12 Takeaways from Today’s Netflix EPIX Agreement

12 Takeaways from Today’s Netflix EPIX Agreement

The joint venture precursor to pay TV channel EPIX was formed by Paramount, Lionsgate and MGM on April 20, 2008 (click here). At the time, we viewed Netflix (click here) as the leading contender to make a success of the three studios’ decision to drop Showtime and start a new network, stating: “If Netflix wants to expand its brand beyond a DVD subscription service, this venture could be a once-in-a-lifetime opportunity, despite the incredibly high annual cost of entry.” 28 months later, Netflix has struck a deal to gain access to all of EPIX’s content for five years starting on September 1, 2010 (click here for the press release) and price was certainly high.

12 Key Takeaways from Today’s Netflix/EPIX Announcement:

1.Silence the EPIX Critics and Take the Money. Viacom and Lionsgate have been pummeled by investors and the press for the past two years about how bad a decision leaving Showtime was and how they would never gain enough distribution to earn an adequate return. On Viacom’s last conference call management indicated that revenues/EBITDA from EPIX for movies delivered were fully-offset by equity losses related to their EPIX ownership. Following today’s EPIX deal, we expect EPIX to be profitable - positively impacting profits at both Viacom and Lionsgate. It’s also worth considering that Paramount is not a core Viacom asset and it has underperformed in recent years, so improving the health of the studio, even if it is not the best decision for the larger movie industry would appear logical (similar to Paramount’s thought process vis-a-vis Redbox).2.Value of Digital Content is Rising, Netflix Paying More than Showtime Offered. Prior to the creation of EPIX, we believe the three studio partners in EPIX were generating $350 mm/year from Showtime for their movie content. Showtime was offering a 50% haircut for a new deal or about $175 mm/year. We believe Netflix is paying EPIX over $200 mm in year one (assuming Netflix averages around 18 mm subscribers during the first 12 months of the EPIX agreement, Netflix is paying a very healthy $1/sub/month). While annual payments step down in the future, the three studios own all of EPIX (vs. none of Showtime) and they have also signed deals with traditional distributors (Cox, Charter, Mediacom, Verizon and Dish). While its not yet clear that this value for digital content is fully incremental to traditional distribution (as EPIX has yet to sign Comcast, Time Warner, DirecTV, etc…), it certainly shows how digital distribution has real value.
3.Standard Definition Will Be Disappointing to Consumers. During the initial phase of the EPIX/Netflix deal, the streaming content will only be offered in standard definition, similar to the quality of the Starz content streamed on Netflix. This issue is minor if you are viewing Netflix on a screen the size on an iPad, let alone the coming iPhone/Android apps. However, when you have a PS3 with Netflix attached to a 50-inch HDTV, SD-quality leaves a lot to be desired. We expect Netflix to address the HD streaming issue with Starz next year, when their contract expires so they can create a complement to what we believe are improving streaming quality rights with EPIX over time.
4.Exclusivity Commentary is Misleading. Consumers who subscribe to EPIX via a multichannel operator already gain access to www.EPIXHD.com, a site that streams all EPIX content online today, with the same 90-day window advantage that the pay TV channel has vs. Netflix streaming. Netflix is simply the exclusive streaming partner for EPIX, meaning the content cannot show up on a to-be-launched Amazon or Redbox streaming movie service. If Comcast signed a deal with EPIX tomorrow they would have streaming rights to multiple devices, 90 days before the content hits Netflix for streaming.
5.90 Day Window is Irrelevant Until Multi-Platform Streaming Competition Exists. While the studio partners in EPIX are trying to highlight the importance of the 90 day delay of the Netflix streaming vs. the traditional pay TV window for EPIX, we believe consumers will simply not care/understand until robust alternatives exist. Movies on Pay TV (HBO, Showtime, Starz and EPIX) are already delayed 11-12 months after theatrical release, so an extra three months seems relatively insignificant, especially compared to the seven year delay that this content previously had on Netflix. In addition, while a Cox subscriber may already have EPIX streaming content with no window (as a paid subscriber), they are currently limited to viewing on a PC, with no way to access EPIX’s larger online library of content on their web-connected TV directly, via a PS3/Wii/Xbox or via mobile devices. Similarly, Comcast may offer HBOGo via Fancast to its HBO subscribers, however, the interface is not only quite weak, but you have no access beyond the PC to access the content. 90 days does not matter yet, but it might in the future. Note the lack of multiple platforms in the examples above are simply due to the fact that multichannel providers have not enabled this functionality yet (could change, but we continue to wait…).
6.EPIX is Far Better Value on Netflix than via Multichannel Operators. If a consumer pays for EPIX as a traditional pay TV service, they are paying upwards of $10/month (FIOS charges $9.99/month, DISH charges $10/month for their HD Platinum add-on with EPIX being the standout channel, etc.). Unless consumers care to have the content three months earlier, gaining access to EPIX via Netflix for as little as $9/month, when that monthly fee also includes streaming Starz content, deep catalog streaming movies from other studios as well as its traditional DVD-by-mail service is a great value. Interestingly, a key Netflix/EPIX deal point is that EPIX content will not be branded EPIX on Netflix (in stark contrast to the Starz Play branding for Starz titles). While at first glance, you might say “who cares,” we suspect this is done on purpose to make it more difficult for consumers to realize they do not need to subscribe to EPIX via traditional pay television.
7.Netflix Will Want to Pay Up for Starz in 2011. We believe Netflix is currently paying less than $30 million/year for streaming rights to Starz content, equates to about $0.15/sub/month, dramatically below the $4/sub/month-plus that multichannel operators pay Starz for the same content, in the same window of availability. The Netflix/Starz three-year agreement was signed on 10/1/08 (click here), and was placed under the Starz Play brand, which offers third parties such as Netflix (and Verizon FIOS) standard definition streaming rights. Starz acknowledges they dramatically underpriced the agreement. We expect Starz to extract dramatically higher fees from Netflix starting in Q4 2011, with HD content possible, especially if Netflix is willing to delay the streaming window (akin to the EPIX deal). Starz’s content deals with Sony and Disney (re-upped over past 18 months) enable them to continue to sell streaming rights to Netflix, however, an unspecified percentage of the increase in fees flows to the studios (currently Starz keeps 100%). While some investors may fear that an EPIX deal makes a Starz deal unnecessary for Netflix, we believe Paramount and Lionsgate content is simply not enough “fresh” content, nor of high enough quality (relative to Starz’s Sony/Disney content) to fuel Netflix’s rapidly growing subscriber base that craves streaming content. While it may seem strange that the Netflix/EPIX deal steps down over time, we actually think it enables Netflix to sign a deal with Starz in a year that steps up over the following five years, effectively leveling off their movie content costs on an annual basis.
8.Industry Battle Lines Drawn: The “FONAR”s and the “NFONAR”s. In our 6/16 blog post (click here), we indicated how the movie industry had become strongly divided on the topic of day-and-date with DVD for Redbox and Netflix versus a 28-day delayed window - what we will call the Friends of Netflix and Redbox (FONARs) and the Not Friends of Netflix and Redbox (NFONARs). Interestingly, with today’s Netflix/EPIX agreement, the same studios that favor Netflix and Redbox DVD releases day-and-date with a DVD’s release, also support Netflix streaming of content of their content within the traditional pay TV window (Disney, Sony, Paramount and Lionsgate), while the same three majors that favor a 28-day window (Warner Bros., Universal and FOX) all have output deals with HBO, whom we believe has no interest in sub-licensing its streaming content to Netflix.
9.Cable Needs to Move Faster, TV Everywhere Stuck in Neutral and its Interface is In-Reverse. On June 24, 2009, Comcast and Time Warner announced an agreement to facilitate TV Everywhere (click here), essentially making it possible to authenticate that you subscribe to multichannel television and then watch programming across multi-devices. Comcast has launched the broadest roll-out of TV Everywhere (with most other operators still in beta), however, content rights are still a work-in-progress and the user interface leaves a lot to be desired (if you do not know what we mean, just go to www.fancast.com, unclear if its called Xfinity or Fancast anymore). Comcast has so far refused to allow programmers to use their own authenticated interfaces such as HBO GO (which is beautiful and intuitive) and other cable operators have yet to sign agreements to enable HBO GO. Cable as an industry is simply moving too slowly and missing a big opportunity, while Netflix’s power and subscription base continues to grow. We really thought Comcast would cut a deal with EPIX, as it had already done deals with HBO, Showtime and Starz, enabling it to offer a one-of-a-kind movie streaming movie service to its multi-pay subscribers and importantly, keeping the content away from Netflix. While a deal is still possible, we sense EPIX simply grew tired of waiting and Netflix now has a five year deal with EPIX in place.
10.Increases Value of Netflix Subscription vs. Redbox, Blockbuster and Showtime. For movie fanatics (in contrast to original programming fans), the value of Netflix continues to grow, especially relative to Showtime (which has lost a meaningful portion of its movie content). While promotional deals abound, adding a premium TV channel to your cable subscription can cost upwards of $10-$15/month, in contrast to Netflix for as little as $9/month. We also believe Netflix’s EPIX deal enables it to differentiate itself from its physical rental-only peers, Redbox and Blockbuster. Not only is Netflix an attractive consumer value proposition for DVD rentals, but the inclusion of multi-platform Sony, Disney, Paramount, Lionsgate, MGM and Relativity Media movie content along with a wide offering of deep catalog of movies and recent (not new) TV show programming will make it that much easier to take share from its physical peers. We also fear that Redbox will feel the pressure from Netflix’s EPIX deal and will seek to pour money into streaming; which could be the wrong decision given the high cost of entry.
11.Netflix Accelerating Shift to Digital with Boldest Financial Move To-Date. Spending over $200 mm/year intially for EPIX digital content is a very significant move for Netflix compared to spending $30 million or less two years ago for Starz content. We believe the boldness of this move relates to the slide (embedded below), they posted in their business opportunity slideshow a couple months ago. Netflix is trying to drive subscriber growth, while shifting consumer behavior from DVD rentals to streaming, and utilize the DVD-by-mail cost savings from that shift to acquire more content to fuel streaming - a virtuous circle of profit growth if they can pull it off. However, this is not without risk; there is no going back for Netflix, this has to work for them given the size of the “bet;” they can no longer simply tweak streaming and marketing to drive/manage earnings growth (given the fixed costs they are taking on). It is worth nothing however, that enhanced streaming content across more and more devices may also enable Netflix to push ARPU, as it is already doing with Blu ray.
12.Pre-cursor to Original Content. While HBO and Showtime will likely say they remain in a whole different category because of their original programming, if Netflix is successful in driving sub growth and shifting consumers to streaming from DVDs-by-mail, we believe the next logical step in two-three years would be to enter original programming (just as Starz is doing today). Netflix will surely deny this type of move today, but the opportunity to leverage an expanding subscriber base attracted to entertainment content appears no different than where HBO or Showtime sat a decade ago looking at original programming.