Netflix: Content + Smart TV = OTT Disruption?

| About: Netflix, Inc. (NFLX)

Summary

SCMP reported that NFLX and Leeco are in talks for content cooperation with more details to be released in Q3.

Leeco’s Vizio smart TV + NFLX bundle could be the likely partnership to drive both TV and subs penetration in the US.

Remain cautious on NFLX but do acknowledge that the Leeco partnership could be very disruptive.

SCMP reported that Netflix (NASDAQ:NFLX) is in talks with Leeco on content cooperation. To remind investors, Leeco recently acquired smart TV maker Vizio for $2b. Details are scant but Leeco management said that they are planning a very significant cooperation with NFLX and details will be announced in Q3. I suspect that it will involve a content distribution agreement in which NFLX content and Leeco smart TVs are bundled together to be sold to both the Chinese and North American viewers.

Given that the increasing competition in the US is pressuring domestic subs growth (see Netflix: Beginning Of The End?), a disruptive approach to subscriber acquisition may be necessary for NFLX to regain subscriber growth and to win back investor confidence.

While I have been skeptical about NFLX's China strategy for some time, I believe that a partnership with Leeco after its Vizio acquisition could potentially change the industry dynamic on OTT/hardware integration and distribution, and could potentially give NFLX an edge over rivals such as Sony (NYSE:SNE), Dish (NASDAQ:DISH), Amazon (NASDAQ:AMZN) and Hulu.

NFLX was earlier interested in entering China without a local partner and I was a strong critic of this move (see Netflix: Taking Middle Kingdom). Recall that NFLX's Chief Content Officer Ted Sarandos told a group of reporters in Shanghai that NFLX planned to enter China alone. In my view, such an idea was simply too naïve because NFLX would have been required to obtain eight different content distribution licenses in order to make its service available. More importantly, a partnership in China ensures a smooth regulatory process.

The good news is that it did not take long for reality to set in for NFLX. The OTT provider was actively engaged in discussions with Wanda (see Netflix: Taking Middle Kingdom - Take Two), BesTV and Wasu Media (see Neflix: Middle Kingdom Taken), but it appears that the Chinese were tough negotiators and nothing came to fruition. The next logical choice would be Leeco, formerly known as LeTV or Leshi Internet, and that company is widely seen as the Netflix of China. NFLX had prior relationships with Leeco after acquiring the popular Chinese drama, "Empress of the Palace," from LeTV for its US platform and I believe that this set up a good working relationship between the two companies. (see Netflix: Taking Middle Kingdom With LeTV).

There are several ways how this partnership could potentially play out.

First, Leeco and NFLX can bundle their content together along with Leeco's existing smart TV models (including the upcoming Vizio models) where Leeco will sell its smart TVs at cost in order to encourage the Chinese and the US consumers to purchase multi-year subscription services. This is essentially the business model that Leeco has been doing in China over the past four years and has proven to be very successful and it's known as the leader in smart TV, set-top boxes and now an emerging player in smartphones and electric vehicles.

Management has indicated the scalability of the Leeco model in China and how it can be adopted by Vizio, which gives me the conviction that this is a potential route for Leeco to drive Vizio penetration in the US with the help of a NFLX bundle. This will not only be accretive to Leeco to drive smart TV penetration in the US, take shares away from Samsung (OTC:SSNLF) and LG, and expand globally but also accretive to NFLX that has been struggling with domestic subs growth.

Additionally, this could potentially pressure other OTT players that do not have a viable hardware strategy such as AMZN, Hulu and DISH. So far, only Sony and Apple (NASDAQ:AAPL) have competitive hardware in both console and set-top boxes but strategies of other players appear to be quite deficient.

The second option is to become a content producer in China. Given Netflix's track record in moving towards content production, particular the recently released Beast of No Nations and Crouching Tiger Hidden Dragon 2, it makes sense for Netflix to take an alternative approach when dealing with the hyper-competitive Chinese OTT market. Rather than competing head-on against a dozen other OTT service providers, Netflix could become the "arms dealer" for the OTT providers by supplying them with blockbuster content.

The Chinese viewers are no strangers to NFLX's original content (which is why Frank Underwood could pull a stunt during Alibaba's (NYSE:BABA) Singles Day festival). This is significantly more attractive than competing with OTT platforms backed by Alibaba, especially after its acquisition of Youku (see Alibaba: Ecosystem Stronger Than Ever).

Going into movie production is also consistent with Netflix's existing strategy of partnering with local heavyweights in content creation and distribution. I note that Netflix is already working with Fuji Films in Japan to cater to the local market (see Netflix: Konichiwa Hastings-San). As part of its strategy for Korea, Netflix will also partner with local players (see Netflix: Going Gangnam Style) and the entry into India makes Eros (NYSE:EROS) a very attractive partner for the OTT giant (see Eros: Bullish Thoughts Post Management Meeting).

Bottom line: I remain cautious on NFLX but do acknowledge that the partnership with Leeco could potentially be highly disruptive.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.