#Netflix: to exit or not to exit?

Netflix’s stock price (Nasdaq: NFLX) was up more than 19% in the latest after hours market trading due to beaten Q3-2016 earnings and subscriber expectations.

In fact, the streaming company generated net income of $51.5M, up 75%, or 12 cents a share (vs 6 cents expected) vs the period last year, on revenues of $2.29B (vs $2.28B expected), up 31.7%.

Just as important: streaming subscriptions beat forecasts. Netflix ended the quarter with 47.5 million domestic subs, an addition of 370,000. International was up 3.2 million to 39.25 million. They expect to add 1.45 million domestic subscribers by year end, and 3.75 million internationally.

“We are now in the fourth year of our original content strategy and are pleased with our progress,” CEO Reed Hastings and CFO David Wells say in a letter to shareholders. “In 2017, we intend to release over 1,000 hours of premium original programming, up from over 600 hours this year.”

All told, “we will continue to operate around break even, and then start generating material global profits in 2017 and beyond, by marching up operating margins steadily for many years.”

The execs reiterated their plan to raise debt “in the coming weeks” to support their expansion plans. The company had $14.4B in streaming content obligations at the end of September, up $1B in the quarter due to “the addition of both new original and non-original content to our library as well as expanded rights for our new territories.”

Netflix expects to spend $6 billion next year for content.

“Over the long run, we believe self-producing is less expensive (including cost of capital) than licensing a series or film, as we work directly with the creative community and eliminate additional overhead and fees,” the company note says.

However, if the post-market increase in the stock price holds tomorrow, then Netflix shares will be back to where they traded around the beginning of the year. Based on today’s closing price, the company is down 12.8% in 2016.

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Despite the shift toward original content continues, Netflix is still starving for cash. Net cash used in operating activities was $462M in Q3-2016 and Non-GAAP free cash flow was negative $506M, which means that the company is burning cash every quarter, reason why they need to issue new debt. Proceeds from issuance of new debt was $1.5B in 2015, it is still none so far in 2016.

“With a debt to total capitalization ratio of about 5%, we remain underleveraged compared both to similar firms and to our view of an efficient capital structure.” – they say in the letter, but that can be as well read as an admission of financial struggle.

Netflix still uses the majority of their revenue to pay studios for licensing agreements– The Wall Street Journal reported in 2015 that of the Major Three, Netflix had planned on designating the most funds toward acquiring content, more than what Hulu and Amazon had projected on spending, combined – so its profit margins are low because they forfeit a lot of said revenue to overhead, distribution, and operating expenses. The ability to acquire strong content also depends on the willingness of producers to accept lump sums without any back-end.

The shift toward original content began in 2011 with a $100 million, 26-episode bet on ‘House of Cards’ which may however actually be seen as a shortsighted move since it did not entail their international expansion strategy because they left on the table the foreign rights to the producer MRC Studios.

Most of the content that Netflix brands as “original”, is actually licensed exclusively for SVOD exploitation, so if they want to control worldwide rights they will need to pay substantial sums, usually at least 120% of the production budget.

To be precise, in a negative pickup deal the show is never physically made by the network but by an associated production company, which in the studio model can be affiliated to the distribution entity. The same dynamic has allowed Netflix to neatly insert itself into the television ecosystem, first by licensing shows for online streaming, and then by simply joining traditional cable and broadcast networks as a fellow buyer. But the scenario leaves Netflix with being nothing more than a distributor, securing programs for a fixed period of time before agreements lapse and competitors have the opportunity to step in. By producing its own content from development to release, Netflix could ensure its new shows remain on Netflix and only on Netflix, an increasingly vital point as the dynamics in the streaming space shift more toward a battle for exclusivity. But they will need to form strong financial alliances and output deals, just like the major studios do.

Netflix seems now to be nearing its startup peak: so to exit or not to exit? They can certainly enlarge their customer base, especially internationally, but can they keep making/licensing great original content that drives organic growth without a studio/conglomerate attached? Data intelligence certainly helps.

As they increasingly rely on debt, and following the announcement of the exclusive streaming deal with Disney and the strong and reinforcing creative ties with Marvel TV, we may argue that we have a prime suspect. Nevertheless, for the love of innovation we should probably hope that they can stay independent and keep breaking rules for much longer.

The current enterprise value of Netflix is $44.04B or about 140.34x EBITDA (vs Amazon’s $391.46B or 37.97x, or Apple’s $656.17B or 8.87x), its trailing P/E is 311.88 (vs Amazon’s 202.18, or Apple’s 13.70).

 

Sources: Netflix IR, Yahoo Finance.

p.s. for past analysis of Netflix check The FlixBiz.

It is about time for a #DigitalSingleMarket in #Europe

Europe is finally waking up and realizing that in order for the digital market to flourish, barriers need to be demolished. If European Union was created for the free circulation of men and goods, one cannot understand why it is not so in the digital space.

The plan to create a Digital Single Market within the 28 EU countries has been unveiled, with the goal of “bringing down barriers to unlock online opportunities”.

The three policy areas that have been identified by the Commission are:

  1. better online access to digital goods and services;
  2. an environment where digital networks and services can prosper;
  3. digital as a driver for growth.

The proposals, which will be on the agenda of the European Council meeting on June 25-26, have already attracted criticism: Robert Atkinson (@robatkinsonitif), President of Washington-based think tank the Information Technology and Innovation Foundation, says Europe would create an isolated market at the expense of the global digital economy, whereas Reed Hastings (@reedhastings), CEO of Netflix, says they are already solving the problem of making the content accessible worldwide at the same time commercially (source: The Hollywood Reporter).

However, the main point here is in fact creating an open and more fertile market that would also benefit the global digital economy, enhancing the circulation of content and therefore empowering the internal market for digital goods, including entertainment, and therefore giving consumers the possibility to choose from more than one content provider. This is what “open market” means. Creative Europe (formerly known as Media Programme) the programme for “supporting Europe’s cultural and creative sectors”, is already working in this direction since 1991, with a budget of €1.46 billion for the period 2014-2020.

Others, such as Randy Greenberg (@RandyGreenberg), Managing Director, Entertainment Content & Investment Strategy at The Greenberg Group and Instructor of Business of Entertainment at UCLA, as well as former SVP International Theatrical Marketing and Distribution at Universal Pictures, have argued that the immediate effect would be the end of the licensing territory by territory and a substantial drop in audiovisual content sales price because a handful of big buyers would emerge to dominate the Old Continent market and drive the smaller ones out of business, which will in turn cause content pricing to drop and ultimately overall revenue for the film and television industries to fall, not only in the digital market, but also in the traditional media and the theatrical distribution as a consequence.

True, it can be reasonably argued that the existence of more powerful buyers could ultimately drive content prices down for the Studios because of a diminished (or, better balanced) contractual power. However it could as well mean the opportunity for European content producers and distributors (as well as for digital startups) to benefit from a stronger internal market and flourish, starting from the digital space. Antitrust law enforcement will hopefully ensure that such power does not grow beyond control jeopardizing consumers.

digital-europe

In addition, as explained by Andrus Ansip (@Ansip_EU), the European Commission’s vice president in charge of the digital single market, a borderless Europe would not mean an end to territorial licensing – selling the rights to a film in various territories on an exclusive basis — or windowing, the system whereby a movie is released in stages on different platforms, from cinemas, to VOD to television. “We do not want to change the system or principle of territoriality,” Ansip said. “We are in favor of the principle of territoriality, but I am not accepting absolute territorial exclusivity.” Furthermore, the planned measures would be nurturing cultural diversity – while opening new opportunities for creators and the content industry. At the end of the day, Europeans will still be very different within each member state, and therefore they will keep liking different kind of content from local producers and distributors.

According to the European Commission, tearing down regulatory walls and moving from 28 national markets to a single one of more than 500 million potential customers could contribute €415 billion per year to the European economy and create 3.8 million jobs.

All in all, it is reasonable to claim that such measures would enhance the circulation and monetization of digital content, should help European digital businesses to grow, balance the power of the Studios as well as of digital e-commerce giants such as Amazon and eBay that by the way already operate cross-borders enjoying the benefits of tax havens such as Ireland and Luxembourg. Finally, increasing the accessibility by eliminating geo-blocking and harmonizing copyright laws wold also have the incredibly positive effect of helping to fight piracy.

Netflix valuation, a House of Cards?

Worldwide fans of Congressman Francis Underwood’s adventures are going nuts for the release of Season 3. Yet the market is not impressed: NFLX share price dropped by 1.68% on the same day.

In fact, analyst widely agree Netflix current valuation (Nasdaq: NFLX) depends heavily on its ability on creating quality original programming and marketing them effectively. The uncertainty on future strategy which causes high volatility and recently determined a fully recovered sharp 26.4% drop needs to be addressed more clearly.

Netflix said its 320 hours of original programming in 2015 actually cost less than most of its licensed content. “We try to make each project more efficient and effective than studio content we’d otherwise be licensing,” the company said in its fourth-quarter investor letter.

house-of-cards-season-3-teaser

For its part, Netflix has been transparent about its ramp-up in spending for original content that brought 45 Emmy, 10 Golden Globe and two Academy Award nominations and several wins in just two years. “We will continue to grow the percentage of our content spending dedicated to originals for the next several years,” the company said. “This will mean more cash usage, which means more debt.” Looking at the number of shows, basically every four weeks we’re going to have something new and fresh to watch on Netflix with House of Cards-like quality. But financially this means using cash and increasing debt for pushing a complicated international growth that is at the moment the most credible growth strategy.

It has also been noted that while concerns over profitability and negative free cash flow appear to be an afterthought for investors right now, at some point that attitude will shift and when that happens, we can expect Netflix shares to trade down significantly from their current levels at 109.84 P/E ratio.

Nevertheless, the recent ruling in favor of net neutrality, the principle that Internet service providers and governments should treat all data on the Internet equally, was a big win for Netflix as product and for the digital distribution sector in general, since ISPs will not be able to discriminate or charge differentially by user, content, site, platform, application, type of attached equipment, or mode of communication.

Season 1 and 2 of House of Cards helped the streaming giant adding globally a total of 3 and 4 million subscribers respectively, whereas the main effect of the new season may be the retention of current customers rather than new subscriptions. The growing curve is slowly flattering and Los Gatos should open up new business opportunities in order to build up new revenue streams if they want to survive the increasing competition, from legal players as well as from piracy, which also causes higher marketing expenditure. One direction could be finding a way to exploit the potential synergies with theatrical day-and-date releases as they are going to do with Crouching Tiger, Hidden Dragon II: The Green Destiny.

#RomaFF9 showcases new patterns of film distribution

The ninth edition of the Rome Film Festival is coming to an end having showcased some interesting new patterns of film marketing and distribution.

The film market named The Business Street has brought to Rome 811 professionals, of which 295 buyers, 104 world sales agents e 246 producers from 52 countries, with a 30% increase of international participants (35% more buyers and 14% more world sales agents). A very needed initiative for boosting the film business.

the-business-street-2014

Among the main happenings, the panel organized by Europa Distribution has been a unique occasion to discuss and dissect the new trends of digital distribution, focusing on how professionals in different territories implement and define different strategies to keep up with the pace of an industry that is in constant change. As consumers have drastically changed the way of watching films and have risen their expectations on availability of content, professionals have had to re-think their communication strategies and look for new ways to communicate with the audience. These new challenges have paved the way for innovative and creative marketing and distribution strategies, designed to increase the audience reach both in cinemas and across additional platforms.

Tim Grady, President of Adopt Films, has pointed out that ideally VOD shall come one week after theatrical, while everything needs to be curated, as there is so much content. He highlighted the importance of non-theatrical releases, even though, regarding day-and-date, distributors like IFC and Magnolia can easily do day-and-date because they own theaters, whereas others cannot unless they rent the theaters. As far as Netflix, he says it is a safety net for independents.

Somehow forced by the sluggish Italian market to have a different and more conservative approach is Stefano Massenzi, Head of Acquisitions and Business Affairs at Lucky Red. He says that local exhibitors want at least 15 weeks between theatrical and digital release and they would like to get a cut of VOD revenues in exchange for shortening the windows but distribution cannot agree upon the deal because it already pays advertising and VPF and that is enough.

Differently, Katie Ellen of the British Film Institute and Madeleine Probst of Watershed Cinema have pointed out that exhibitors must take risks if they want to flourish and work in synergy with VOD creating a halo effect for it, whereas Kobi Shely of Distrify has added that VOD helps understanding who the audiences are thanks to big data.

The VOD in Europe is growing and therefore digital distribution is by far the hottest topic to discuss at the moment.

Trends-of-the-European-Market

The conference Audiovisual market and regulation: an industry at crossroads, hosted by the Italian Presidency of the Council of the European Union and organised by the Directorate-General for Cinema of the Italian Ministry of Cultural Heritage and Activities and Tourism, has provided an opportunity to discuss the changes that need to be made to the European regulatory framework in the light of the changing scenario, paying particular attention to technological developments, the role of new players, future business models and the status of independent audiovisual producers.

It has been pointed out that the arrival of new players such as SVOD platforms is going to change the role of typical film producers, who are going to become crossmedia producers and experiment new forms of creativity. For instance, Netflix opens up new opportunities for local producers because they need to connect with local audiences.

It is also going to change the role of theaters, which will be the place for exceptional experiences and social gatherings, while pan-European day-and-date releases experiments show a low rate of cannibalization and increased availability of movies and global audience.

The main pros of digitization has been found to be new alternative production formats associated with lower costs, new alternative release and marketing strategies, larger consumption of audiovisual products, whereas cons may be piracy and changing consumption habits connected to a generally lower willingness to pay for quality content. The main trends observed in the audiovisual market in the latest five years show EU market share down from 20.7 to 15.4 percent, US market share up from 59 to 68.8 percent, and physical home video decline not compensated by digital.

Christoph Schneider, MD of Amazon Instant Video Germany added that free TV is benefiting from having previews on new digital non-linear services because this creates awareness, whereas YouTube’s representative underlined how they are opening up opportunities for the film industry through creating engagement, and BskyB’s Director of Policy and Public Affairs, David Wheeldon highlighted that they have been offering new online services in addition to the traditional ones and they have been very successful. Christopher J. Dodd, former US Senator and now CEO of MPAA has said that disruption is the opportunity as Netflix has invested $7B in feature production, while 50B films and 56B series were consumed digitally in a year, even though a better and more productive dialogue between content and tech providers is needed, and also search engines need to cooperate not driving traffic toward illegal services.

Many rules and regulations that apply to linear players do not apply currently to non-linear services: for instance, advertising and restrictions of audience, hate speech rules, promotion of european works. Authors want their cut of the pie and share risks and benefits as much as they are the production level. Both production and distribution will increasingly be driven by big data, but level of requirements are currently quantitatively different for linear and non-linear services.

netflix-europe

Meanwhile, the difference between broadcasters and non-linear services is fading, as some pay-TV distributors try to compete on the SVOD market: for instance, BSkyB with Sky Now, Canal Plus with Canal Infinity, HBO with HBO Go, CBS, and even smart TV producers such as Samsung and Sony push content to audiences, therefore acting by regulation as service providers, perhaps. Meanwhile, piracy and copyright are crucial issues to address. Most of the pay-TV distributors will look for deals with Netflix, but they will probably continue to provide their own transactional VOD service or third service.

AVMS (i.e. AudioVisual Media Services) that offer OTT services (e.g. Netflix) are covered by the directive because they exercise editorial responsibility over the content: the debate is whether the directive should also cover other internet gatekeepers such as Google. The art.13 of the directive imposes to promote European works on the platforms but it is not clear as of how to do it, therefore this is up to the member States (e.g. a section for European works, a section in the home page, financial obligations, or a percentage in the catalogue). Obligations are currently applied depending on where the service is based, not upon where it goes to (e.g. Netflix is based in Luxembourg).

The best method for promoting European works is considered to be marketing effort, whereas financial contribution to production funds makes sense, according to VOD operators, only if they get something in exchange such as exclusive licenses. Also, a question should be asked as if theaters do not have (at least not in every Country) quotas, why should VOD operators do? One thing is sure, there is a mandate from the European Union to foster creative industries, production, audience development.

It has also been acknowledged the positive effect of fiscal incentive schemes supporting film and audiovisual productions in Europe, such as tax shelters, rebates, tax credits, together with slate funding mechanisms both from the EU, the States and the Regional funds: in particular, there has been some movement away from a tax shelter model, which is less transparent and has historically seen abuse, even though it has the advantage to provide cash flow during production.

franceschini

The Italian Minister of Culture, Dario Franceschini has closed the conference saying that we need rules at the global level or the market will be easily dominated by global players that skip national or even continental regulations, that cultural exception is useful to protect national identities, that we need to improve the connection with audiences and the international circulation of works, because creative industry is the main strategic sector for Europe.

All in all, a flexible mindset is needed to operate profitably within the changing film industry, whereas a set of rules may help to guide the flow if there is clear evidence of necessity.

Some painful after-hours for Netflix

Netflix (Nasdaq: NFLX) shares fell 26.4% to $330.00 in recent after-hours trading, offsetting the 22% rise in 2014. Wow.

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Reed Hastings, CEO of Netflix

Why?

  1. Subscribers. The Los Gatos, CA company released a Q3-2014 financial report showing that the company has grown to 53.1 million total members worldwide, but the addition of 3.02 million subscribers in the third quarter fell below the company’s previous prediction of 3.69 million. The reason for this is partially due to the price increase of $1 a month to $8.99 which “appeared to be offset for about two months by the large positive reception to season two of [its series] ‘Orange is the New Black.’” says Reed Hastings, CEO. This means their customer base is very sensible to price changes, and this limits their ability to increase investments importantly. Furthermore, the forecast was missed both regarding the US (980,000 vs. 1.33 million) and the international markets (2.04 million vs. 2.36 million).
  2. Financials. Netflix reported a profit of $59.3 million, or 96 cents a share, up from $32 million, or 52 cents a share, a year earlier. However, Netflix is only predicting earnings of 44 cents per share for the current quarter, which is far below the 91 cents per share that analysts had predicted, a 44% drop compared with last year’s fourth quarter, as losses in its international segment widen due to its aggressive European expansion. In September, Netflix launched in six additional European countries, including France and Germany, and this led to (narrower-than-expected) losses of $31 million in the international segment, even though they declare that the international markets it launched before this year—places like Canada, the Netherlands and countries in Latin America—are now collectively profitable. Besides marketing expenses and technology investments, Netflix’s costs are growing as it seeks to become a global service. Netflix’s streaming content obligations rose nearly 37% to $8.9 billion, driven by new content deals it entered in the quarter as part of its European expansion.Nevertheless, the company’s closely watched total streaming contribution margin rose to 18 percent from 10.4 percent a year ago, but Netflix also reported that it burned cash in the third quarter, to the tune of $74 million.
  3. Competition. Hours before Netflix released its latest financial report, Time Warner and HBO announced that the latter’s online streaming service, HBO Go, will be offered as a standalone option starting next year – something cord-cutters everywhere have been clamoring for in recent years. Netflix said it expects people to subscribe to both HBO and Netflix, since the two have different shows. It is “likely we both prosper as consumers move to Internet TV”, a market that has been growing consistently: nearly 45 percent of Americans stream television shows at least once a month – a figure that is expected to jump to 53 percent by 2018, according to eMarketer research, whereas Europe is also moving fast.  Netflix has grown to become the biggest stand-alone subscription programming service in the U.S., with 36.3 million paid members. HBO had 30.4 million at the end of the second quarter, according to SNL Kagan. While it has bigger profits than Netflix, HBO has been growing slower in terms of revenue. That is largely because HBO is a mature business while Netflix is still pursuing a costly global expansion. HBO’s operating income for the quarter ended in June was $548 million, while Netflix’s in the third quarter was $110 million. Mr. Hastings reiterated in the interview that the company plans to “take all of our profits and put them into international expansion” because “we see it as such a big opportunity.” The online content provider operates in about 50 countries.
  4. Bold announcements. Last but not least, a volatile market usually gets nervous and suspicious in front of bold announcements coming from a risky business. In fact, in the latest days the company announced a series of wave-making deals in the quarter, including a global licensing deal with Warner Bros. for the Fox series “Gotham.” The company also said it would back the sequel to Academy Award-winning “Crouching Tiger, Hidden Dragon” in a deal with Weinstein Co. allowing for Netflix to premiere the martial-arts movie on the same day it is released in select IMAX theaters world-wide, and causing the protests from many important theater owners. Netflix additionally struck a deal with comedian Adam Sandler to back four new feature films that will be exclusive to Netflix. And, in June, Netflix signed a deal with comedian Chelsea Handler to produce multiple stand-up specials for the site as well as a new online talk show. In addition, immediately after the HBO announcement, they said they will start streaming all 10 seasons of Friends, starting in January, and has also been rumored to be in the running for streaming rights to Seinfeld. Well, to an expert opinion, it may sound a little bit like they are trying to debunk the attention from the facts and figures.

All in all, the lesson here may be as follows: never raise expectations too high or the risk is a painful fall.