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.

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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.

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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.

“Netflix rhymes with Wet Chicks” for Sandler, means an opportunity for all

Any game changes and evolves, so players’ attitude, and laws and regulations need to evolve accordingly.

The primary game changer Netflix has just announced, right after declaring that the first day-and-date worldwide release of a blockbuster will happen soon, that they are going to produce and distribute as soon as 2015 four feature films starring Adam Sandler, therefore coining the term web film, which is a film meant specifically for online distribution.

Said Sandler: “When these fine people came to me with an offer to make four movies for them, I immediately said yes for one reason and one reason only: Netflix rhymes with ‘wet chicks.’ Let the streaming begin!”

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We’ve seen Netflix give TV a run for its money with a number of well-worth-watching original series, including House of Cards, starring Kevin Spacey, and prison-set dramedy Orange is the New Black. Now it seems the streaming video service has set its sights on the big screen… ish. And this means, for some, that they are continuing to thumb nose at theaters.

Well, probably. But first of all it means adding opportunities for talents. Ok, not everyone is Adam Sandler: the actor’s films, most of them comedies, have grossed more than $3 billion globally, and he is going to keep his agreement with Sony, while his films consistently rank among the most viewed by Netflix members, both in the U.S. and overseas. Therefore Netflix is prepared to pony up as much as the majors studios do for a Sandler film, which, on average, costs in the $80 million range. But this latest Netflix’s move is designing a new path, where theatrical release is not the only synonymous of artistic dignity anymore, where online distribution is not some kind of underground and neither alternative, but a perfectly viable and smart option.

Because, hey folks, not everyone can make it to the theater… right? Well, now not everyone wants to make it to the theater. Which will mean, in my opinion, that quality of theatrical releases is going to rise as there will be movies meant for the theater and others which will be better off with other types of distribution strategies. As a result, theater programmers will not be pushed by distributions to get packages of content, whereas will be able to select according to their specific audience. And audiences will be willing to pay a premium price for premium content and premium experiences. This is a win-win-win paradigm, just like it happens any time market opens up with new opportunities.

Furthermore, as said in the first paragraph, I believe also that laws and regulations related to funding production and distribution need an update. For instance, in Italy at the moment productions are eligible for tax benefits and public funding only if the film is meant priory for theatrical release and such benefits are assigned proportionally to previous year theatrical box office. Such provisions create a non-sense overcrowded line for accessing theaters even when strategic thinking would not suggest it, even for one week only or less, therefore saturating the market and lowering the quality.

Business models are changing, but theaters will be alive in 100 years for now because people need that kind of social gathering and they enjoy the magic, no doubts about it. They will increasingly be the destination for a premium or very customized experience, whereas new business models will get into the game because probably “being able to compete for consumers’ attention and dollars over the preciousness of access is a thing of the past” and so “people should have the opportunity to see it on a big screen if they want to, but if they want to watch it at home, they can stream it” as Netflix’s Ted Sarandos says, adding up to his concerns that “as theater owners try to strangle innovation and distribution, not only are they going to kill theaters, they might kill movies.” (video: Keynote Address | 2013 Film Independent Forum).

All in all, a more open discussion between the parts of the value chain is desirable in order to stay closer to customers needs and flourish in a fast changing market.

Day-and-date release, Bubble or Tiger?

The Weinstein Company planning worldwide day-and-date release on Netflix and IMAX theaters of Crouching Tiger, Hidden Dragon sequel is nothing new to the industry practice.

The first noticeable (because of the combination of a high-profile director and the backing of maverick billionaires Todd Wagner and Mark Cuban) example of such strategy was in 2006 when Magnolia Pictures released the Steven Soderbergh’s movie Bubble simultaneously to theaters and cable television channel HDNet Movies, whereas four days after they released the DVD. The well-wisher of the initiative was Mark Cuban, the outspoken Internet billionaire who also owns the NBA’s Dallas Mavericks, who used his network of art-house Landmark Theaters and digital television for giving the consumers the choice of how they wanted to watch a new film, even though receiving harsh criticism from Hollywood purists, windowing lovers, and being boycotted by the other theater chains who refused to screen the film.

Because of the limited release and the hardly marketable art-house nature of the movie, the experiment was a total flop as it only grossed $145,626 in the US, shown for four weeks in 32 theaters, and $116,340 internationally. Nevertheless, it definitely shook the conscience of the industry regarding windowing.

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Here is how Cuban responded to John Fithian, National Association of Theater Owners head:

With the release of Bubble on January 27th in theaters, on DVD and for 2 showings on HDNet Movies, there has been a ton of press and discussion about the future of the movie industry. The most extreme has come from John Fithian, who wins the award for the best ever imitation of Jack Valenti’s famous comparison of the VCR to the Boston Strangler when he was quoted in FastCompany as saying [Fithian] called Iger’s suggestion this summer a “death threat” against his members. Fithian says that “if [release] windows were eliminated, what you would have would be fewer movies, fewer total dollars for the industry, and less choice for the consumer.” He thinks movies would become little more than commodities and that hundreds or thousands of theaters would close. But he wasn’t done there. He said the same thing to USA Today: It’s the biggest threat to the viability of the cinema industry today,” John Fithian, president of the National Association of Theater Owners, said of the so-called “day and date” release strategy. How sad is it when the President of the National Assoc of Theater Owners doesnt think his members can create a better movie going experience than what we can see in our houses and apartments? Guess what John, I can whip up a mean steak, but I still like to go to restaurants. Because I enjoy it. I enjoy getting out of the house with family, friends, who ever.

How would he respond today to major theater chains announcing they will be boycotting the Netflix-IMAX release? Probably, in a very similar way, even though this time the “other” distributor is VOD and not television, and the rationale behind is a little different as no customer experience can be more different than the ones offered by IMAX and Netflix, and therefore we are talking about two tatally different products which cannot cannibalize their own sales.

In 2006, a typical film used to earn about half of its revenue from home video and only about 25% from theaters. The remainder coming from selling the film to cable and broadcast TV and other sources. Media companies were already aware they had to adapt to the changing demands of consumers and the rise of digital consumption.

By 2018 the biggest chunk of revenue for film consumption will come from electronic home video, growing by 114% to reach $45B globally, with this figure possibly being even bigger if we manage to fight piracy consistently, which includes shrinking windows for films that we can forecast not performing exceptionally theatrically and most of all with a relatively short product life-cycle. Generally, while large, event movies such as King Kong may work best on the big screen, simultaneous release could be beneficial for small, independent films that often struggle for an audience while blockbusters hog theater screens. But this really needs to be analyzed on a case-by-case basis.

The future of theatrical film distribution is unknown. Practices that might not have worked 5 years ago are commonplace today, such as movies opening via VOD weeks before they reach theaters, or enjoying day-and-date release structures to reach a wider audience. Probably it will depend on the ability to provide exceptional experiences to their audiences, and also on their openness to innovation. Including experiments like Warner’s Veronica Mars crowdfunded production followed by day-and-date release, for instance: AMC Theaters rented out 260 out of 270 screens for the limited “four-walling” release, where the theater gets paid a flat rental rate, the studio keeps 100 percent of the ticket sales and the theater does not violate the industry’s theatrical “window” policy, so the risk is very low and everyone is happy.

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It’s worth asking would this stance if this Netflix model is adopted by major studios. Not that this would occur in the next year or two. But let’s say, down the line, that the latest Marvel movie would be available on Netflix on the same day that you also could see it on an IMAX screen. Would they still refuse to carry an obvious moneymaker on principle? Is it worth for theaters to fight Netflix and other major VOD platforms as their worst enemies, or shall the industry converge on possible synergies and new strategies in order to maximize overall returns? 

The discussion is ongoing and is more interesting than ever. But #SmartMoviegoing is too powerful to be stopped and there is no industry that can survive without listening what their customers want and need, that is a fact. Therefore, a more flexible mindset is needed.