Is Starz Truly Done Negotiating with Netflix?

Yesterday afternoon, Starz LLC (NASDAQ:LSTZA) announced that it has ended talks about a renewal of its streaming video deal with Netflix (NASDAQ:NFLX). According to the announcement, the current agreement will expire on February 28, 2012, and will not be renewed.

We estimate that Starz (NASDAQ:LSTZA) has received $30 million annually under its current deal, which allows Netflix (NASDAQ:NFLX) to stream unlimited Starz content to its more than 25 million customers. Based upon deals signed by Netflix over the last year, we had previously expected Starz to seek as much as $350 million annually to renew the current arrangement. It is clear that Netflix balked at the terms sought by Starz, although we are truly surprised that the parties would break off negotiations six months before the current deal expires.

Starz has the exclusive rights to Disney (NYSE:DIS) and Sony film (NYSE:SNE) content in a specified window beginning approximately 1 year after the films are released on DVD, and ending several years later (some films are in the Starz window as long as seven years). Under each studio’s respective agreements with Starz, Disney and Sony film content are offered exclusively through Starz via cable or Internet during the terms of the deal, so Netflix has no opportunity to circumvent Starz should it wish to continue to exhibit Disney and Sony content within the Starz window.

We are skeptical that yesterday’s announcement signals a true end to the negotiations, and note that the Starz announcement comes on the day when Netflix (NASDAQ:NFLX) increased prices for many of its customers by as much as 60%. It is our belief that Starz chose to announce the end of negotiations six months early in order to highlight Netflix’s efforts to raise price, by demonstrating that without Starz content, the Netflix offering is diminished.

In our view, Starz is seeking significantly more than Netflix (NASDAQ:NFLX) is willing to pay, and has used yesterday’s announcement to bring Netflix closer to its number. We think that while Netflix, indeed, needs quality content in order to continue to grow its subscriber base, it is highly likely that the company has been firm in its resolve to limit its rapidly escalating content costs. Netflix has taken advantage of its position as the only bidder on much of the content it provides via streaming, and the size of its audience allows it to play hardball with content owners that have increasingly become dependent upon the large checks that Netflix has been willing to write.

It is premature to write this deal off permanently; we think it is far more likely that the timing of this announcement on the same day as Netflix’s price increases will bring Netflix back to the bargaining table in short order. However, Netflix must avoid allowing Starz to set a precedent, as it has several one-year deals in place — notably with Disney television and CBS (NYSE:CBS) — that expire within the next several months. We think that Starz and Netflix will ultimately resolve their differences, with Netflix taking a slightly smaller subset of Starz content (perhaps delayed for 90 days after first exhibited on cable) in exchange for a lower overall number than the one Starz seeks. However, we think that Starz is counting on a large payday from Netflix, and think that all four parties involved—Starz, Netflix, Disney and Sony—end up losing if the companies don’t make a deal.

In the event that a deal is not reached, we think that Netflix (NASDAQ:NFLX) runs the risk of seeing its subscriber growth sharply reduced, if not stalled completely. Netflix has become a subscriber growth story, and has managed to maintain a delicate balance between its content quality, spending and subscriber acquisition in order to keep subscriber growth high. We think that today’s announcement upsets that delicate balance, and reveals a chink in Netflix’s armor.

Michael Pachter is an analyst at Wedbush Morgan.