Oppenhemer analyst Jason Helfstein launched coverage of Netflix (NFLX) Wednesday morning with a Perform rating and a $35 price target, below Tuesday’s closing price at $39.60. His thesis is that, while the company has carved out a successful niche, with 7% of the home video market and 17% of the rental market, “the changing dynamics of DVD consumption will ultimately cut into the company’s margins, and studios will limit or change the pricing of electronic or streaming distribution.”
He also has some shorter term concerns, including the counter-cyclical nature of the stock, tough comps in the second half and a potentially landscape-changing piece of litigation involving Universal Studios Home Entertainment, which is majority owned by General Electric (GE), and the DVD-kiosk vendor Redbox, which is a subsidiary of Coinstar (CSTR).
Helfstein contends that the biggest threat to Netflix is the studios themselves, as the competitive landscape shifts. He notes that current streaming economics does not provide enough incentive for the studios to license new content. He reports that existing streaming content was secured under a deal that will expire in 2012. “A large streaming catalog is necessary to drive gross margin expansion and drive rising postage/packaging expenses, as well [to] secure [its] competitive position,” he writes. The risk is that the studios either limit access to content for streaming, or alternatively, that the studios will charge more and hurt the company’s margins.
According to Helfstein, the home-video market accounted for 54% of the U.S. film industry’s $45 billion in 2008 revenues. He figures Netflix with $1.4 billion in revenue was just under 6% of the home video sector last year, increasing to 7% this year; he thinks Netflix will be at 10% by 2013. He estimates 49% of the home market came from DVD sales, with 21% from in-store video rentals. But he says the industry dynamics are changing, given economic weakness, the emergence of Blu-Ray, and the rise of low-cost DVD rental kiosks from companies like RedBox, which offer new releases for $1 a day.
The analyst thinks the studios “will be forced to pursue higher revenue share agreements from rental companies, higher licensing fees from streaming and video-on-demand content providers.”
As for the Universal/Redbox litigation, Helfstein notes that Universal last summer approached Redbox seeking a revenue sharing agreement, with the threat of altering Redbox’s wholesale relationship if they refiused. Redbox turned around and sued Universal, alleging anti-competitive behavior. Helfstein notes that Universal is seeking to bar Redbox from renting DVDs for the first 45 days after they are release; to limit the number of DVDs carried in any given kiosk; to require Redbox to destroy used DVDs, to eliminate re-sale; and to provide Universal with 40% of gross revenue. Universal is apparently threatening to bar Redbox’s two main wholesalers from selling content to Redbox if the demands are not met. Universal is also barring retailers from selling their content to Redbox.
If Redbox wins, Helfstein says, it will be a negative for the rental industry. He thinks the studios would shift to a rental-only window, similar to the early days of VHS, while shifting to a more aggressive stance on VOD and streaming pricing. But the bottom line is that “if the studios have to extract more revenue prior to sell-through,” it will cut into rental margins.
If Universal wins, he contends, other studios would take a similar stance, “resulting in dramatic changes to the kiosk model,” eliminating the competition from low-cost kiosk rentals and low-cost resale of used copies. He thinks a Universal win could be a positive for Netflix, since it would eliminate some low-cost competition - and that the kiosk industry might not survive.
Helfstein’s theory is that Universal is not likely to succeed in barring wholesalers from selling DVDs to Redbox, citing the First Sale doctrine, which is a provision of copyright law that, according to Wikipedia, allows the purchaser to transfer a particular lawfully made copy of the copyrighted work without permission once it has been obtained, or int other words, “the copyright holder’s rights to control the change of ownership of a particular copy end once that copy is sold, as long as no additional copies are made.”
Either way, he says, the lawsuit could be “a major catalyst” for Netflix shares.
NFLX Wednesday is down $2.14, or 5.3%, to $38.19.