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Netflix Transitions to Streaming, Stock Soars

21 Oct, 2010 By: Erik Gruenwedel


Three years after launching its Watch Instantly digital service, online disc rental pioneer Netflix Inc. now considers itself primarily a streaming service.

That appears to be management’s message after the Los Gatos, Calif.-based company again posted stellar financial results, increasing its subscriber base by nearly 2 million members.

In a call with analysts, Netflix CEO Reed Hastings said the number of hours subscribers viewed streamed content had surpassed discs, and that more than 50% of users in the current fourth quarter would watch more than 50% of their content via digital distribution.

Netflix management also based changing user habits on the fact disc shipments declined in the San Francisco Bay Area – the company’s largest market penetration nationwide.

Netflix, which launched a streaming-only service in Canada this summer, is expected to do likewise in the United States by the end of the year. It currently offers unlimited streaming with its $8.99 monthly DVD plan. The new service would offer streaming at a lower monthly price with the option to also rent discs with a surcharge.

Similar to studios pushing transactional video-on-demand (VOD) instead of physical rental due to the former’s lower costs and higher margins, so too does Netflix see improved economics via streaming – notably shrinking its $500 million to $700 million annual postage tab.

“We believe this will give Netflix more power to acquire key streaming content (i.e., movie releases closer to street dates) that is likely to attract and retain subscribers,” Merriman Curhan Ford analyst Eric Wold wrote in a note.

Wold believes that a lower priced streaming-only monthly charge would still generate Netflix higher profits per subscriber, and could accelerate launch of a European-based streaming service by the second quarter 2011.

“Given Netflix’s increasing penetration of CE devices and OEM relationships, we believe Netflix could quickly become the streaming option of choice for consumers worldwide — and believe management would move fast to stay ahead of the competition.”

Indeed, Netflix plans to invest about $50 million for beyond North America international expansion in the second half of 2011, according to Ralph Schackart, analyst with William Blair & Co. in Chicago.

Schackart said Netflix still plans to deliver operating margins in excess of 12%, regardless of whether it pursues expansion into additional international markets in 2011.

Michael Pachter, analyst with Wedbush Securities in Los Angeles, said Netflix’s rock star status on Wall Street and heady stock valuation (up $20 in midday trading) no doubt will oblige content holders to charge accordingly for electronic rights going forward.

“We expect the cost of studio content to increase to parity with the Epix deal (around $95 million for 35% of all library content, so an increase of around $90 million or so), and we expect the cost of TV content to double,” Pachter wrote in note. “By 2012, we expect to see Netflix’s streaming costs grow from a run rate of $220 million annually earlier this year to a rate of around $630 million, and we expect to see the ‘newish’ content delayed by an average of 90 days over the current deal with Starz.

Netflix’s license deal with Starz Entertainment, which includes Disney and Sony content, expires in about a year.

Pachter believes Netflix has grown much of its strong subscriber growth through the company’s deals with video game consoles, including the Nintendo Wii, Sony PlayStation 3 and Microsoft Xbox 360.

He said about 15% of the 65 million gaming consoles sold in the United States include Netflix subscribers, including 50% new members. Pachter believes Netflix’s penetration will max at about 18% to 20% of the current console install base, with future growth predicated on new game system sales.

“We expect around 53 million new consoles to be sold by year-end 2013, and think that future net subscriber growth will be limited to no more than 12% of these purchasers, or around 2 million net subscriber additions per year,” Pachter wrote.

Regardless of the growth in streaming, the analyst said that even if subs only streamed content (no discs), Netflix would only realize annual postage savings of about $100 million.

“Applying this same logic to another year of similar growth in 2012, overall postage savings would total only $200 million, while overall streaming content costs would rise by $400 million, resulting in far less leverage from higher revenues than current Netflix’s share price suggests,” Pachter wrote.

The analyst, who contends Netflix shares are grossly overvalued, also believes Netflix’s success will likely increase competition from deep-pocket competitors.

“We think that new services from Hulu, Amazon, Google TV and Apple have the potential to increase bidding on limited content, and have even greater potential to create pricing pressure on subscriptions,” Pachter wrote.

The analyst believes such a scenario would force Netflix to significantly upgrade its streaming content, which would increase costs comparably.

“We would expect Netflix to pay more in order to avoid seeing its churn grow,” he wrote. Churn represents free and paying subs who elect not to renew their monthly service during the quarter.

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