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Can Netflix Offset Rising Content Costs?

20 Oct, 2010 By: Erik Gruenwedel

While all eyes await today’s (Oct. 20) release of Netflix’s third quarter results at the close of the market, much attention will be on how management plans to absorb rising streaming content costs going forward.

The Los Gatos, Calif.-based online disc rental pioneer has successfully built considerable hype into its Watch Instantly streaming service, a strategy that continues to push strong subscriber growth.

Indeed, Eric Wold, analyst with Merriman Curhan Ford in New York, projects Netflix will report a subscriber base of 16.62 million members, up from 15 million during the previous quarter and 50% higher than the same period a  year ago.

With Netflix streaming now available on hundreds of consumer electronics devices, the company is under increasing pressure to improve the quality and freshness of streaming content, which heretofore has consisted of mainly dated B-movies and catalog TV programs.

Better streaming content costs money, which Netflix management continually stresses in calls, was addressed in part this year when Netflix signed a $1 billion license deal with pay-TV service Epix.

Yet absorbing that cost, and others, is a dilemma considering Netflix doesn’t charge its predominantly packaged media subscriber base extra to stream. Netflix launched a $7.99 (Canadian) streaming-only service in Canada this summer and is expected to bow a similar service domestically by the end of the year.

“We believe Netflix management will need to be convincing that accelerating subscriber growth, improving gross margins (from the shift away from DVDs), and reduced [subscriber acquisition costs] costs (with reduced competitive choice for consumers) will all be more than enough to offset the ramp in streaming content costs over the next three-to-five years,” Wold wrote in a note.

The analyst expects renewal of Netflix’s content deal with Starz Entertainment, which expires next year and includes Disney fare, will cost the company 10-to-15 times more than the original deal.

Wold reiterated that increased attention on streaming should in no way undermine Netflix’s core strength: disc rentals. He sees Netflix’s by-mail service and kiosks as the only long-term viable business models within the physical segment.

“Not only do physical rentals still represent roughly $8 billion of the $10 billion movie rental industry, but we believe the estimated 91 million U.S. households that own a DVD player are more likely to gravitate toward the less-expensive and technologically-easier-to-understand DVD rentals over digital for at least the next five-to-10 years,” Wold wrote.

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