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Analyst: Netflix Can’t Keep Profits Up in Digital World

18 Aug, 2010 By: Chris Tribbey


Growing competition in the digital space and an expensive deal to stream Epix titles to its customers has Morgan Keegan analyst Justin Patterson worried that Netflix can’t keep its stock price in the stratosphere too much longer.

In an investors note Aug. 18, Patterson downgraded Netflix’s stock with a target price of $100, and lowered his estimated earnings per share for the company for both 2010 and 2011. The news sent Netflix’s stock down more than 5% to $125.70 Aug. 18.

On Aug. 10 Netflix added titles from Epix, the pay-TV channel co-owned by Lionsgate, Paramount and MGM, to its streaming line-up starting Sept. 1. While the addition of Epix titles to the 17,000-plus Netflix already allows for streaming to its customers, the cost could be too high, Patterson said.

“It’s a far cry from the [more than] 100,000 titles in Netflix’s DVD library and with the cost rumored to be $1 billion over five years, Netflix is paying $1.11 [per] month [per] subscriber,” he wrote. “The Epix deal now represents a baseline for future content negotiations and it is plainly clear that Netflix has limited ability to take on such deals without eroding margins.”

Time Warner’s HBO has Internet streaming rights to films from Warner, Fox and Universal, and HBO executives have expressed no desire to give up exclusive streaming rights to titles from those studios. Netflix subscribers do have streaming access to titles from Sony and Disney.

Patterson said this puts Netflix in a bind. “Obtaining more content in the future is going to be challenging,” he wrote. “Netflix can either pay up and risk eroding margins or maintain a modest content library and risk higher churn and lower [subscriber] growth.”

He outlined a few ways Netflix could cut costs. With an estimated $700 million in postage and $110 million in DVD acquisition expenses for 2010, Netflix could look to cut the amount of titles it ships in the mail, but that would risk upsetting subscribers and content partners alike.

Increasing subscription prices by just $1 would provide an extra $180 million per year, Patterson said, but that could lead to some consumers moving to other services like Hulu Plus and HBO’s upcoming HBO Go service.

Netflix could also cut by nearly a half the amount it plans on spending on marketing in 2011, which could result in savings of roughly $30 million, he said.

“Give [Netflix CEO] Reed Hastings and his team their due,” Patterson wrote. “For over a decade, they have defied expectations and grown Netflix into a company on pace to generate $2 billion in annual revenues. Our original thesis was that the company’s early mover advantage in streaming would represent another inflection point for growth.

“While we remain believers in the service, data from recent content deals suggest the business is evolving differently than we had foreseen.”

Earlier in the week, HBO co-president Eric Kessler said in an interview with Bloomberg that online movies from HBO may not be available to Netflix online subscribers any time soon.

“There is value in exclusivity,” HBO co-president Eric Kessler said in an interview with the news service. Consumers “are willing to pay a premium for high quality, exclusive content.”

Owned by Time Warner, HBO has cable and Internet streaming rights to films from Warner, Fox and Universal. Last week Netflix reached an agreement with the Epix channel to secure online rights to titles from Paramount, Lionsgate and MGM. Netflix subscribers are also able to stream titles from Sony and Disney.

“We would love to do a deal as well with HBO,” Netflix spokesman Steve Swasey told Bloomberg. “Compete with us or collaborate with us, but we would much rather work with them.”

Kessler said in the interview that in 2011 HBO subscribers will have free access to HBO Go streaming service via Apple’s iPad.

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