Weekly Update

Disney’s first-mover advantage

For Netflix, the euphoria that greeted this week’s announcement of its ground-breaking exclusive streaming deal with Disney quickly turned to skepticism as analysts and investors began to recon the deal’s cost.

“In our view, the market’s positive reaction to Tuesday’s announcement (Netflix shares closed up 14% on Tuesday) was unwarranted,” wrote Wedbush Securities analyst Michael Pachter. “The exclusive nature of the deal for premium Disney content implies that Netflix outbid all other interested parties, and necessarily means that Netflix paid more than Starz has paid for such content in the past.”

Caris & Co. analyst David Miller “re-downgraded” Netflix shares to “below average,” or sell, citing “industry sources” who put the price of the deal at roughly $300 million per year (others put it higher). That price, Miller wrote, “loudly underscores what we’ve been saying about the pickle in which NFLX finds itself – if all deals end up non-exclusive, NFLX opens itself up to a price war. If all deals end of exclusive, NFLX will remain a net cash user.”

I’d say the jury is still out on whether Netflix overpaid for the Disney content. Whatever the actual price, Netflix doesn’t start paying it until 2016, and a lot can happen in three years, especially in a fast-evolving market like over-the-top video streaming (a separate, presumably smaller deal for Disney’s catalog and direct-to-video content goes into effect immediately).

The verdict on Disney, however, seems pretty clear: the Netflix deal is a shrewd move, both tactically and strategically. By striking now, Disney seizes something akin to first-mover advantage among the major studios, securing for itself a rich new subscription-VOD rights deal that may not be available to those who come later to the party.

As a movie distribution channel, Netflix has never been a great business for the studios. It’s flat-prices, subscription DVD rental model shifted market share away from Blockbuster-style over-the-counter rentals, where the studios generally got a piece of each transaction. And in the eyes of the studios, it played a lead role in undermining the DVD sell-through market, where studio margins were higher than in any other channel. No matter how many DVDs Netflix itself bought, its impact was a net negative for the studios.

Netflix’s subscription streaming business has been equally problematic. At the dawn of the internet-VOD business, Netflix conditioned consumers to regard on-demand access to movies as a low-cost, all-you-can-eat service, effectively strangling the more margin-friendly transactional VOD business in its crib.

Though the studios have since woken up to the danger posed by Netflix’s low-cost strategy they face another threat: the loss of revenue from the pay-TV window as well. As HBO, Showtime and Disney’s pay-TV partner Starz have moved aggressively into original productions, major-studio movies have come to play an ever-shrinking role in their strategies and their prime time schedules.

The inevitable result of that shift is that the traditional pay-TV “movie” channels will no longer be willing to pay top dollar for movie rights. Indeed, Starz was reportedly offering as little as $100 million to renew its deal with Disney. With this week’s deal, however, Disney replaced Starz in the movie food chain with Netflix, but at a price more in line with the traditional pay-TV business than with the subscription streaming business. Embracing streaming also restores the possibility of growth for the studio in the pay-TV window at a time when the number of pay-TV households is declining.

The question now is whether a similar deal will be available to other studios. There’s reason to believe the answer is no.

Disney struck at the moment when landing a major studio deal in the pay-TV window probably has the greatest strategic value to Netflix. Netflix is facing increased competition from Amazon Instant Video and the new Redbox-Verizon streaming service (now delayed until 2013) and needed something big to halt their momentum. The Disney catalog content Netflix is getting immediately also makes it a must-have service for young families, which will help grow subscribers in the meantime.

It’s unlikely Netflix will be willing or able to make many more such deals with other studios, however. Even if it weren’t facing stiffer competition, Netflix probably could not grow its subscriber base fast enough to pay those deals without raising prices. And that’s likely the last thing Netflix wants to do at this point.

Netflix has been working hard to pitch itself to consumers as a supplement to their existing cable or satellite service. At a time when the average cable bill is $86 a month and rising, it’s imperative that Netflix keep a lid on its own price. It also needs to avoid signalling that it is willing to raise its price to accommodate content owners.

That doesn’t leave a lot of room for the next studio looking to escape the shrinking pay-TV business by leveraging a deal with Netflix. Amazon and Redbox remain options, but neither has the subscriber base to sustain the sort of price Netflix is paying Disney.

In moving to secure their deal now, Netflix and Disney have each gotten what they most needed. That may not be the case the next time.