Quick Thoughts: If Netflix Builds It, Will They Come?

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–          Netflix’s 3Q story of negative cash flow and decelerating sub growth is troubling given the leverage of content owners and potential rivals like HBO, Amazon, Google, and Apple on the horizon.

–          If Netflix is to re-establish a growth trajectory and sustain its pricing, it MUST build a strong following for its forthcoming original programs – the next 12 months will be crucial.

–          In addition to pushing the global growth of streaming subscribers, Netflix ought to consider extending its brand to VOD and/or ad driven content.

–          With a $3.5B cap, Netflix may be an attractive acquisition candidate to the platforms: Apple, Amazon, Google, of Microsoft; a tie-up with Hulu would also offer compelling synergies.

 

Like Amazon, Google, Facebook, and other companies vying for a slice of the new TMT paradigm, Netflix is looking past its quarterly earnings as it continues to invest in building its content catalog. Investors, however, are not as inclined to overlook the company’s cash burn and flagging subscriber growth, and they took out their frustrations on the stock.  The cash burn is coming as Netflix is pouring money into the production of original content, such as new episodes of cult-favorite Arrested Development, and entirely new series such as the Kevin Spacey vehicle “House of Cards”, the Eli Roth produced “Hemlock Grove” starring Famke Janssen, and “Orange is the New Black” from Weeds creator Jenji Kohan.  These shows have been filming all fall and will be available for streaming sometime early in 2013, prompting CEO Reed Hastings to guide to negative free cash flow for the next couple of quarters, until the investment begins to pay off by juicing subscriber growth and loosening the company’s dependence on expensive exclusive deals with the studios.  Of course, this is a big IF, making the next 12 months critical for Netflix as it fends off increasingly pesky competitors that include the major device platform owners, cocky cable operators, and the content producers themselves.

So far Netflix has been riding the growing market for streaming, laying waste to video rental chains and contributing to the sag in TV viewership.  Wednesday night’s “South Park” was a strangely appropriate coda after the Netflix conference call, spoofing “The Shining” with an episode set in a derelict Blockbuster store with the rest of the world having moved on to streaming Netflix and Hulu on their TVs, game consoles and tablets.  Usage data from both ComScore and Nielsen pegs “South Park” as directionally correct, revealing a migration of viewer eyeballs from TV to streamed content.  In Q3, Netflix reported over 3 billion hours of content streamed in what is usually the weakest quarter for television audiences and with added competition from the Olympics.  This translates into about 40 hours of viewing per month per subscriber, and accounts for about 26% of the time Netflix subscribers spend watching TV each month according to Nielsen.  Netflix also makes up about 25% of the total streaming viewing in the US, as measured by ComScore.  Moreover, there is still additional runway to grow streaming households as consumers get faster broadband connections and upgrade to internet enabled TVs. The majority of streaming continues to be via 7th generation game consoles such as xBox 360 and Playstation 3 with Nielsen reporting a 39% household penetration.

However, streaming is becoming more mature.  Amazon launched free streaming for its “Prime” customers in early 2011 with a similar but smaller catalog of content.  Hulu has built a significant streaming audience for its advertising driven service despite the less than enthusiastic support of its broadcast network parents, and has launched a premium subscription service “Hulu+” with a broad catalog of TV content.  Cable nets like Pay TV pioneer HBO are trying to hold onto their customers with TV everywhere initiatives like the HBOGo app.  Hastings predicts an unbundled HBO streaming service in his sandbox, despite the protestations to the contrary by TimeWarner CEO Jeff Bewkes.  Verizon and Coinstar, which owns Red Box announced a joint venture to provide a streaming service by the end of this year. Even Blockbuster whose remains were acquired by Dish has a streaming service. AOL and Yahoo also gave digital upfront presentations earlier this year trying to court Madison Avenue for their original streamed programming.  Google’s YouTube is Netflix’s only rival for overall streaming rivals, although its strategy remains resolutely advertising driven, it has expressed support for its content partners’ interest in subscription services.  Google could also launch a streaming program within its Google Play store, which currently sells video downloads to mobile devices and has aspirations to the living room TV.  Finally, rumors of an Apple television product continue to swirl, and although the company has neither the content deals or the infrastructure in place to launch a streaming service to rival Netflix, Apple cannot be taken lightly.

In this context, Netflix must differentiate its core service and find itself ways to grow revenue.  Hastings has adamantly defended his price point, particularly with the customer relations debacle of the aborted split still in the rear view mirror.  Instead, Netflix has focused on growing subscribers, making the sharp deceleration in US sub growth for 3Q a red flag for investors.  Another road to subscriber growth is geographic expansion, as Netflix currently is established in the US and Canada, and trying to gain a foothold in a handful of European and Latin American countries.  International expansion however brings operational complexity and added costs around licensing and serving content.  As each region requires idiosyncratic content deals, some of the expense can be mitigated with Netflix’s original programming, which we see as a major upside.

By investing original content, Netflix is taking an early page from HBO’s playbook. HBO began as a repository of catalog film content and second tier sports, but began a transition to original content in the mid-1980s. While the network’s ultimate identity became synonymous with its Emmy award winning series programming, some of its early successes were live sports broadcasts of secondary sports like boxing, hockey and Wimbledon tennis.  Thus far, Netflix has not bitten on live programming, something rival YouTube has actively pursued, with Felix Baumgartner’s record breaking sky dive watched by more than 8 million people.  From BSkyB’s bold play for British Premier League Football to DirectTV’s exclusive NFL Sunday Ticket, exclusive live programming and, in particular, sports, has been a proven route to subscriber growth.  Netflix could also explore expanding into a la carte streaming of newly released content, or ad driven content to expand its revenue opportunity, but Hastings has shown little interest in either model in the past.

Though Netflix faces an uphill battle in the streaming marketplace, it is goes into it as the leader with penetration into 32% of broadband homes and 57% of 7th generation game console households. This significant head start, combined with a catalog of content under contract, makes the company a regular topic of the M&A rumor mill.  There is no shortage of potential suitors.  Amazon has shown interest in the past, and would make sense as Bezos builds out his electronic media distribution platform in anticipation of competition from Apple and Google.  The fear that the Netflix DVD distribution business could expose Amazon to state sales tax is far less of an obstacle given strong indication that the taxes will be imposed anyway.  Microsoft would also be in the running given most Netflix streaming is done via its Xbox 360 game console. Apple desperately needs content to launch its long rumored TV game changer. Google has $47B on its balance sheet and could make a power play just to disrupt the streaming landscape and would gladly wage war with the nation’s cable companies.  A merger with Hulu would tie a subscription model with an ad driven model, and a movie heavy content library with the leading roster of television programming, all with preferred access to the media content produced by Hulu’s parents, Disney/ABC, NewsCorp/FOX, and NBC/Universal.

Short of a surprise deal out of left field, even M&A will depend on the success of Netflix new original content.  Establishing a series or two as bona fide hits would calm the nervousness around subscriber growth deceleration, potentially renewing the enthusiasm of investors and potential acquirers alike.  Reed Hastings is hoping that “Arrested Development” is not a description of his company’s future.

For our full research notes, please visit our published research site.

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