By Michael Corty, CFA
Starz (LSTZA) issued a press release on Sept. 1 that disclosed it is ending discussions with Netflix (NFLX) about renewing the streaming content deal for Disney (DIS) and Sony (SNE) movies. The current deal does not end until February 2012, so we think the network is wisely flexing its negotiating muscle. Starz hit Netflix with the public announcement on the first day that Netflix's price increase (which was announced in July) took effect.
We believe Starz has the leverage in this negotiation, and this dispute is an example of why we don't assign an economic moat to Netflix. Content owners hold the upper hand, as evidenced by the ability to sign shorter licensing deals that allow them to consistently reprice content. Among the headwinds facing Netflix: heightened competition from new entrants, lack of access to high-quality television content, and higher future costs for movie content. Starz has the rights to Disney and Sony films (roughly 28% of domestic box-office sales in 2010), and these are the best streaming movie options available to Netflix subscribers. The streaming rights for content from other major studios are locked up for several years. Time Warner (TWX) management previously disclosed that its HBO unit has the digital and pay-TV rights to Warner Brothers, Fox, NBC Universal, and DreamWorks Animation (DWA) (about 50% of domestic box-office sales in 2010) through the middle of this decade.
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We had expected Netflix to pay at least 10 times more ($300 million) than the current agreement, widely estimated at about $30 million per year. Starz clearly undervalued the content at the time of the deal in 2008, when Netflix only had 9 million subscribers (it has 25 million currently). We now believe Netflix will have to pay even more than $300 million per year for exclusivity, and we would not be surprised to see some kind of hybrid pricing that includes a fixed price plus escalators in a per subscriber basis. We think the current licensing agreements that Netflix has in place for television content are expensive. However, they are attractive deals for the content owners based on the age and quality of the programming included. In our view, TV content owners will be selective and negotiate hard with aggregators like Netflix, especially for highly rated TV content that has tremendous value in syndication. CBS Corporation (CBS) announced a two-year, nonexclusive licensing agreement that will include select TV shows from its library, including episodes of "Medium" and "Flashpoint," full seasons of classics such as "Frasier," and "Cheers," and select episodes from the original "Hawaii Five-0," "Star Trek," "The Twilight Zone," and "The Andy Griffith Show." CBS retains an option to extend the agreement for up to two additional years.
CBS' chief financial officer Joseph Ianniello commented at the company's investor day in February:
This is a good time to pause and mention our new Netflix deal. We’ve always said we’re going to maintain flexibility with our content. The deal with Netflix is nonexclusive and it’s for library content that has already been sold in syndication. We kept it short term and have the ability to extend the deal for two additional years at our option. I want to point out that we took our time evaluating this deal, and we proved that you don’t have to be first mover to get the best economics. And since it is nonexclusive, we can replicate this over and over and over again. Each of these opportunities represents hundreds of millions of dollars for a fraction of our vast library.
If Netflix's lofty growth expectations are based on streaming video still being in the early innings, then we think it's also logical to assume that the competitive landscape will intensify for Netflix as well. We view firms like Comcast (CMCSA), Time Warner, and DirecTV (DTV) as overlooked competitive threats to Netflix. Admittedly, these firms have suffered from inertia in building out a more attractive video-on-demand product for pay-TV subscribers. However, we believe this will change as they work closer with content owners to offer a better video-on-demand (VOD) experience, including a deeper catalog of library TV shows. We think Netflix has made these firms less complacent than they were several years ago. Also, the movie studios, many of which also own TV content, realize that a better pay-per-view alternative for home video is better economically than pushing consumers to discount DVD rental services like Redbox and Netflix. We also think there are several large, cash-rich companies looming on the horizon as potential competitors to Netflix. To date, Amazon (AMZN) has not invested nearly as much in its streaming business as Netflix, but we think this could change soon. Amazon's deal with CBS for older library shows is likely similar to the deal Netflix has with the content provider. We think its new tablet will be priced competitively in order to gain share on the iPad. The strategy could be to take losses on the hardware and make it up with a streaming service. Amazon's overall operating margins are 6%, so generating a 10% margin on streaming is additive (Netflix's U.S. margins currently hover around 15%). We view Apple (AAPL) as the elephant in the room with a cash balance that is more than 20 times Netflix's sales. If the subscription streaming business is in the early stages, then there is plenty of time for Apple to compete as they have the means to make a substantial upfront investment for more current or higher-quality content. Apple already offers the ability to purchase content on its popular iTunes platform.
We believe several media stocks have gone on sale and that these are a better way to bet on the value of quality content. The recent market pullback has created a buying opportunity for companies like Time Warner and Disney. Time Warner is trading at 28% discount to our fair value estimate. The conglomerate owns a leading filmed entertainment studio and widely distributed cable networks. CNN, TBS, and TNT are entrenched in basic pay-television packages and its premium HBO network has 29 million subscribers who also have access to HBO's streaming service HBO GO, which provides a deep library of current and past programming. We believe investors overlook the value of Warner Bros., the TV and movie studio, which has a deep library of content and generates new hits on an annual basis. We expect Time Warner eventually to join its peers and add incremental cash flow from licensing old library content to firms like Netflix and Amazon.
Disney also is trading at a 28% discount to our fair value estimate. We think of this media conglomerate in two parts: cable networks and branded businesses. More than half of its overall cash flow comes from the cable networks, which garner a majority of their sales from monthly affiliate fees. We expect both ESPN and the Disney Channel to maintain a dominant position during the next decade as live sports and quality children's programming are unique offerings that most pay-TV households value greatly. We also believe Disney's brand power is as strong as ever, which allows the company to exploit its characters and franchises through box-office and home video sales, theme park attendance, and merchandising.
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