Online Movie Delivery Changing the Picture for Netflix
Netflix's advantages will fade as online movie delivery gradually replaces DVDs.
Netflix's advantages will fade as online movie delivery gradually replaces DVDs.
Executive Summary
Distribution Channels Continue to Evolve in the Film Industry
During the past century, the film industry has operated under one underlying strategy: produce a movie and distribute it as widely as possible to maximize revenue. Originally confined to theaters, movie distribution has expanded to television licensing, VHS, and DVDs over the past several decades. While we expect theatrical releases and television licensing to remain steady, we think another evolution is under way--the transition from DVDs to digital delivery. We think this transition is likely to disrupt several companies along the way. In this article, we focus on the impact to Netflix, but touch on other companies and sectors that will be affected by this transition as well.
Netflix has Benefited from Technology and the Regulatory Environment, Thus Far�
It is no surprise that Netflix's success has coincided with the proliferation of DVDs, as the DVD format provides advantages over VHS. Most importantly, DVDs are much smaller than VHS tapes, making distribution via the postal service affordable; we don't believe Netflix's business model would have worked with the much larger, heavier VHS format due to much higher shipping charges. In addition to its cost advantages, the DVD format also provides a superior home viewing experience, leading to increased consumer demand. Netflix has benefited from the Internet as well. The birth, advancements, and widespread adoption of the Internet have allowed Netflix's business model to flourish, as consumers can easily review, order, and comment on movie titles from anywhere with an Internet connection.
In addition to technological innovations, Netflix has also benefited from a favorable regulatory environment. The first sale doctrine is what enables rental companies to rent DVDs, and has been crucial to the rental business since the VHS days of the 1980s. In a nutshell, anyone that buys a DVD is free to sell, exchange, rent, or lend it to others. Therefore, rental companies like Netflix, Blockbuster, and Redbox can buy DVDs from the cheapest source and rent them as they please. Although these companies usually work directly with the studios, they still have the option to acquire content through a middleman (distributor, wholesaler, retailer) if necessary. As a result, we think the rental companies have the upper hand in negotiations. In essence, the first sale doctrine has allowed Netflix to acquire content fairly cheap, as we estimate Netflix is paying the studios on average a paltry $0.54 per DVD shipped.
�but Netflix Will Not Benefit from Technology and the Regulatory Environment to the Same Extent in the Future
Ironically, we think the forces that have allowed to Netflix to thrive (technology and a favorable regulatory environment) will become headwinds in the future. First, as online speeds, home PC performance, and UIs (user interfaces) improve, we expect online movie delivery to gradually replace DVDs as the primary home-entertainment distribution channel. With digital delivery, a nationwide network of distribution centers is no longer necessary, and storage and digital content delivery is very inexpensive. We estimate that it costs Netflix about $0.06 to deliver a movie digitally, compared with $0.66 per disc for postage and packaging. Over time, we expect improvements in compression technologies to allow higher-quality streams to be delivered at lower prices, so we think pricing will remain fairly steady. However, if consumers demand Blu-Ray quality streams, technologies don't improve, and pricing holds at current levels, it could cost about $0.20 to deliver each movie. Whether it costs $0.06 or $0.20, the relatively low price of online movie delivery would seem to benefit Netflix. However, we think it actually works against the company by opening the door to more competition.
Although delivery costs and upfront capital requirements are significantly reduced, a distributor still needs to obtain licensing deals with the studios and develop a compelling UI. These licensing deals take time, but we expect the studios to work with numerous distributors to prevent a small number of players from dominating distribution like Apple (AAPL) has done in the music industry with iTunes. We don't think developing a compelling UI is a significant barrier either, as Apple, YouTube, Hulu, and Vudu are prime examples of companies that have developed consumer friendly UI's and have entered digital content delivery without any experience in physical distribution. Due to low barriers to entry, we expect more to follow. Additionally, companies exposed to DVD sales and rentals like Best Buy, Walmart, Amazon, and Blockbuster have all entered digital distribution as well.
In addition to technological disruption, the regulatory environment will be less favorable. The first sale doctrine only applies to physical products (DVDs, books, etc), and does not apply to electronic copies. Therefore, a company wishing to rent movies cannot simply buy digital copies at the lowest possible price and rent them. As a result, we think the studios will regain some pricing power, leading to higher content prices for Netflix.
Netflix's Revenue Growth and Margins Will be Pressured by This Evolution
Due to low barriers to entry in digital distribution, we expect Netflix to face a plethora of competition as digital delivery gains steam. Recognizing this threat, Netflix now offers its subscribers free movies that can be streamed to PCs or to televisions that are connected to a device that has Netflix-embedded software (including game consoles, Blu-Ray players, and some TVs). However, the current selection of streaming titles is rather poor, as the company has not obtained licensing rights for many high-quality movies, most likely because Netflix is unwilling to pay what the studios demand. And because the first sale doctrine doesn't apply to digital content, Netflix does not have the option of acquiring cheap content through third parties. We think this works in the studios' favor, as they can license similar content to multiple distributors, preventing Netflix from gaining a "selection" advantage.
While we recognize this evolution could take a few years to play out, we expect Netflix's subscriber growth to slow dramatically in the future as consumers have more options to find and consume similar content. Additionally, although we expect content costs to rise, we think Netflix may need to lower prices in light of competition. We also expect new subscribers to continue choosing lower priced plans, causing the company's average subscription price to continue to fall. As a result, we forecast the company's revenue to flatline, and eventually decline, after solid growth during the next few years.
In addition, we expect higher content costs to more than offset lower distribution and fulfillment costs for digital delivery. According to Adams Media Research, studios retain about 65% of cable video-on-demand revenues. Assuming an average price point of $5, this means the studios are receiving about $3.25 per movie, compared with just $0.54 per movie from Netflix. However, video-on-demand titles are primarily new releases, whereas about two thirds of Netflix's rentals are cheap, catalog titles. Assuming that this holds true in the digital world for Netflix, we estimate that the company would pay about $1.50 per movie. At $1.50 per movie, Netflix's gross margin would fall to 22.4% for digital delivery compared with 35.3% for Netflix in 2009. We assume that in 10 years, Netflix's business will be equally divided between disc rentals and digital rentals, resulting in a gross margin of 28.9% (halfway between 35.3% and 22.4%) by 2019. As a result, we project the company's operating margin to fall by the end of our forecast period, despite lower operating expenses. Further, if our estimates for digital content costs are too conservative and they are actually $2.00 per movie, Netflix's gross margin would basically be zero.
We fully recognize that Netflix is poised to deliver solid financial results in the near term, and its shares are likely to reflect this momentum. However, we think the competitive landscape will change dramatically as digital distribution gains steam. As a result, when looking at the long-term prospects for cash flow generation, we think the shares are currently overvalued.
Impact of Digital Distribution on Other Sectors/Companies
Retailers
Although retailers like Wal-Mart (WMT), Best Buy (BBY), and Amazon (AMZN) often discount new releases during the holidays to drive traffic to their stores and websites, these retailers still earn solid profits thanks to catalog sales and full-price new releases. Recognizing the threat of digital distribution, each of these retailers has responded in one way or another: Wal-Mart bought Vudu; Best Buy partnered with Sonic Solutions; Amazon offers video-on-demand. While we doubt that any of these solutions will fully replace DVD sales for any of these retailers, we think Best Buy has the most to lose, as a decent amount of their floor space is still dedicated to DVDs. This was one of several reasons we recently downgraded our moat rating for Best Buy (see our Stock Strategist article "The Erosion of Best Buy's Economic Moat?").
Film Studios
Overall, we think the shift to digital distribution will be fairly neutral for the film studios. While the price point (and thus revenue) for movie purchases are likely to be lower, the studios will save on disc manufacturing and distribution, likely resulting in comparable profit margins per unit. However, we don't expect consumers to rebuild their library of films to the same extent as they did during the transition from VHS to DVD. As a result, we think overall profits from movie purchases will fall. Offsetting this decline, we think the studios will regain some pricing power for movie rentals, as the first sale doctrine does not apply to digital copies. Additionally, digital delivery will give the studios greater control over distribution channels, as companies cannot resell digital copies without studio consent. Not only will this allow the studios to control where and when their movies are available, but it also eliminates "used" DVD sales, which the studios don't benefit from.
Multiple System Operators (MSOs)
Cable and telecom firms like Comcast (CMCSA) and AT&T (T), respectively, will be affected by this transition as well. We think these companies have the best opportunity to become a primary distributor of digital movies for a number of reasons. First, the MSOs already have well-established relationships with the film studios' parent companies, as five of the six major film studios (Sony being the only exception) are owned by companies that also own cable networks. Additionally, according to the National Cable & Telecommunications Association, more than 42 million households subscribe to digital cable. We think having hardware devices in millions of homes is a big advantage. Not only does this guarantee that MSOs' customers will have access to their content, but it also gives MSOs the best opportunity to help the studios control piracy. While the MSOs are best positioned to benefit from the shift to digital content, they have enjoyed these advantages (existing relationships with studios, hardware in place) for a number of years and have failed to capitalize thus far.
The MSOs also own the pipes that all this digital content will pass through. As a result, we think they will benefit as long as they can pass along the price of upgrading their networks onto consumers. To that end, cable companies can add capacity at a lower marginal cost than telecom firms. This is one of the reasons we like the competitive position of cable companies like Comcast over telecom firms like AT&T.
Apple/iTunes
Over the past five years, Apple has put its products (iPod, iPhone, iTouch, iPad, Macs) into the hands of millions of consumers. Along with the hardware devices, consumers have also grown accustomed to iTunes, which allows consumers to seamlessly download audio and video content. As such, we think Apple's installed based of devices gives content providers a huge platform to reach consumers. However, the company has been less successful with Apple TV, the company's standalone set top box geared toward viewing content on the television screen. We doubt most people want to pay for yet another device in their living rooms, so we don't think Apple TV is poised for success. However, a number of digital content distributors (Netflix, Amazon, Vudu) are taking a different route by partnering with hardware providers to have their software solutions embedded in a variety of devices (game consoles, TiVos, television sets). Considering the popularity and familiarity of iTunes, we think Apple would have an advantage over these companies if it decided to take this route.
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