Will Comcast Really Partner With Netflix?

Oct.24.13 | About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) is reportedly in talks with Comcast (NASDAQ:CMCSA) concerning a partnership which could significantly enhance its distribution and marketing capabilities. The company intends to build upon its ground breaking deals with Virgin Media and Come Hem in Europe, and expand its domestic streaming business. At this point, there is no doubt that Netflix’s streaming is complementary to traditional pay-TV services. The recent spat between Time Warner Cable (NYSE:TWC) and CBS (NYSE:CBS) as well as the possibility of DISH Network (NASDAQ:DISH) dropping Disney (NYSE:DIS) channels (read Will DISH Dump Disney Over ESPN?) suggest that the pay-TV operators may become more flexible about their content choices. But given that Comcast already has strong content relationships and its own online streaming service, why would it consider carrying Netflix? We try to answer this question and consider the impact on Netflix.

We currently forecast Netflix’s U.S. streaming subscriber base to reach close to 54 million by the end of our forecast period. If the partnerships with pay-TV companies are successful, and Netflix manages to retain its advantage in terms of content and device reach, our forecast could turn out to be conservative. In an event where Netflix’s U.S. streaming subscriber base reaches 60-90 million, which is the company’s long-term goal, there could be an upside of about 10%-40% to our current price estimate. Subscriber growth of such magnitude will also imply higher margins than we currently forecast, which means that the upside could be much more. Perhaps the current market price reflects such lofty expectations. Our price estimate for Netflix stands at $232, implying a discount of about 30% to the market price.

What Could Prompt Comcast To Partner With Netflix?

It makes a lot of sense in having a streaming service packaged with traditional pay-TV. Having Netflix could potentially allow Comcast to have greater leverage in carriage fee negotiations with content owners, a competitive advantage over other players and an incentive for its subscribers to upgrade to faster tiers of Internet. The question is, why can’t the company achieve the same with its own Xfinity Streampix service? Given that Comcast doesn’t typically release numbers around this offering, it is hard to gauge the kind of adoption that it is getting. There appears to be two main possibilities that could prompt Comcast to partner with Netflix.

One, Xfinity Streampix hasn’t lived up to the company’s expectations and leveraging Netflix’s brand and device reach would be a better option. Two, Comcast is having a hard time negotiating content deals for online streaming. This may appear to be counter intuitive, but not implausible as evident from DISH Network’s statement last year. During one of its earnings announcements, the satellite company indicated that getting content rights for online streaming is a different ball game and hasn’t been easy. There is a good chance that many of Netflix’s deals involve certain clauses and conditions that would deter content owners to strike similar deals with other players.

Whatever may be the case, a successful partnership with Netflix can enhance Comcast’s core competency. On the other hand, it will help Netflix sustain its subscriber growth. Comcast has more than 20 million pay-TV subscribers and over 18 million broadband subscribers. Even if we assume that 40% of these subscribers already have Netflix, this still leaves the online streaming company with a potential target customer base of 10-12 million. Acquiring these customers will be easier with the backing of Comcast’s distribution and marketing muscle.

Partnerships With Pay-TV Operators Can Help Netflix Control Rising Content Costs

Partnering with an established pay-TV operator will create an entity that will have stronger negotiating power over content owners. This can help the company reign in content costs and achieve profitability in international markets sooner than we expect.

Netflix’s content costs have risen substantially over the last few years due to its efforts to expand its streaming library both in the U.S. and international markets. Back in 2011, Starz was demanding as much as a ten-fold increase in payments for the renewal of its content contract with Netflix. This would have amounted to an annual payment of around $300 million compared to its original deal of close to $30 million. This is a classic example demonstrating how streaming content costs have skyrocketed in recent years as competitors are bidding up prices and media companies are realizing the value of their content.

Netflix has been adding some original and exclusive programming to its streaming library, which seems to be paying off. The company has effectively marketed these exclusive shows to maintain its subscriber momentum. However, such content does not come cheap, which is evident from the significant jump in Netflix’s streaming content costs, overall content costs and streaming obligations over the last two years. The trend has continued in the first half of 2013 as well. It is estimated that Netflix is paying somewhere around $4 million per original episode.

Our price estimate for Netflix stands at $232, implying a discount of about 30% to the market price.

Disclosure: No positions.