclosed it is ending
discussions with Netflix(
) about renewing the streaming content deal for Disney(
) and Sony(
) movies. The current deal does not end until February 2012, so
we think the network is wisely flexing its negotiating muscle.
Starz hit Netflix with the public announcement on the first day
that Netflix's price increase (which was announced in July) took
We believe Starz has the leverage in this negotiation, and this
dispute is an example of why we don't assign an economic moat to
Netflix. Content owners hold the upper hand, as evidenced by the
ability to sign shorter licensing deals that allow them to
consistently reprice content. Among the headwinds facing Netflix:
heightened competition from new entrants, lack of access to
high-quality television content, and higher future costs for movie
content. Starz has the rights to Disney and Sony films (roughly 28%
of domestic box-office sales in 2010), and these are the best
streaming movie options available to Netflix subscribers. The
streaming rights for content from other major studios are locked up
for several years. Time Warner(
) management previously disclosed that its HBO unit has the digital
and pay-TV rights to Warner Brothers, Fox, NBC Universal, and
DreamWorks Animation(DWA) (about 50% of domestic box-office sales
in 2010) through the middle of this decade.
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We had expected Netflix to pay at least 10 times more ($300
million) than the current agreement, widely estimated at about $30
million per year. Starz clearly undervalued the content at the time
of the deal in 2008, when Netflix only had 9 million subscribers
(it has 25 million currently). We now believe Netflix will have to
pay even more than $300 million per year for exclusivity, and we
would not be surprised to see some kind of hybrid pricing that
includes a fixed price plus escalators in a per subscriber basis.
We think the current licensing agreements that Netflix has in place
for television content are expensive. However, they are attractive
deals for the content owners based on the age and quality of the
programming included. In our view, TV content owners will be
selective and negotiate hard with aggregators like Netflix,
especially for highly rated TV content that has tremendous value in
syndication. CBS Corporation(CBS) announced a two-year,
nonexclusive licensing agreement that will include select TV shows
from its library, including episodes of "Medium" and "Flashpoint,"
full seasons of classics such as "Frasier," and "Cheers," and
select episodes from the original "Hawaii Five-0," "Star Trek,"
"The Twilight Zone," and "The Andy Griffith Show." CBS retains an
option to extend the agreement for up to two additional years.
CBS' chief financial officer Joseph Ianniello commented at the
company's investor day in February:
This is a good time to pause and mention our new Netflix deal.
We've always said we're going to maintain flexibility with our
content. The deal with Netflix is nonexclusive and it's for library
content that has already been sold in syndication. We kept it short
term and have the ability to extend the deal for two additional
years at our option. I want to point out that we took our time
evaluating this deal, and we proved that you don't have to be first
mover to get the best economics. And since it is nonexclusive, we
can replicate this over and over and over again. Each of these
opportunities represents hundreds of millions of dollars for a
fraction of our vast library.
If Netflix's lofty growth expectations are based on streaming
video still being in the early innings, then we think it's also
logical to assume that the competitive landscape will intensify for
Netflix as well. We view firms like Comcast(CMCSA), Time Warner,
and DirecTV(DTV) as overlooked competitive threats to Netflix.
Admittedly, these firms have suffered from inertia in building out
a more attractive video-on-demand product for pay-TV subscribers.
However, we believe this will change as they work closer with
content owners to offer a better video-on-demand ((VOD))
experience, including a deeper catalog of library TV shows. We
think Netflix has made these firms less complacent than they were
several years ago. Also, the movie studios, many of which also own
TV content, realize that a better pay-per-view alternative for home
video is better economically than pushing consumers to discount DVD
rental services like Redbox and Netflix. We also think there are
several large, cash-rich companies looming on the horizon as
potential competitors to Netflix.
To date, Amazon(AMZN) has not invested nearly as much in its
streaming business as Netflix, but we think this could change soon.
Amazon's deal with CBS for older library shows is likely similar to
the deal Netflix has with the content provider. We think its new
tablet will be priced competitively in order to gain share on the
iPad. The strategy could be to take losses on the hardware and make
it up with a streaming service. Amazon's overall operating margins
are 6%, so generating a 10% margin on streaming is additive
(Netflix's U.S. margins currently hover around 15%). We view
Apple(AAPL) as the elephant in the room with a cash balance that is
more than 20 times Netflix's sales. If the subscription streaming
business is in the early stages, then there is plenty of time for
Apple to compete as they have the means to make a substantial
upfront investment for more current or higher-quality content.
Apple already offers the ability to purchase content on its popular
We believe several media stocks have gone on sale and that these
are a better way to bet on the value of quality content. The recent
market pullback has created a buying opportunity for companies like
Time Warner and Disney. Time Warner is trading at 28% discount to
our fair value estimate. The conglomerate owns a leading filmed
entertainment studio and widely distributed cable networks. CNN,
TBS, and TNT are entrenched in basic pay-television packages and
its premium HBO network has 29 million subscribers who also have
access to HBO's streaming service HBO GO, which provides a deep
library of current and past programming. We believe investors
overlook the value of Warner Bros., the TV and movie studio, which
has a deep library of content and generates new hits on an annual
basis. We expect Time Warner eventually to join its peers and add
incremental cash flow from licensing old library content to firms
like Netflix and Amazon.
Disney also is trading at a 28% discount to our fair value
estimate. We think of this media conglomerate in two parts: cable
networks and branded businesses. More than half of its overall cash
flow comes from the cable networks, which garner a majority of
their sales from monthly affiliate fees. We expect both ESPN and
the Disney Channel to maintain a dominant position during the next
decade as live sports and quality children's programming are unique
offerings that most pay-TV households value greatly. We also
believe Disney's brand power is as strong as ever, which allows the
company to exploit its characters and franchises through box-office
and home video sales, theme park attendance, and merchandising.
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