Amazon (AMZN) announced that it has signed a 3-year deal with cable channel Epix, bringing in popular movies like "Iron Man 2" from Paramount Pictures and "The Hunger Games" from Lions Gate Entertainment (LGF). This increased Amazon's film archives in its streaming video site, Amazon Prime Instant Video.
Epix is a premium cable channel that has more than 15,000 titles on its library. Its parent company, Studio 3 Partners is a joint venture between Viacom (VIAB), Paramount, Metro-Goldwyn-Mayer Studios and Lionsgate. The cable channel offers movies from different genres, including classic titles, comedy, music and sports to viewers across the country.
Recently, Amazon has been upgrading and promoting movies and televisions shows on its streaming video service. For the last 12 months, it has signed a deal with every major Hollywood studio, as well as some major cable networks. For example, it has recently signed a deal with NBC Universal for its popular award-winning TV shows such as Parks and Recreation and Friday Night Lights. It has also announced an expanded licensing agreement with ESPN for 30 film series. At present, Amazon video streaming service has a library of more than 22,000 movies and TV episodes.
I believe that this expansion strategy has worked well for Amazon. Going forward, the company is expected to further boost its content. There is a growing trend toward the shift in mobile and tablet usage recently. This will further strengthen Amazon's case to invest heavily on content. But, industry experts agree that traditional TV will still dominate. In the case of the 2012 Olympics, traditional TV continued to dominate, albeit there are signs that mobile and tablets are gaining traction. But, the forecasts still favor traditional TV as the major force among consumer consumption. Having said this, I expect that the massive demand for mobile and tablet in video consumption will take a while.
Bad News for Netflix
This news is a major blow for Netflix (NFLX). Recall that Netflix had a 5-year streaming agreement with Epix. It paid $200 million every year beginning 2010 for exclusive online rights to Epix movies. This exclusive deal expired at the end of August, which required the company either renegotiate the terms with Epix or allow the rights to be sold to other internet video players. Unfortunately, Netflix renegotiated Epix on a non-exclusive basis paying the network $180 million a year, lower than the $200 million annual payment for exclusivity.
This transaction highlights the increased competition in the video streaming space. This would definitely have an impact on margins. Netflix's operating margins have significantly decline to 5% this year, lower than its average operating margins of 11%. The lower margin is due to increasing acquisition costs. At present, acquisitions costs have increased to 40% of total sales from the previous year's 16% to total sales. In contrast, Amazon's operating margins have remained stable at 3% to 4% a year. Other media companies like Time Warner (TWX) have operating margins increasing to 20% from the previous year's operating margins of 16%. The increasing operating margin of Time Warner is attributed to strong gains in VOIP offsetting the declining subscribers. Meanwhile, Dish Network (DISH) has also increased its operating margins from 13% to 20%. This is due to the higher gross subscriber activations from its Hopper set-top box.
The heightened competition will also result in price wars. Amazon's offering is at $79 per year for its Prime video service, compared to Netflix's charge of $95 per year. The key advantage of Amazon is that it has a steady and loyal customer base. The company would have to invest in fresh content to keep its subscribers happy.
Netflix faces significant odds as most of its competitors are well-established players with enough spending capability. It is also interesting to note that none of these established players have streaming as their main businesses. For instance, Amazon has online retailing as its core business and Dish Network from its pay per view television and broadband businesses. The problem is that these companies generate massive cash flow and could spend as much as they want to keep its streaming business profitable. Also I believe that its streaming business is an important component to its main businesses. Thus, I believe that Netflix is in a tough situation and must bank on its international expansion to convince investors of its profitable path.
Netflix: Expensive Valuations Amid Risks
At current levels, Netflix is currently trading at 32 times earnings. This is higher than its 5-year average earnings multiple of 30 times. This is also higher compared to the industry's average of around 14 times.
If you compare this to Amazon, this seems lower. Amazon trades at 82 times earnings, higher than its 5-year average earnings multiple of 76 times. But, Amazon trades at 2.4 times price over earnings growth ratio. This means that Amazon is reasonably priced relative to its growth rate.
Meanwhile, other media and entertainment stocks are trading at lower valuations. Time Warner trades at 17 times earnings and has a dividend yield of 0.94%. Also Dish Network trades at 12 times earnings. Even Viacom, a long established player in the field, is valued at 12 times earnings and carries a dividend yield of 0.80%.
The current decline in shares of around 70% is justified. The overhang includes uncertainties over its international expansion, slower operating margins and heightened competition. All of these negative factors that weigh on the stock are valid. I do not see the further decline in its shares as an opportunity to buy. Investors should be advised to stay from a highly valued stock with poor prospects in the future. Thus, the risk-reward ratio for Netflix appears unfavorable.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.