In its quest for better content and to keep customers satisfied, Netflix (NASDAQ:NFLX) started 2013 by signing a deal with Time Warner’s (NYSE:TWX) Warner Brothers group to make some of its shows available to its subscribers.  While the deal indicates that the company’s content costs will continue to remain high, the quality of Warner Brother Televisions Group is unparalleled and will give Netflix a distinct advantage over its competitors if it can grab some exclusivity or have the first mover advantage.
Content Costs Continue To Rise
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We estimate that Netflix’s overall content acquisition costs (as % of total revenues) have skyrocketed from about 22% in 2011 to close to 44% in 2012. This was expected as the company needed plenty of content to make a compelling offering in new geographies that it expanded to. After its foray in Canada in 2010 and Latin America in 2011, Netflix expanded to the U.K., Ireland, Denmark, Norway, Sweden and Finland in 2012.
However, the international expansion is not the only factor driving the content costs higher. The increasing competition in the U.S. is another reason why Netflix will have to try harder to keep subscribers interested and loyal. Amazon (NASDAQ:AMZN) has made significant progress in improving the online video content of its streaming service. Amazon Prime had over 22,000 titles in its streaming library in August 2012, representing 70% growth in 2012 alone. The company further signed a deal with Epix in September 2012 to add 3,000 more titles to its library, bringing its total to 25,000.
The Advantage Of Having Warner Brothers’ TV Shows
The success of Warner Brothers is evident from the fact that its TV show production & licensing revenues increased from $3.05 billion in 2008 to $4.24 billion in 2011. The increase has been fairly consistent and we expect this trend to continue. For 2011-12 season, Warner Brothers Television Group produced some of the famous TV shows such as The Big Bang Theory, Two and a Half Men, The Vampire Diaries, Gossip Girl and more. For this season’s upfront market, the group has received programming orders from broadcast networks for 16 returning series and 9 new shows.  It has also produced two shows for NBC, which are partially responsible for NBC’s fantastic performance in the new TV season.
If Netflix can grab some sort of exclusivity for Warner Brothers’ shows or just have the first mover advantage, it will give it a competitive edge. As customers look for streaming options, the quality of the content is the single biggest deciding factor along with the price. Netflix already has a reasonable pricing structure and what remains to be seen is whether that pricing can continue to support its heavy investment on the content front.
Our price estimate for Netflix stands at $81, implying a discount of about 15-20% to the market price.Notes: