Seeking Alpha
Profile| Send Message| ()  

Not the Jack of All Trades.

Netflix (NFLX) has some big problems. I am convinced that anyone with Google (GOOG) search at their disposal can observe this. Netflix is sending its profitable business in DVD rentals out to pasture supposedly in order to make room for a low or no profit business in streaming media. I have had a difficult time wrapping my head around this decision which has been backed up by plenty of bravado from Reed Hastings about the future of media distribution.

Netflix in a picture
(Click to enlarge)

Netflix pays and/or promises to pay various content providers large sums to license content from them for its subscribers. Most of these obligations are left off the balance sheet because of their variable cost nature. Thus I find it odd that on the Jan. 25 earnings conference call David Wells stated that content deals are fixed.

Ellie Mertz -

Similar to previous quarters, we've organized the questions by topic as we received them this afternoon. So we're going to start with general content questions. First question. Can you help us better understand the fixed versus variable components in the content deals you are signing, or how the industry is maybe moving more towards variable mechanisms as content owners better understand digital?

David Wells - Chief Financial Officer

This is David. We have been bidding in an industry that was set up before us by the cable, satellite and paid television world. So all of our deals are fixed. And that reflects the nature of the market that we're competing in. It's been like that for 10-plus years.

While the latest 10-Q contains this note regarding off balance sheet content obligations.

The Company had $5.0 billion and $4.8 billion of obligations at June 30, 2012 and December 31, 2011, respectively, including agreements to acquire and license streaming content that represent current or long-term liabilities or that are not reflected on the Consolidated Balance Sheets because they do not meet content library asset recognition criteria. The license agreements that are not reflected on the Consolidated Balance Sheets do not meet content library asset recognition criteria because either the fee is not known or reasonably determinable for a specific title or it is known but the title is not yet available for streaming to subscribers.

For those agreements with variable terms, the Company does not estimate what the total obligation may be beyond any minimum quantities and/or pricing as of the reporting date. For those agreements that include renewal provisions that are solely at the option of the content provider, the Company includes the commitments associated with the renewal period to the extent such commitments are fixed or a minimum amount is specified.

The Company has entered into certain license agreements that include an unspecified or a maximum number of titles that the Company may or may not receive in the future and/or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether the Company will receive access to these titles or what the ultimate price per title will be. Accordingly, such amounts are not reflected in the commitments described above. However such amounts are expected to be significant and the expected timing of payments could range from less than one year to more than five years.

Whatever the case, these deals are expensive and only growing. As of June 30th $2B is coming due in less than one year, up from $1.8B at the end of the prior quarter.

Netflix does one thing really well.

It is important to go over those details as they paint the backdrop for the other characters in the scene. Those characters are the content companies. So what does Netflix do so well? Netflix does an excellent job buying content!

Netflix has deals with the following companies either directly or indirectly via subsidiaries.

  • Viacom (VIAB)
  • MGM Holdings - in which Sony (SNE) & Comcast (CMCSA) each own a 20% stake
  • Lionsgate (LGF)
  • Relativity Media
  • Regal Entertainment Group (RGC) & AMC Theaters
  • FilmDistrict
  • The Weinstein Company
  • Revolution Studios
  • Dreamworks Animation, SKG Inc. (DWA)
  • Time Warner, Inc (TWX)
  • News Corporation (NWSA)
  • CBS Corporation (CBS)

We can assume that the deals Netflix signs with these providers have impact on others in the space such as Hulu, Amazon (AMZN), and soon Redbox Instant by Coinstar (CSTR) & Verizon (VZ). Unfortunately, quantifying that is not very simple since the deals are confidential. However, verifying the causality between Netflix and license deal value increases is rather easy. Take for example this last weekend when Reed Hastings boasted to the Telegraph the following regarding bidding against BSkyB for premium content deals.

Reed Hastings, the founder and chief executive of the US firm, told The Sunday Telegraph that BSkyB was a "powerful, formidable competitor" but that Netflix was prepared to invest heavily to win the rights.

"We will be really aggressive in our bidding," he said. "It may be that we win in the first round. It may be that it takes two or three years, but we're incredibly confident that we will win the bidding for some of Pay 1 [the first window rights]."

Full article

I read that over the weekend and questioned it. How will Netflix pay for these deals when it has just announced another expensive international expansion? Why would the studios give Netflix the time of day if it may not be able to pay up a year down the road? Will it require a secondary offering? Why does Reed want to drive up prices, and who does that help? Show me the money!!!

Who wins?

Actually Netflix really helps the content creators, directly and indirectly. In a sense the "big 6" major film studios have an ace in their sleeve with Netflix. Netflix may or may not be able to pay for what it bids but the studios don't care, not as long as the average bid rises. When Netflix outbids BSkyB for some Pay 1 rights, everyone else interested will need to raise their bids as well. Works out wonderfully for the likes of Viacom, Lionsgate, News Corp, Time Warner, CBS, et al. I'm not saying that Netflix is a shill bidder or that anything untoward is happening, that would be unsubstantiated. I am saying that it certainly isn't hurting the studios having these cowboys at the auction. I believe Netflix has a special place in the big studio's hearts (or balance sheets). I think Netflix has found its calling!

Who Loses?

Netflix investors. Whatever happens here, with Netflix spending profligately on content deals the end result will be thin margins and/or further dilution. Netflix isn't growing revenue meaningfully nor earnings in its current domiciles. The story that more international expansion is going to accomplish this seems silly at best and disingenuous at less than best. Take a look at revenue growth and note the last year or so where DVD has been on the decline and international expansion has been on the rise.

NFLX Revenue Growth Chart
(Click to enlarge)

NFLX Revenue Growth data by YCharts

Now What?

I think the writing is on the wall here. Netflix needs more money to pull off these big deal stunts. Money that the grand international expansion plan doesn't seem to be providing. Expect dilution to accompany delusion. I have and will be buying puts while I wait for a secondary offering. I will probably buy calls to strangle the puts if it breaks above 67 in the meantime.

Source: Expect Dilution To Accompany Delusion As Netflix Finds Its Calling