Netflix to Pay More for Starz - Analyst Blog

A leading provider of online movie rental services, Netflix Inc. (NFLX) may pay $200 million to $300.0 million a year to renew a licensing agreement for movies and television shows with Liberty Media Corp.'s Starz (LSTZA) unit, as reported by Reuters.

Currently, Netflix pays approximately $30.0 million a year as license fees for the deal, which was signed in 2008 and expires in 2012. However, Netflix has yet to renew the agreement and management did not specify the exact amount.

Netflix's current agreement with Starz covers original movies from Sony Corp. (SNE) and Walt Disney Co. (DIS). Besides Starz, Netflix went on to sign a number of licensing agreements with Relativity Media and General Electric's (GE) NBC Universal Domestic Television Distribution division.

These deals have catapulted Netflix from primarily a DVD-by-mail company to a premier online streaming company over the last 12-18 months. At the end of 2010, net subscriber additions were 7.7 million, compared with 2.9 million in 2009, way ahead of management's target of 3.6 million for the year.

As of March 31, 2011, the total number of subscribers (Domestic and International) increased by a net 3.6 million sequentially and by 9.6 million from the year-ago quarter to 23.6 million.

Netflix is focused on becoming an entertainment powerhouse by adding content to its already vast and varied library, through partnerships with big production houses like Paramount Pictures and Twentieth Century Fox, to name a couple. In order to expand its video library, which already has 20,000 titles, Netflix has been entering into partnerships with big Hollywood production houses.

Most recently, Netflix signed a multi-year agreement with Miramax films, thereby enabling its US members to watch critically acclaimed and popular titles like “Pulp Fiction,” “Good Will Hunting” and “The English Patient" from June. Through this agreement, Netflix will gain the rights to Miramax's film library, which boasts 700 titles.

We also believe that these content additions will enable Netflix to reduce its dependence on cable TV operators and also provide the necessary competitive edge over its peers in the emerging market of online video streaming.

In March, Netflix obtained the exclusive Internet streaming rights for the upcoming 26-episode drama called “House of Cards” from Media Rights Capital for approximately $100.0 million. The deal represented a first step toward establishment of Netflix as a heavy-weight player in the pay-TV segment, which includes the likes of Time Warner Inc.'s (TWX) HBO and CBS Inc.'s Showtime.

While Netflix management agreed that the company was paying more every time it renewed an existing contract, they continue to believe that the overall market trends are positive for the company. We think that they may be right for a number of reasons.

First, the rapid increase in Netflix's subscriber base indicates that the sales model is catching on. Therefore, if the company doesn't join in the race, it will be pushed out of the market altogether. Second, the older method of mail-ordering came hand-in-hand with higher costs, so the on-demand model makes more sense.

Of course, rising license fees is a concern and could very well impact margins. But the way to win would be to grow the subscriber base very rapidly, which means more agreements such as this one.

In this context, the intensifying competition from large players such as Amazon.com Inc. (AMZN), Apple Inc. (AAPL) and Google Inc. (GOOG) in the online streaming market is significant because it will further push up the license fee and also make subscriber acquisition more difficult.

We think that the company is moving to a high-volume, low-margin model, where dollar profits will be more significant than margins (as in a typical retail business).

Netflix has expansionary plans that will stretch its business beyond Canada and into two new countries by early 2012. The company is also investing to gain rights of films and TV shows outside the US. We expect margins to remain under pressure due to expansion costs on the international front.

Recommendation

We maintain our Neutral recommendation on a long-term basis (6-12 months) owing to this increasingly competitive market and lack of visibility regarding Netflix's international expansion strategy. Currently, Netflix has a Zacks #3 Rank, which implies a Hold rating on a short-term basis.