Netflix & Starz’s Breakup Highlights the Rising Costs of Netflix’s Growth

Starz has decided to break up with Netflix (NASDAQ:NFLX) and so the content partnership between the two that began in 2008 will likely end in Feb 2012. This implies that Netflix’s subscribers may lose a lot of Disney (NYSE:DIS) and Sony (NYSE:SNE) content as well as newer movies. We believe Starz is the most important source of newer movies for Netflix and so this split leaves a gap in Netflix’s offering that the company will look to quickly replace. ^[1]

In an attempt to quantify how much this relationship is worth, we look at our estimates of much Starz contributes to Netflix versus how it’s asking to determine if this move is justified.

Starz is Perhaps Demanding Too Much

Netflix stated that Starz accounted for 8% of total domestic viewing. ^[1] Let’s go ahead and say that this applies to the international subscribers as well for our back of the envelope analysis.

We estimate that Netflix’s content acquisition and revenue sharing costs will average about $1.6 billion per year for next 3 years based on our current subscriber growth assumptions and our forecasts that costs as a percentage of revenues will be around 23%, 25% and 27% over the coming 3 years. This latter assumption may ultimately need to be modified in light of recent content acquisition trends if Netflix pursues newer content aggressively.

Nonetheless, if we assume the cost of content should roughly equate to how much revenue it contributes, we can estimate that Startz content should cost about $130 million per year (8% of $1.6 billion).

According to The Wall Street Journal, Starz is demanding as much as a ten-fold increase in payments of around $300 million per year compared to its original deal of around $30 million annually. ^[1] This is over twice the amount of what we estimate to be a “fair amount” paid to Starz.

What Does This Failed Deal Tell us?

What can we learn from this ordeal? Clearly the cost of content is rising, especially the price of newer content. In the past agreement, Netflix was perhaps paying Starz too little but now Starz has overplayed its hand by asking for $300 million. On the other hand, it could be willing to act this aggressively if it feels that it could get a better deal elsewhere.

Since Netflix primarily distributes older content, this could also be a clear indication of the costs involved if Netflix wants to acquire and distribute newer content. Not only will this content be more expensive, but it will further threaten the pay-TV providers as it will give subscribers an incentive to drop cable subscriptions, for example, and subscribe to Netflix.

Starz has a fair amount of newer movies and could have been prompted to act more aggressively perhaps due to encouragement from cable companies that feel threatened by Netflix. This points to rising competition for Netflix that will lead to higher acquisition costs of new content.

See our note on Dish’s plans to stream Blockbuster movies in our note titled Dish Plans to Take on Netflix with Blockbuster Streaming Offering.

Our price estimate for Netflix stands at $221, implying a premium of about 5% to the market.

See our complete analysis for Netflix’s stock

1. Starz to Split From Netflix, The Wall Street Journal, Sept 2 2011 [↩] [↩] [↩]