12-11-13 6:30 AM EST | Email Article
 

By Andre Mouton

 

Keep it simple.

 

That's good advice in life, and it's great advice for technology investors. The more novel a thing is, the less we can predict about its future, so it's important that we stick to the basics. What is a company selling? What price can it get? What are its costs?

 

Netflix (NFLX) sells used video content. It repackages movies that have left the theater, and television shows that have concluded their season. The video-on-demand service charges $7.99/month per subscriber, and pays somewhere in the neighborhood of $6/month per viewer for content, plus any and all expenses.

 

The company is widely seen as a threat to cable TV, and the success of original content like the Emmy Award-winning "House of Cards" would seem to be proof that the challenge is real.

 

However, definition and price work together. Original content cannot be had for $6/month per viewer, and in order to turn a profit, Netflix must resell content that it cannot afford to produce on its own. That makes it a used video seller.

 

This is may sound trivial, but it's an important point. The moving pictures that Netflix sells for $7.99/month cost far more than that to create.

 

Let's break it down. In the third quarter, Comcast (CMCSA) paid out $35/month per subscriber in content costs. This money went to content providers like Time Warner (TWX) , whose network division includes HBO and basic cable channels like TBS and TNT. This $35/month is supplemented by advertising, which can account for a third of total revenue -- or more, in the case of a high-profile channel like ESPN -- putting us at $50/month or more in total revenue per subscriber.

 

The cost of operating Time Warner's network was 61% of revenue last quarter; Disney (DIS) and Twenty-First Century Fox (NWS) paid out even higher percentages. In other words, we're looking at a minimum of $30/month per subscriber to run one of these cable networks -- a ballpark figure, but one that's nearly four times the price of a Netflix subscription.

 

Thirty dollars per month is an average, not a total. In other words, this is what it costs to produce the televised content that the average cable customer watches in a month. Whatever the New York Times and Sen. John McCain might think, there's no premium here for channels you never use, or shows you don't like. Cable TV is a buffet, and the quantity and quality of food are determined by what gets eaten. Cable customers like to believe they'd save money by purchasing channels a la carte, but in reality, they're only paying for what's on their plate.

 

No math yet exists that would allow Netflix to cook the same meal at a quarter of the price. In FY 2012, Time Warner, Disney and Twenty-First Century Fox logged operating expenses of $24 billion for their cable networks. That's the equivalent of 250 million Netflix subscriptions, or three times what the video-on-demand company estimates as its total addressable market in the United States.

 

Still, there's no denying that cable companies are hurting. And since Netflix already controls 89% of the streaming market, it seems likely that future growth will continue to come at the expense of cable. So far, cable providers have made up for lost eyeballs by raising their prices, rather than cutting costs -- notably, Time Warner Cable (TWC) lost a game of chicken with CBS (CBS) earlier this year -- but this only makes the problem worse.

 

Viewers are moving away from the medium that actually pays for content, and adopting one that does not. That affects CBS just as much as it does TWC.

 

In the end, content providers and cable companies may join forces to protect an ecosystem that they both depend on. This could happen in any number of ways.

 

They may cooperate to prevent or delay content from moving to Netflix. They could throw the game in favor of in-house streaming services, like Comcast's Streampix and Dish Network's (DISH) Blockbuster. They might transition to usage-based cable internet, a move that would effectively raise the price of a Netflix subscription, and which the FCC has tacitly endorsed.

 

Certainly, content providers will eventually demand a better payout from Netflix, should it continue eating into their revenue base.

 

It's not clear that Netflix could pass on these higher expenses by raising prices. An RBC survey taken earlier this year found that 17% of Netflix customers were either 'very' or 'extremely' likely to dump their subscriptions in the event of a 13% price hike -- a negative statistic that somehow received positive spin.

 

Amazon (AMZN) and Hulu already offer competing services at the same or, in Amazon's case, a lower rate. Netflix enjoyed an early advantage in the form of smart TVs and streaming devices like Google's (GOOG) Chromecast, which bundled the company's app; but with personal computers and tablets invading the living room, competitors will have fewer barriers to entry, and pirated content will continue to haunt the on-demand industry.

 

There's no predicting the future, but there's also no reason to believe that Netflix will ever be more than what it currently is: a place to watch things a second time. In all likelihood, the streaming giant will continue to charge $7.99/month. It will continue to pay $6/month for content, little of it original. And Netflix won't be taking over the world.

-Andre Mouton; 415-439-6400; AskNewswires@dowjones.com

 

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(END) Dow Jones Newswires

12-11-13 0630ET

Copyright (c) 2013 Dow Jones & Company, Inc.
Copyright 2014 MarketWatch
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