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Netflix (NFLX - UNDERPERFORM): A Change of Heart? Netflix Negotiates Exclusive Content Deal with
Disney, Comes Only Months after Dismissing Starz; Expect a Lofty Price Tag
12-Month Price Target: $45
• On Tuesday, Netflix and The Walt Disney Company (“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.
• 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 by Verizon, reportedly
including cheaper streaming-only ($6 per month) and hybrid ($8 per month with four Redbox rental
Wedbush Securities does and seeks to do business with companies covered in its research reports.
Thus, investors should be aware that the firm may have a conflict of interest that could
affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision. Please see page 3 of this report for analyst
certification and important disclosure information.
• Ultimately, we think that deals such as the Disney deal could spell doom for Netflix.
The company offered Starz content from 2007 – 2011 and grew subscribers each year, then lost the
content in 2012 and saw its domestic subscriber growth slow. We think that management’s band aid
in restoring half of Starz content at a steep price will limit profitability once the deal kicks
in, and believe that the restoration of the content will come too late to stem the inevitable
slowing of subscriber growth. We expect Netflix domestic streaming subscriber growth to slow to a
crawl in 2013 and beyond, and do not think that a content deal commencing in
2017 will come soon enough to stimulate growth. Once growth stalls, we expect Netflix’s share
price to retreat to far more reasonable levels.
• Perhaps more importantly, a long-term and expensive content deal makes Netflix less
attractive to potential acquirers.
While we never expected any serious offers, Netflix’s cost structure limits the ability of a
prospective suitor to achieve synergies, and limits the potential for any serious offers.
• Maintaining our UNDERPERFORM rating and 12-month price target of $45. We value domestic
streaming at $15, domestic DVD at $20, and assign a speculative $10 option value to international
streaming. Our price target is at risk if domestic streaming growth slows more than we have
modeled, or if the domestic DVD segment loses more subscribers than we currently have modeled.
• Risks to the attainment of our share price target include: a sudden increase in subscriber
growth, declining competition from other movie rental competitors, lower than expected costs for
content, technology development and deployment, and improving macroeconomic factors.