How The New Deal With Virgin Media Helps Netflix

Netflix (NASDAQ:NFLX) has bagged a unique deal in the U.K. and its services will now be offered by Virgin Media to its pay-TV customers. ^[1] This essentially demonstrates that online streaming can be complementary to traditional pay-TV services rather than being a competitor. This is something we have advocated for a long time. The partnership with Virgin Media will expand Netflix’s subscriber base and potentially save marketing costs. Virgin Media has 3.77 million subscribers in the U.K., but only 1.7 million of them have TiVo set-top box, which is a necessary requirement for browsing through and watching Netflix’s collection in this case. ^[1]

If successful, this could pave the way for more such deals and give a strong boost to Netflix’s business in Europe. The company is still unprofitable in international markets due to high content costs. These costs are fixed in nature, and Netflix can gain strong operating leverage by simply adding more subscribers. This is where such deals with pay-TV operators can come in handy.

The recent spat between Time Warner Cable (NYSE:TWC) and CBS (NYSE:CBS) as well as the possibility of Dish Network (NASDAQ:DISH) dropping Disney’s (NYSE:DIS) channels (read Will Dish Dump Disney Over ESPN?) suggest that the pay-TV operators may become more flexible about their content choices. Carrying a subscription based online video service such as Netflix can help them retain their appeal to customers in a scenario where they have to drop certain popular networks due to pricing disputes.

See our complete analysis for Netflix

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Such Deals With Pay-TV Operators Can Help Netflix Control The Rising Content Costs

Partnering with an established pay-TV operator will create an entity that will havestronger negotiating power over the content owners. This can help the company reign in its content costs and achieve profitability in international markets sooner than we expect.

Netflix’s content costs have risen substantially over the last few years due to its efforts to expand its streaming library both in the U.S. and international markets. Back in 2011, Starz was demanding as much as a ten-fold increase in payments for the renewal of its content contract with Netflix. This would have amounted to an annual payment of around $300 million compared to its original deal of close to $30 million. This is a classic example demonstrating how streaming content costs have skyrocketed in recent years as competitors are bidding up prices and media companies are realizing the value of their content.

Netflix has been adding some original and exclusive programming to its streaming library which seems to be paying off. The company has effectively marketed these exclusive shows to maintain its subscriber momentum. However, such content does not come cheap, which is evident from the significant jump in Netflix’s streaming content costs, overall content costs and streaming obligations over the last two years. The trend has continued in the first half of 2013 as well. It is estimated that Netflix is paying somewhere around $4 million per original episode.

The Deal Will Help The Company Stay Ahead Of Amazon In Europe

A deal with Virgin Media will give Netflix wider reach and more visibility and help it maintain its lead over Amazon’s Lovefilm

Amazon is arguably Netflix’s toughest competitor due to its reasonably large content library, strong spending capacity and presence in Europe.  The company acquired Lovefilm in 2011 to mark its foray in the European market, which later attracted Netflix as well. Amazon had over 22,000 titles in its streaming library in August 2012, which represented 70% growth in 2012 alone. ^[2] By the end of June 2013, the number of streaming titles increased to 41,000 representing an annualized growth of roughly 100%. ^[3]

Amazon continues to strike new deals and is placing greater emphasis on kids-focused programming. The company mentioned that such programs are one of the most watched TV genres on its Prime video service. In the recent months, several analysts have attributed the decline in TV ratings of Nickelodeon to more kids watching programs on alternative platforms such as Netflix. This again reinforces the popularity of kids-focused content on the Internet. Amazon can leverage its recent deal with Viacom to add more content to its Lovefilm service in Europe. Besides this, Amazon Studios, the company’s original movie and series production arm, has been working on bringing more original content to Amazon Prime’s arsenal.

Our price estimate for Netflix stands at $163, implying a discount of about 45% to the market price.

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Notes:

1. Netflix Added to Virgin Media U.K. TV in Industry First, Bloomberg, Sept 10 2013 [↩] [↩]
2. Amazon Prime Crosses Big Milestone: More Items Are Now Shipped with Prime Free Two-Day Shipping Than with Free Super Saver Shipping, Amazon Press Release, Aug 27 201 [↩]
3. CBS’s Under the Dome Now Available for Exclusive Online Subscription Streaming on Prime Instant Video, Amazon Press Release, June 28 2013 [↩]