#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.

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Fancy a negative pickup?

Superman, The Empire Strikes Back, Never Say Never Again and Lone Survivor. What do these films have in common?

They were all financed and distributed according to a negative pickup arrangement. Even Terry Gilliam’s Brazil, a negative pickup for Universal Pictures produced by Arnon Milchan: in this particular case, the studio had creative disagreements with the director over choice of star, content, and duration, and failed to resolve these issues to its satisfaction, because the negative pickup had essentially granted Milchan final cut.

The negative pickup is a type of film financing arrangement, an interparty agreement in which the parties involved are bank, completion guarantor, producer, and distributor, usually bank financed with the collateral being a Distribution Agreement from a trusted and creditworthy Distributor or Studio then owning distribution rights upon delivery of a completed film negative by a stipulated date and in accordance with the terms of the agreement, where the pickup price shall include cost of budget (which has to include a completion bond which premium usually amounts 3-5% of the production budget and contingency), cost of interest, origination fee, bank and legal expenses.

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Superman (1978)

The Producer, having agreed to sell distribution rights for certain territories to a Distributor (or two, in the case of a split rights deal where one gets domestic and the other international rights) who has in turn agreed to pay on delivery within the Distribution Agreement, borrows funds for production to be repaid on delivery from a Bank within the Loan and Security Agreement, whereas a Completion Guarantor oversees production and has right of takeover within the Producer’s Agreement, and agrees to guarantee delivery per Distribution Agreement or repay the bank within the Completion Guarantee.

The interparty agreement defines effective delivery, inspection, quality control (usually 10-14 days), cure periods (usually 10 days) and arbitration procedures (a period of time that bears interest) as defined by IFTA if Distributor, Producer and Completion Guarantor argue over whether effective delivery has occurred or not, and thereby who repays the Bank, the Distributor if effective delivery has occurred or the Guarantor if it has not, and at that point the Guarantor owns the film. Therefore the Guarantor has both Preliminary (Production Analysis) and Balance of Requirements (Document Analysis) and reviews all the related documents before issuing the bond: the Guarantor does not like essential elements (e.g. stars), and also can stop enhancements (additional items added to production) and force the producer to pay from his own salary.

Pre-sales is a variation of negative pickup in which distribution rights are sold territory by territory resulting in multiple Distribution Agreements that are used as collateral for the loan, where there is usually a Minimum Guarantee plus revenue share arrangement for each primary territory (secondary territories are usually not accepted as collateral), an advance paid immediately and the rest upon delivery, there is usually one or more sales agents who get a 10% fee collectible once the bank has been paid back (so agents usually oversell till 120% to get their fees), unsold territories can be added up as collateral paying an extra interest on the gap and usually only if they are worth twice the financing gap and such gap does not exceed 20%.

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Brazil (1985)

A negative pickup arrangement reduces the downside risk for investors that the film does not find a distributor at all, perhaps because it is not as good as anticipated, from the studio’s point of view it is not taking much risk because if the negative is not delivered or delivered not exactly as agreed, then the studio has no obligation, and safer also for the producer because such requirements are purely contractual and not regarding artistic value of the work. Furthermore, the distributor does not share the risk that the film goes over budget, since a completion guarantee will have been provided, the producer may get a better deal from competing distributors upon a potentially good film, and it enhances foreign sales potential. However, the producer still has to obtain financing from sources other than the studio or distributor that is a bank or other investors; also, the arrangement embeds a risk/reward ratio in the sense that the more risk the producer assumes relative to the distributor, the better deal the producer will be able to negotiate, and is potentially less rewarding for the producer and less expensive and somehow speculative for the distributor, requiring complex transactions and high therefore high transaction costs, thus definitely belonging to producers with a proven track record, major and trusted distributors and a relatively small circle of qualified professionals and financiers.

#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.