As has become the norm with Netflix (NFLX), another earnings release has come and gone leaving fireworks in its wake. After reporting earnings that were largely in line with consensus estimates, the company nonetheless saw its stock up almost 25% after its earnings release. This particular earnings release and subsequent earnings call focused heavily on the investments the company has begun making in original programming. In Q1 2013, Netflix aired "House of Cards", the first major original program developed by the company. In the second quarter, multiple other original programs will also debut exclusively on Netflix. In the short term, the company appears to be benefiting from an uptick in subscribers that some in the market will attribute to this original programming. Yet, the company is still barely turning out a profit. The company CEO, Reed Hastings, made it clear during the earnings Q&A that there are no imminent plans to increase the fees charged to subscribers. At over $200 a share, Netflix trades over 150 times the consensus earnings estimate of $1.32 per share for 2013. The market clearly expects Netflix to continue to grow. What it does not anticipate, however, is that Netflix could be sowing the seeds of its own demise with a deeper push into original programming.
The Content Distribution Landscape Today
To understand how Netflix could be sowing the seeds of their own demise it is prudent to describe the various forms of contribution distribution available to consumers today. Focusing just on the pay for content experience, you have the traditional cable and satellite television distribution outlet. In addition to those, you have the established programming networks such as HBO, Starz, and Showtime delivered in most cases as a bolt on to one's cable package. There are also the movie studios and theaters, along with their distribution partners such as the familiar little Redbox or Blockbuster kiosks. Finally, you have the new entrants to the distribution field serving customers through streaming data online. Here you have Netflix, Amazon (AMZN), Hulu and other smaller competitors.
The biggest question in the content distribution world today centers around the future of the traditional cable and satellite distribution model. Do consumers ultimately decide they can do without a $100 month cable subscription in lieu of a Netflix subscription that costs $7.99? It's a question that will not be answered immediately, although anecdotal evidence does show that consumers are willing to cut ties with their cable tv provider in certain instances. Yet these consumers willing to "cut the cord" are the exception and not the norm, today.
More importantly, the dynamic relationship between the traditional cable TV provider and traditional content producer is enormous in its size and scope. At the same time, this relationship has the power to shut off the flow of programming to Netflix the minute the winds of change begin to blow harder.
Netflix Is Just An Added Source Of Profits For Content Providers
Today, Netflix simply offers content providers an added platform to generate additional revenue. The same can be said for Amazon or any other digital distribution platform. However, stop for a minute and consider the major content distribution partners of Netflix and their related interests. Warner Bros., owned by Time Warner, which also owns multiple cable TV channels such as TBS, TNT, and many others. The recently signed exclusive, and highly touted, deal with Disney (DIS) to distribute its films. Disney also owns a small cable network you may have heard of, called ESPN. Finally, you have NBCUniversal as another large content partner. NBCUniversal is now fully owned by another company you may have heard of, called Comcast (CMCSA).
What you need to understand is that just about every major content partner of Netflix is a diversified company. At the same time, the amount of revenue derived from licensing content to Netflix is a pittance of the overall revenue for each of these companies. Take Disney as one example. Here, you have a company that has cable and broadcast channels such as ESPN and ABC respectively, that generated over $19B in revenue for FY 2012. It is estimated that ESPN alone generated over $10B in revenue between affiliate fees and advertising revenue. On the other end of the spectrum sits Netflix, which analysts estimate will generate about $4.3B in revenue this year. Disney will be happy to take the money that Netflix is willing to pay for their content, for now. Yet if a time comes where consumers begin to shift away en masse from traditional cable TV programming, the story will be much different. A cable subscriber paying $5 a month, or more, for ESPN is much more valuable to Disney in the long run than selling content to Netflix. Rest assured that if Disney programming becomes an important part of the Netflix value proposition, it will disappear in the blink of an eye if Disney begins to feel that their ESPN empire is threatened by cord cutting.
NBCUniversal and its parent Comcast provide an even more pertinent example of the battle Netflix faces. Comcast generated over $60B in revenue in 2012 between the traditional cable/internet revenue stream combined with the NBCUniversal programming and films. Here again, you find a company in Comcast that is leveraging content assets from NBCUniversal and generating additional revenue through licensing them to Netflix. However, this is a pittance of the overall business for Comcast. It is naive not to believe that, the moment this giant media company senses that a real trend might be developing in the move away from traditional cable subscriptions that Netflix will be shut out of any and all NBCUniversal content immediately.
Can Netflix Survive On Original Content Alone?
While surmising that Netflix could be completely blocked from the content deals it has in place today may seem outrageous, it really is not that far fetched. The content distribution world today is one where the various parties can co-exist while finding new ways to monetize their content assets. However as detailed above, those same entities providing Netflix content have larger businesses that are more directly tied to the number of households subscribing to cable TV. While there will always be certain programming that is available for licensing, the acclaimed programming that viewers desire to see is today in most cases the property of companies whose existence dictates that Netflix remain a revenue adding nuisance and not a threat.
The question becomes, can Netflix find a happy medium between the role they facilitate in content today versus becoming an actual threat to the established media and content companies? In becoming a content producer, by developing its own original programming, Netflix risks disrupting the equilibrium that exists in the content market today. The problem for Netflix is that trading at 150x their forward earnings, the market expects they will continue growing, but that growth will not go unnoticed by the major content partners. Bear in mind that the explosive growth seen in Netflix as they shifted to a streaming business model, and away from a DVD by mail model, came in large part due to their licensing of hit television programming. It would be this same television programming that would be the first to go if the large media companies saw their cable and affiliate fees at risk.
What Is The Investing Outlook For Netflix?
There are plenty of articles that will tell you how fundamentally, Netflix is a broken company due to their outrageous content obligations and negative cash flow. I would agree that fundamentally the company has bitten off more than it can chew with regard to its content obligations. The financial situation looks even bleaker when you consider the company is estimated to be spending close to $50M to produce one season of their original programming such as "House of Cards". However, outside of raising prices which the company has said it will not do, additional original programming is the best bet to continue growing subscribers and in turn coming close to justifying the lofty valuation of the company. The problem for Netflix is that over 25M streaming subscribers started using the service before any type of original programming made its way onto the platform. Would original programming be enough to offset the loss of that content that made those 25M member sign up in the first place? For the sake of Netflix investors, you should hope this question never has to be answered. In the meantime, enjoy the 150x multiple on a stock that faces a damned if you do and damned if you don't future. Just make sure you are not the last one holding the shares when the music stops.