A Disney 'Output' Deal With Netflix Answers A Key Strategic Question

| About: Netflix, Inc. (NFLX)
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Investors have pummeled Netflix (NASDAQ:NFLX) shares because of concerns that the online streaming service had neither the competitive clout nor financial strength to obtain "A" list movies that consumers want. Termination of the Starz "output" deal evoked further dark worries in the Netflix investor base. The signing of a deal to stream Disney (NYSE:DIS) movies beginning in 2016, should re-ignite the zeal of long time bulls and capture the interest of new investors in the company.

Strategically the deal answers a huge question: can Netflix, Inc. compete for "A" list studio films against the big pay TV competitors? Resoundingly, the answer is yes. NLFX has received a vote of confidence from arguably the most important and the most cautious studio in the media landscape. It is rare, if not unheard of, for Disney to lead into new strategic territory with its highly valued children's product but they have done so with Netflix. At the UBS media conference chief content officer for NFLX, Ted Sarandos, called it a "game changer". We agree, we think that the output deal with Netflix will change the game for Netflix and the landscape for all communications companies.

Clearly, the Lucas film partnership with Disney shifted strategic alignments in large and unpredictable ways. We believe it made signing the deal with Disney absolutely vital for Netflix to survive. If Amazon, or Wal-Mart or some potentially new competitor had acquired those rights, then Netflix would have been relegated to a "Universe long ago and far away". Now, with Disney locked up, Netflix has established strong positions in key demographics, young men and young families. Under the agreement, Disney will provide its library of existing wholly owned films to NFLX, beginning immediately, Disney will provide its library of family films to the streaming service. Beginning in 2016, new releases from Disney's entire stable of brands, Disney, Pixar, Marvel and Lucas will also become available. The new episodes of the Star Wars franchise will go into theaters in 2015 and presumably entire the pay TV window three to six months later.

No doubt there are risks to Disney if Netflix were not to survive. But, we think that this is a visionary move for Disney because it reinforces if not ensures the potential for Netflix to thrive and grow -- for which the Disney will be amply rewarded. At the same time, the DIS /NLFX output deal will drive pay distributors, like HBO (Time Warner, TWX: and Showtime (VIA:) to pay more for product causing their margins to contract, should studios turn even more aggressively to online distributors. But we also think Netflix will not be alone in the space. We see online distribution as eventually replacing the existing pay TV market place. We think new online players are likely to emerge out of the studio community or out of whole cloth. We do not believe that scale economies in the online space are as significant as in the pay cable or satellite space as online distribution is already in place. We see satellite distribution companies, Direct TV (NYSE:DTV) and Dish Networks (NASDAQ:DISH) as being vulnerable to subscriber losses in particular.

In addition, the transition from cable to downloading will also increase demand for online bandwidth. It seems clear that huge new capital investments in future infra-structure, backbone, trunk and drop to the home, lie ahead and will disrupt the structure of the communications landscape in enormous and unpredictable ways.

Cost pressures will increase, but presumably, the deal had to make financial sense for Disney as well and press reports have the transaction valued at over $350 million per year in total though we don't know the cost per film yet. Netflix hopes to convert its investment into gains in the subscriber base-currently 30 million, globally, about twenty million in the U.S. The company has publicly confirmed that it will not raise price from its current $8 per month fee for unlimited streaming as a result of the Disney deal, but since the bulk of the expense is three years out we expect increases in the monthly rate by that time. But the profit math is compelling for Netflix: assuming Netflix adds 10 million new subscribers over the next three years then the incremental revenue at $8 per month would equal $96 per year or $1 billion in new revenue. Now, this would NOT all flow to the bottom line -- there would be costs in addition to the Disney costs (by then we guess about $400 million) -- but the profit opportunity is clearly substantial for NFLX. We think that the company will not be able to maintain margins in the first couple of years of the deal because most of the new subscriber gains will arrive with the introduction of new Disney product in 2016, but we also think that Disney wants NFLX to become a viable competitor to iTunes, Google Play, Wal-Mart (NYSE:WMT) and Amazon (NASDAQ:AMZN). Other studios would also like to see an independent online streaming service survive for competitive balance in the pay TV space will be compelled to make deals with Netflix -- though clearly not as attractive as that made by Disney.

In the short term, we continue to believe that earnings comparisons for Netflix will be flat. Also consensus estimates are likely to be revised to reflect the costs of the Disney output but have not been yet.

NFLX consensus quarterly estimates are $(0.12) and $(.07) for the March quarter next year.

Annual estimates for NFLX are $(0.04) for this year and $0.44 per share next year. These consensus quarterly and annual earnings estimates reflected margin pressure from increased program acquisition costs and marketing costs before the Disney output deal. Once the company factors in the Disney Output transaction and it effect on cost and subscriber gains then we are sure they will update their guidance and the analysts will change estimates accordingly.

We believe that investors will not pay much attention to short-term earnings results but will focus on subscriber gains and the execution of future deals with studios. If momentum and tech investors abandon the shares then the company will probably be vulnerable to takeover offers or other investor coercion. So downside is covered.

Here are Historic Quarterly results .

NFLX EPS Diluted Quarterly Chart
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NFLX EPS Diluted Quarterly data by YChart

Disclosure: I 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.