Will Netflix Win with this Expensive Content Deal?

Netflix’s most important content deal is reportedly about to become 11 times more expensive. According to the New York Post, Starz — which has exclusive first-run premium cable rights for Disney (NYSE:DIS) and Sony (NYSE:SNE) films — is seeking upwards of $350 million per year from Netflix to renew its content deal, well above our prior expectation of $150 – 200 million per year. We believe the current Starz deal costs Netflix $30 million per year and expires in October 2011.

The Starz (NASDAQ:LSTZA) deal provides Netflix with high quality streaming content from Disney and Sony. The content (including content from Disney, Touchstone, ScreenGems, Hollywood Pictures, Pixar, Columbia, Tristar, Sony Pictures, Overture Films, Yari Film Group, and Warren Miller Films) is mainly newish movies (90 days after the premium cable window), although new TV content, catalog movies, and catalog TV (through Starz Play broadband subscription movie service) have been available as well. In April, we noted that Netflix streaming content included almost half (23 of 49) of the top grossing Disney (NYSE:DIS) and Sony (NYSE:SNE) movies from 2010 and 2009.

Increasing streaming costs will pressure growth in profitability. In our Q1:11 review note, we conservatively estimated that Netflix (NASDAQ:NFLX) would see its annual streaming content costs rise to a total of $1.7 – 2.3 billion by 2012 from $180 million in 2010. Given the magnitude of the new Starz deal, it is likely that the high end of our range will be the base case if Netflix renews the deal, and content costs could rise as high as $2.5 billion annually. Although Netflix has not confirmed financial terms of its studio deals, it has acknowledged that spending on streaming content will increase substantially going forward.

In our view, the increase in streaming costs will more than offset savings from declining fulfillment, marketing, DVD purchase, and postage expenses, reducing profitability. We note that Netflix (NASDAQ:NFLX) had $1.6 billion of commitments related to streaming content license agreements that do not meet content library recognition criteria at Q1:11, up from $1.1 billion at Q4:10 and $0.2 billion at Q1:10.

Despite the new Starz (NASDAQ:LSTZA) deal’s potential impact on profitability, we believe Netflix will be forced to renew at more expensive terms in order to limit customer attrition. We believe that the Starz deal is the most high-profile of the five deals that provide Netflix with new movie streaming content. If Netflix were to lose Starz, the quality of its streaming content would suffer, and a loss of this content would potentially cause existing Netflix customers to defect. At the same time, several Netflix competitors are beginning to offer unlimited viewing for a monthly subscription fee, such as Hulu Plus (NYSE:GE) (which costs $7.99/month, and focuses on new TV shows, but also has some catalog movies) or Amazon (which is free for Amazon Prime customers and focuses on catalog items). We fully expect a subscription offering from Amazon (NASDAQ:AMZN) later this year.

Although we think that Netflix (NASDAQ:NFLX) can continue to grow earnings, we are not optimistic that its earnings can grow sustainably at a 50% annual pace. In our view, Netflix is valued based upon a view that its earnings will grow to $10 per share in the foreseeable future, and will continue to grow from there to something approaching $20 per share. We believe it is doubtful that the company can actually grow its profits as fast as the bulls expect, and think it far more likely that the company will revert to more modest earnings growth beginning in 2012.