Netflix (NFLX) announced earlier this week that it signed a multi-year licensing agreement with Time Warner (TWX) unit Warner Brothers Domestic Television Distribution. The agreement will allow Netflix to domestically stream all of the previous episodes of ABC Family's Pretty Little Liars and The Lying Game. Netflix already has some of the popular ABC titles such as The Secret Life of the Teenager, Melissa & Joey and Make it or Break It.
The recent acquisition of these titles will definitely boost the content portfolio of Netflix. These titles have a huge following across the U.S. Netflix is currently beefing up its portfolio to improve its numbers of streaming members and strengthening its position in the Internet TV network space. On a separate note, it has also recently added blockbuster names such as Thor, Transformers, Captain America and Immortal.
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Based on the latest quarterly results, Netflix has added 1.7 million in streaming members and 1.9 million paid net additions for the quarter. The number of total domestic streaming members has reached 23.4 million. Meanwhile, the company's total international streaming members have added 1.2 million members and almost 1 million in paid net additions. The international business is gaining traction as it accounts for nearly 12% of the total Netflix streaming members. This is relatively good as the company launched its international business just 6 months ago.
These results confirmed the report of research firm IHS. According to the firm, Netflix increased its market share in the online-movie space to 45%. Conversely, the market share of Apple (AAPL) fell to 32% from the previous market share of 61%. It also added that the streaming industry is poised to double this year to $1.1 billion. This means that the company faces tailwinds on shift of consumption to online streaming.
Netflix attributed the growth to new content additions, improvement to the Netflix user interface and personalized services. Moving forward, the company will invest significantly in its domestic content library to bolster its current offerings.
Concerns on Increasing Costs and Competition
A careful analysis of Netflix's costs will reveal that its costs of subscription, including the cost to acquire content licenses have significantly increased. Over the last 5 years, cost of revenues increased from $786 million in 2007 to $2.03 billion in 2011. If you dig deeper, it has increased from 54% of sales to roughly 56% of sales. For the fiscal year 2011 alone, the company spent $1.8 billion in licensing and acquiring content. This is an increase of 55% compared to the previous year. In the long run, this will most likely be higher as content owners and producers have the leverage to charge higher fees to players like Netflix.
Is original production the solution to these concerns? I believe this would worsen the situation. It will run the risk of producing expensive shows that customers would not like. It seems like a gamble to me. Another thing is about reputation and perception. If Netflix is planning to add subscribers, this would not help. It doesn't have the reputation of producing great shows yet. The best way to bet on this project is to start slow and focus on targeting the loyal fan base of Netflix.
The competitive landscape for this space is intense and subject to rapid technology change. In fact, low cost competitors are showing up at Netflix's doors to challenge its leadership in the online streaming space. It also competes with free to air content producers including Time Warner and Comcast (CMCSA). Comcast plans to roll out extensive online offerings to its cable subscriptions. Other internet movie and TV content producers such as Apple's iTunes, Amazon.com (AMZN), Hulu.com and Google's (GOOG) YouTube are also competing for the streaming dollars.
As the costs of acquiring content go up, the company should be able to pass the costs on to the customers. Unfortunately, this is not the case for Netflix. Since there are alternatives to Netflix's products, it could not increase its price or it would run the risk of losing customers. The current net profit margin is at 4.81%. This is lower than the 6.79% average net profit margins over the last 5 years. It seems that margin pressures are already present as more competitors are taking a bite at the prospects of higher streaming demand.
Stock does not seems cheap despite concerns on costs and competition
At present the stock is trading at 22 times earnings. Over the last 5 years, the stock has traded between 17 times to 60 times earnings. The company does not pay dividends, and I don't expect the company to pay dividends any time soon as it requires a lot of cash to increase its content portfolio. Over the next 5 years, the company is expected to grow its earnings by 15%. This translates to a current price earnings to growth ratio of 1.46 times. The valuations do not look cheap but reasonable relative to its earnings growth.
In contrast, similar stocks are trading lower. Time Warner trades at 13 times earnings and carries a dividend yield of 0.95%. Viacom (VIAB) is valued at 12 times earnings and DirecTV (DTV) also at 12 times earnings.
If costs will continue to pressure Netflix's profitability, the valuations will continue to reflect that. I believe that the future growth is based on the company's online streaming business as its DVD rental business continues to post subscriber losses. The overcrowded online streaming market will hurt the probability of its overall business moving forward. It looks like the way to win this competition is to lower your average selling subscription price and offer value-added services. Otherwise, the giant competitors like Microsoft (MSFT), Amazon.com and Google will find ways to attract customers away from Netflix. This will definitely translate into shareholder losses in the future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.