The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.
On Tuesday, Netflix (NASDAQ:NFLX) and The Walt Disney Company (NYSE:DIS) (“Disney”) announced an exclusive multi-year content licensing agreement that will allow Netflix’s domestic streaming subscribers to watch first-run live-action and animated feature films during the pay TV window beginning with the 2016 feature film slate. The agreement with Netflix replaces Disney’s current agreement with Starz for theatrical releases through 2015. Netflix will also receive direct-to-video new releases beginning in 2013 under the terms of the agreement. In addition, Netflix will receive older catalog movies, including “Alice in Wonderland” and “Dumbo.” Financial terms of the agreement were not disclosed, but we suspect that the deal will require Netflix to pay $250 million or more per year, and likely escalates to as much as $500 million per year.
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In our view, the market’s positive reaction to Tuesday’s announcement (Netflix shares closed up 14% on Tuesday) was unwarranted, as the exclusive nature of the deal was highly likely to involve a steep price tag. The exclusive nature of the deal for premium Disney content implies that Netflix outbid all other interested parties, and necessarily means that Netflix paid more than Starz has paid for such content in the past. In its most recent financial statements, Starz disclosed annualized programming expenses of almost $660 million based on the September quarter figure, implying that roughly $330 million was paid to Disney (the deal involves exclusive rights to Disney and Sony film content in the pay TV window), and we estimate that at least 2/3 of this figure was for more recent movies. In a note from September 2011, we estimated that Starz, had sought as much as $350 million annually from Netflix to renew their earlier deal. However, Netflix apparently balked at the price, and the deal expired earlier this year, resulting in Netflix’s losing roughly 25% of its “newish” content. We think Netflix paid at least $225 – 250 million annually for the Disney content, and believe that the starting point could be as high as $300 million, with likely escalator clauses built into the agreement. The eventual annual price tag could easily exceed this range if Netflix is able to attract a meaningful number of new domestic streaming subs over the next few years.
In addition, content availability is heavily back-end loaded. Although Netflix will likely add many direct-to-video releases and older film content over the next year or so, the most highly valued content will likely be unavailable before 2017. Over the near term, we expect increasing competition from Amazon and Verizon to challenge subscriber growth, and we expect limited profitability (Netflix domestic profits are expected to be reinvested into international expansion for the foreseeable future). It is impossible to forecast the impact that premium feature film content will have on Netflix subs beginning in the latter half of this decade, but it is easy to forecast a sharp upturn in content costs. In any case, we think that the likely high price tag for Disney content makes Netflix an exceedingly unattractive acquisition candidate, and think that a sharp uptick in content costs in the latter half of the decade will challenge Netflix’s profitability for the term of the Disney contract. In our view, Netflix will likely never generate significant profits, and a costly content deal will trigger substantial negative leverage should the company see subscribers defect to competitive services offered by Amazon and Verizon.
Netflix’s commitment to an expensive long-term content deal with Disney is at odds with comments made by Netflix management in the Q4:11 Investor Letter, released roughly one month before the Starz deal expired. At that time, management stated that the Disney content remaining under the deal accounted for a very small percentage of viewership: “the only significant loss (with the expiration of the Starz deal) is the current 15 Disney output titles, such as “Toy Story 3” and “Tangled,” which currently constitute about 2% of our domestic viewing.” At the time, we speculated that management had been somewhat disingenuous in its dismissal of Starz, and that losing some of Netflix’s most appealing movie content was similar to losing a favorite cable channel, likely prompting some subscribers to look elsewhere. We are surprised that investors accepted management’s dismissal of the value of Starz content earlier this year, yet are willing to reward management a few months later when the company chooses to pay approximately the same amount that they rejected for only half of the Starz content.
Due to the steep long-term price tag of the Disney deal, the back end-loaded nature of content availability, and Netflix’s unclear financial performance over the next few years, we view Tuesday’s announcement as a short-term fix to recent pressure on the company’s shares. Netflix shares have been negatively impacted by management’s seeming refusal to work with investor Carl Icahn, culminating in the recent adoption of a shareholder rights plan, and speculation about the prices and plans to be offered by Redbox Instant (NASDAQ:CSTR) by Verizon (NYSE:VZ), reportedly including cheaper streaming-only ($6 per month) and hybrid ($8 per month with four Redbox rental nights) plans.
Michael Pachter is an analyst at Wedbush Securities.