Universal Misses the Big Picture

Universal Studios Home Entertainment president Craig Kornblau should know the halcyon days of DVD sellthrough aren’t coming back anytime soon.

It’s a rental market where consumers can watch new-release discs for $1.20 a night, with studios getting pennies on the transaction.

So why assist in the destruction of sellthrough (and studios’ bottom line) by extending — not lengthening — the 28-day embargo with Redbox? Why not join Warner Home Video in doubling the embargo to 56 days? After all, it was Warner that first windowed new releases to kiosks and by-mail subscription — a practice Universal and 20^th Century Fox Home Entertainment embraced.

Obviously, Universal thinks the current window has the right economics. But considering that operating cash flow at Universal Pictures plummeted more than 95% in 2011, is the status quo really working?

The studio recently said Oscar-nominated adult comedy Bridesmaids was the top transactional video-on-demand title in history, generating $40 million in revenue across multiple digital platforms, including iVOD, pay-per-view, hotel viewings and electronic sellthrough. The movie also generated $100 million in disc sales.

Those tallies — which approximated nearly 50% of the title’s domestic box office — began accumulating 28 days before Bridesmaids was officially available at Redbox.

Now suppose Bridesmaids wasn’t available at Redbox for 56 days — ignoring for the sake of argument any workaround program. A typical transactional VOD purchase generates seven times the margin of a kiosk or by-mail subscription rental. Sellthrough generates 20 to 30 times the margin of a kiosk or by-mail transaction.

Bridesmaids was a popular movie with enduring demand; why give it to the 99-cent store just four weeks after street date?

Kevin Tsujihara, president of Warner Home Entertainment Group, was asked Feb. 29 why a consumer should pay $18 for a sellthrough title when a $2 (48-hour) rental edition existed down the street. Tsujihara said the only way to justify sellthrough was by creating scarcity of supply when demand is greatest — a basic tenet of supply-side economics.

“Otherwise, $2 beats $18 every time,” Tsujihara said.

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Is Apple's Stock Really Worth $18,000 a Share?

In the tumultuous world of Wall Street, determining just what a tech company really is worth can be an exercise in crazy making.

Take Apple Inc., which recently reported a record fiscal quarter generating $13 billion in profit on $46.3 billion in revenue. Its stock Feb. 14 is trading at around $503 per share, or 11.78 times projected annual earnings of $42.69 per share. The P/E ratio is determined by taking Apple’s stock price (P) and dividing it by estimated annual earnings (E).

In other words, it would take someone buying a single share of Apple 11.8 years to recoup the purchase price based on annual earnings and ignoring inflation and other issues. The P/E ratio underscores a stock’s demand on the market, which, of course, doesn’t necessarily reflect its actual value.

While stock trading at $500 a share might be considered high to the casual observer, Apple’s P/E ratio actually is below that of the S&P 500 with a current P/E ratio of 13.5. If the S&P ratio was applied to Apple, its stock price increases to $576.31 per share.

Now factor in Netflix and Amazon, two peer media tech stocks with stratospheric P/E ratios unlike Google (P/E 14.5) and Microsoft (P/E 11.4).

Amazon has a P/E ratio of 78.8, while Netflix’s P/E ratio is an astounding 422.5. Amazon’s diversified product mix is reflected in its P/E ratio as much as the reality that ecommerce is the future and the Seattle-based company is firmly in the driver’s seat.

For Netflix, its stock currently is trading at $123 per share, despite a projected annual loss of 26 cents per share. In fact, Netflix’s meteoric P/E ratio would appear to confound logic and yet underscores its front-runner status in what investors believe is a burgeoning streaming video marketplace. In other words, Netflix — despite recent PR gaffes — remains a speculator’s dream.

“Not even the Fed can print enough money to cover a price that high,” according to a post by Bespoke Investment Group, which conducted the analysis on theoretical share prices.

Applying Netflix’s P/E ratio to Apple’s stock results in an outsized valuation of $17,998 per share. Of course such a valuation is unrealistic, but it does shed light on the vagaries of the stock market and underscores the reality that valuing a company’s stock — when compared to its peers — can be subjective.

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Analysis: Home Entertainment Driving Studio Results

Home entertainment remains an enduring — if not divergent — profit center to studios saddled with a fickle theatrical market and rising ticket prices, according to the recent fiscal results.

While DVD sellthrough revenue continues to shrink, sales of higher-margin Blu-ray titles are strong, and transactional VOD, subscription VOD and physical rental generate increasingly significant revenue to studios with varying margins.

Warner Bros. Home Entertainment Group underscores an aggressive studio approach that embraces cloud-based digital locker UltraViolet while tweaking release windows to maximize distribution channels. Indeed, Warner’s 28-day embargo of new releases to rental channels (recently expanded to 56 days for Netflix discs) contributed to the studio’s best fiscal year ever.

“That enabled our titles last year to significantly outperform comparable titles released by other studios without a window,” Time Warner CEO Jeff Bewkes said in a Feb. 8 call with analysts. “In 2012, we’ll keep pushing to define the next generation of business models for home entertainment. As part of that we are using windows to advantage our higher contribution, distribution channels.”

Meanwhile, sales of higher-margin Blu-ray titles helped Walt Disney Studios report first-quarter (ended Dec. 31) operating income of $413 million — up 10% from operating income of $375 million during the previous-year period.

News Corp. president Chase Carey said despite the buzz surrounding digital distribution, physical media continues to generate the bulk of home entertainment revenue — a reality the COO doesn’t see changing much in the near future.

Indeed, 20th Century Fox Studios reported quarterly operating income of $393 million, up 108% from operating income of $189 million during the previous-year period. The studio said results were driven in part by global home entertainment sales of Rio, Rise of the Planet of the Apes, X-Men: First Class and Mr. Popper’s Penguins, among other sources.

“Blu-ray and electronic and digital distribution are our future,” Carey said. “DVDs have been around for a long time … but I don’t want to imply that DVDS don’t have real legs. Blu-ray has been pretty strong growth derivative. We are going to make sure we manage that business intelligently. And I think the DVD business continues to have legs.”

Lionsgate continues to mix up release windows and formats spearheaded by the early transactional VOD release of Abduction — ahead of packaged media. Digital and transactional VOD revenue for its most recent quarter increased 80%.

Nonetheless, Lionsgate/Summit Entertainment reported more than 3.2 million disc sales of The Twilight Saga: Breaking Dawn — Part 1 during the title’s first weekend of release — a tally that didn’t include 50,000 electronic sales and 80,000 transactional VOD sales.

Even Sony Pictures, which saw a 85% decline in studio operating income, said revenue increased 7.7% to more than $2 billion due in part to strong home entertainment results from The Smurfs.

Michael Pachter, analyst with Wedbush Securities in Los Angeles, said the evolving home entertainment channels represent to studios diversified revenue streams with higher margin revenue opportunities than theatrical.

“I completely agree that home entertainment is a bigger profit driver than theatrical,” Pachter said. “It’s clear that theatrical is not going to grow much.”

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Analysis: Disc Rental Profits Don’t Lie at Netflix

On its way toward streaming dominance an interesting old school reality has emerged in Netflix’s bottom line.

DVD and Blu-ray Disc rentals are delivering five times the profit margins compared with streaming. In dollars, that amounted to $194 million in profit for disc (52%), compared with $52 million (11%) for subscription video-on-demand (SVOD) in Netflix’s most recent fourth quarter.

The discrepancy underscores an inconvenient truth for Netflix. Namely that while the future may belong to streaming, the present still is very much a disc-driven business, no matter how much management wants to spin it otherwise.

The notion of all-you-can-eat streaming access to movies and TV shows for $7.99 a month may be nirvana to consumers. It also is a double-edged sword to content holders and over-the-top providers such as Netflix and Hulu. Selling the concept of low-cost SVOD is not nearly as difficult as making a profit off of it.

For Netflix, its singular creation of a streaming business coupled with tech buzz and outrageous stock valuation have made it both foe and favorite to media companies. The media companies are concerned about SVOD’s impact on traditional distribution channels while at the same time lured by its incremental largess.

The profit imbalance might explain why Netflix wanted to spin off its disc business in the ill-fated Qwikster platform debacle last fall. If the company mantra revolves around the notion that streaming is the future (which it is), it’s kind of embarrassing when the original business plan (by-mail disc rentals) just won’t retreat into the shadows.

Indeed, in Q4 (ended Dec. 31, 2011), Los Gatos, Calif.-based Netflix generated $847 million in revenue, which included $476 million from SVOD and $370 million from disc. Yet, physical rentals delivered $17.32 in profit per subscriber, compared with $2.40 for each streaming sub, according to Erick Schonfeld, who dissected the numbers in a story for TechCrunch.com.

“The new business kind of sucks,” Schonfeld wrote.

Netflix ended the period with more than 21 million streaming subscribers and 11.2 million disc subs, which included 8.4 million hybrid disc-streaming members. It’s the latter group that’s key to the imbalance since hybrid subs pay $15.98 per month to rent one disc (out at a time) and unlimited streaming. This is the equivalent to two separate streaming or disc subs paying $7.99 each. In other words, those 8.4 million hybrid subs generate the same revenue as nearly 17 million streaming members but with half the operating costs.

Why? Disc rentals involve variable costs such as postage (which is not insignificant) and physical handling at numerous distribution centers around the country. While the former — including the specter of the elimination of Saturday mail delivery — cannot be ignored, distribution centers largely figure costs already amortized. More importantly, content-license rights paid to studios for discs typically feature umbrella agreements for numerous titles. This is not true for the millions Netflix is shelling out to content holders for exclusive SVOD rights — much of it on an à la carte basis per title.

Netflix CFO David Wells says streaming margins are greater than those of disc due to modest credit card fees and related bandwidth and content delivery charges.

“The contribution margin is almost twice what it is for a DVD subscriber,” Wells told analysts Jan. 25. “So that's the way we think about it.”

Meanwhile, the burgeoning value of SVOD content rights are no more magnified than next month’s ending agreement between Netflix and Starz Entertainment. Netflix was paying about $30 million a year for access to select Disney and Sony movies, among others. That agreement, which apparently won’t be renewed, now would cost Netflix about $300 million annually going forward, according to analysts.

With Netflix management predicting a loss throughout fiscal 2012 as the company expands into Latin America, the United Kingdom and Ireland, the service would appear to be behind the eight ball justifying its content spend vis-à-vis streaming subscriber growth.

“We don't feel great about the profit stream we have for this [first] quarter,” Hastings told analysts. “And for the content to grow, it shows up in our profit stream. We hope to mitigate that, obviously, as we grow the subscriber base over this year and return back to break even and continued rapid international expansion.”

Yet, Hastings & Co. continue to give short shrift to disc rentals, including coveted hybrid subscribers — many who abandoned the service last fall after Netflix imposed a 60% price increase. On fan site HackingNetflix.com, Netflix’s indifference toward discs elicited puzzlement from subscribers.

“DVD's are essential to my subscription,” wrote bobodod.

“Why abandon DVD’s at all … if they can still make money on it?” wrote Daniel L. “DVD's are good for movies that should be both viewed with the best possible quality and with the proper audio/subtitles. Streaming is good for watching season after season of older TV shows, and movies that aren't worth quite worth the investment of getting the DVD.”

“Given that Netflix has done the hard work on building the support infrastructure (and a first-rate one, as far as I can see) to support disc distribution, I think it would be foolish to dismantle it too quickly,” wrote moom. “It sounds like there [could] be profits made with physical discs for many years to come.”

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Netflix Discs Fund Streaming

Netflix’s bullish stance on subscription video-on-demand long has excited technology pundits, analysts and helped drive expectations on Wall Street. It also undermines the service’s core value — by-mail disc rentals — which underscores what could be a very long, unprofitable year.

On the cusp of Netflix’s fourth-quarter financials Jan. 25, the Los Gatos, Calif.-based service is projected by Wedbush Securities analyst Michael Pachter to lose more than 3.6 million disc subscribers in the quarter — or about 8 million to 9 million in the second half of 2011.

In the third quarter, Netflix said nearly 14 million of its 23.8 million subscribers enjoyed the option of renting physical media — including 2.3 million exclusively.

Richard Greenfield with BTIG Research in an Oct. 25 blog reported that Netflix generated about $10.30 in monthly revenue per disc sub, compared with $7.99 per streamer. Indeed, nearly 10 million subscribers opted to exclusively stream in Q3 — a tally that is expected to increase to 12.8 million during Q4.

Meanwhile, Netflix subs choosing discs exclusively and/or with streaming is projected to top 11.6 million in Q4 as more than 3.1 million subs who preferred the option to stream and rent discs departed the service, due to the 60% price increase imposed last fall.

Who can blame them? For the past several years Hastings has steadily beat the drum that disc rentals were unimportant (and by extension its subscribers) to the company’s streaming future.

At the same time, Netflix needs packaged media’s revenue to help roll out its streaming empire, including service launches in the United Kingdom and Ireland this month.

“At this point, it’s a source of profits funding our international [streaming] expansion,” Hastings told analysts last October.

And if disc subs keep leaving, that foreign expansion cost gets incrementally bigger and bigger.

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