Will Netflix Feel the Squeeze From Higher Streaming Costs?

Online movie rental company Netflix’s (NASDAQ:NFLX) digital content costs are poised to rise.  If we compare the movie licensing terms that  Netflix  negotiated with Starz in 2008 to what the company recently agreed to pay Epix (a network launched by Paramount, MGM and Lionsgate), it seems likely that acquiring quality streaming video content will only grow more expensive going forward.   Streaming digital content is a crucial part of Netflix’s strategy and an area in which the company is facing growing competition from players like Redbox, Hulu and Comcast’s Fanbox service (NASDAQ:CMCSA).

Does the Epix deal make sense for Netflix? Below we compare the deal terms to Netflix’s historical content acquisition costs and analyze the potential impact on the company’s stock.

Epix deal raises Netflix’s content costs

Netflix has been paying Starz $30 million a year  to license online distribution rights to a few thousand movie titles. By contrast, the company’s recent licensing deal with Epix requires it to pay $1 billion over five years, suggesting average annual payments of $200 million. The deal gives Netflix online distribution rights to about 1,500 movie titles, including hits like Indiana Jones, Star Trek and the Godfather series.[1]

The $200 million annual fee to Epix deal approaches Netflix’s total estimated content acquisition costs for  2009 which were just over $240 million [2]. This figure excludes Netflix’s revenue-sharing costs, which totaled about $240 million for 2009.

Excluding the impact of the Epix deal, we would expect the company’s content acquisition costs to amount to about 13.5% of revenues going forward.  However, Epix licensing fees could push these costs up to as high as 18% to 20% of revenues, resulting in a potential 12% downside to our price estimate for Netflix.

You can drag the trend-line in the chart above to create your own forecast for Netflix’s content acquisition costs as a percentage of revenues, and see how it impacts the company’s stock price.

Some costs could be offset by a faster shift from DVDs to streaming

The rationale for spending so heavily on Epix content is obviously to encourage more rapid customer adoption of streaming video delivery (as opposed to physical DVDs) by consistently improving the quality and quantity of Netflix’s online catalog. If the movies that Netflix licenses from Epix help stimulate this shift, the number of DVDs mailed per subscriber could decline faster than we expect, thereby offsetting some of the increased content costs by reducing the amount of money that Netflix spends on physical content delivery (in form of DVD shipments).

You can modify our chart above to see how Netflix’s stock is dependent on DVDs mailed per subscriber.

And you can see the complete $85 Trefis price estimate for Netflix’s stock here.

Notes:
1. (WSJ) Netflix’s Achilles Heel: Content Costs?
2. Estimated based on information in SEC filings and Investor Presentation