Is the market reaction to Netflix’s (NASDAQ:NFLX) recent deal with Disney warranted? Netflix recently outbid even the pay-TV networks to grab exclusive rights to some of Disney’s (NYSE:DIS) content.  And the market rewarded the streaming company for this move with the stock soaring by nearly 15% before settling down. While this is a bold move and certainly bolsters Netflix’s content, the market seems to be ignoring the associated risk. Netflix is not only paying too much but also positioning itself as a competitor against pay-TV channels.
The Deal Is Expensive, Is It Worth It?
Currently, Liberty Media’s premium network Starz holds the rights to air Disney’s movies after their theater run. This contract expires in 2015 and Netflix has grabbed the rights for the following 3 years. Netflix’s subscribers will be able to watch Disney’s newly released movies as soon as 7 months after they are released in theaters. The deal is exclusive and a further step to bring unique and fresh content to the company’s subscribers. And as always, such deals don’t come cheap. It is estimated that Netflix may be spending between $300-500 million per year for this deal and that’s a lot!  It appears that the market is only looking at content addition and ignoring the expenses associated with the deal.
Netflix could have gained similar content by re-negotiating with Starz earlier this year, but the talks didn’t materialize. At that point, Netflix stated that Starz content was a small portion of its total subscriber viewing. If that was the case, why is it spending so much for that small portion now? One answer is that Netflix finally realized Starz content was worth more and that it could perhaps entice more subscribers by including Disney’s content which no doubt has good demand.
Other reason is to gain a strategic advantage. A deal directly from Disney, and not Starz, implies that the content will be exclusively on Netflix and not a duplicate copy of pay-TV content. This could give subscribers a reason for not dropping Netflix as they can expect newer movies frequently coming to Netflix. This can reduce the churn and improve the subscriber outlook for the company.
Rising Content Costs
Netflix is already facing high content acquisition costs. These costs have jumped from 13% in 2009 to an estimated 44% in 2012 (not taking into account content costs related to the revenue sharing model that the DVD business employs). A lot of this can be attributed to the company’s aggressive international expansion which is putting severe pressure on its overall profits. Expensive deals such as the recent one with Disney can exacerbate this effect. Content obligations can rise, thus making Netflix a less attractive acquisition candidate. This is important because acquisition is one way the company can continue to prosper given the emerging competition from giants such as Amazon (NASDAQ:AMZN), Verizon (NYSE:VZ), Blockbuster and Comcast (NASDAQ:CMCSA).
Our price estimate for Netflix stands at $81, implying a slight discount to the market price.Notes: