Will Disney Save Netflix?

| About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) made a blockbuster (no pun intended) announcement last Tuesday afternoon that it is partnering with Walt Disney (NYSE:DIS) in a multi-year licensing deal. The deal solidifies Netflix as the exclusive subscription service carrying Disney's "first-run live-action and animated feature films". This agreement will grant Netflix the "exclusive" right to stream Disney movies approximately eight months after finishing their theatrical release. It is believed the "exclusive" will continue to mean that movies will be available on-demand, via pay-per-view television and Apple's (NASDAQ:AAPL) iTunes as well as on Netflix. Netflix reportedly outbid Liberty Media (LINTA) which operates Starz, a premium cable channel that competes with Time Warner's (NYSE:TWX) HBO.

I continue to bearish on Netflix and believe that you cannot own the stock but initially this deal appears to be a big win for Netflix. I want to take the time to dig below the surface and see if this is truly good news for Netflix. The market's initial reaction has been very positive as the stock has jumped from $75 to $86 but this announcement may not be as great for the company as it initially seems.

(Source: Yahoo! Finance)

It is clear why Wall Street is reacting to this news in a positive sense. Netflix gains access to "high-profile Disney direct-to-video new releases" in 2013 which should have an immediate impact on the size and quality of Netflix's library. Additionally, the partnership will unlock access to some of Disney's classic films such as Dumbo.

The former content is simply the direct-to-video sequels that lack the broad appeal to garner a theatrical release. For example, this includes sequels and spinoffs to movies such as Cars that Disney decided to not release in theaters. The fact that these movies were not theatrical releases should indicate that they lack wide consumer appeal. For example, you might not know that Disney released not one but two sequels to Aladdin, both via direct-to-video releases? These films both received Rotten Tomato critic ratings of 30%, lending support to the statement that these are not exactly high caliber films.

The classic films will definitely draw consumers to Netflix, but it is difficult to quantify the associated increase in demand from these classics. These movies have been available on DVD and video for years and are often the "babysitter" movies that keep children occupied on long car rides or when visiting others' households. In that respect, the demand for DVDs will exist as Netflix is not an ideal solution to the problem. Make no mistake, having access to the entire Disney library of classics for $7.99 certainly appeals, but do not expect a huge increase in domestic subscribers as a result of this news.

The more realistic scenario is a gradual increase in domestic subscribers over time rather than a significant uptick. This does not address Netflix's true problem as its North American operations are quite successful while its European and South American expansions face obstacles. If this Disney deal strengthened the library in Europe I would be far more optimistic on it but that is not the case. Until Netflix improves abroad, you still cannot own the stock.

New Disney theatrical releases will not available on Netflix until 2016 and no one really knows what Netflix will look like at that point. To put this in perspective, the best aspect of the Disney deal will not even be implemented until a new U.S. president has been elected. The company's financial position is quite tenuous and may not be an independent company in four years.

Making matters worse is the fact that the deal was likely prohibitively expensive and will only put more pressure on Netflix's cash flow situation. Financial terms of the agreement were not disclosed but I believe the cost to Netflix will be quite staggering. Not only was Netflix involved in a bidding war but Netflix needs Disney far more than Disney needs Netflix. Disney had all of the bargaining power in the relationship and was likely able to extract very favorable terms. The deal has been estimated to be worth approximately $300-$500M per year.

Netflix spends over 50% of annual revenue on content and Michael Pachter, an analyst at Wedbush Securities, believes that the deal "likely guarantees Netflix will be profitless for another several years once the deal kicks in". Netflix currently charges $7.99 per month and the company will likely have to increase the base subscription price or introduce some form of tiered pricing model to remain solvent. As I have stated in the past, the DVD business is a cash cow but is quickly losing steam and will be a shadow of its former glory in a mere two years. Even if you believe that this is a fabulous deal for Netflix, do you believe it justifies the lofty valuation bestowed on the company? The company will likely continue to lose money in the near-term and has a ludicrous forward P/E of 195. If the terms of the Disney deal get leaked I could see Netflix quickly correcting back into the $65 area.

Before I close, I want to discuss Disney briefly. Disney has been extremely active in expanding its reach in the Iger era, as evidenced by its deals with Marvel and Lucasfilms for a combined eight billion dollars. Media companies are often very conservative and unwilling to consider alternative distribution channels but Disney has been very open-minded. Disney has rallied from the low $40s in April and hit a peak of $53 in October only to have declined back below $50. With a forward P/E of 12.8 and a yield of 1.5% there is a decent opportunity to go long but I believe the risk/reward profile is unattractive for material gains. A strategy to capitalize on range bound Disney may be best.

UPDATE: Netflix disclosed in an 8K filing Thursday that both the company and CEO Reed Hastings have received Wells Notices from the SEC regarding the violation of Reg FD. Hastings commented that Netflix had surpassed one billion of monthly streaming in June in a Facebook (NASDAQ:FB) posting. Hastings has already responded to the notice, ironically via Facebook where the original comment was made. Essentially Hasting is arguing both that the original statement was public and not material. This is certainly bad news for the company but this should not impact your investment decision. The media reaction to the Wells Notice has been very pro-Netflix and anti-SEC thus far given the details of the disclosure. If you believe Netflix is a strong growth story than you will probably ignore the Wells Notice. If you are a Netflix bear, this is yet another reason to ignore the stock..

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please refer to profile page for disclaimers.