In a surprising turn of events, HBO has decided to discontinue selling DVDs to Netflix Inc. (NFLX”>NFLX). This move on HBO’s part is expected to escalate Netflix’s procurement costs as the latter will have to purchase DVDs from other sources at a higher cost as against the discounted price offered by HBO earlier.
However, Netflix assured its DVD rental customers of the availability of HBO discs regardless of HBO’s negative stance. Time Warner Inc.'s (TWX”>TWX) HBO previously declined to license any online streaming material to Netflix. Its decision to stop selling DVDs as well is likely on account of its own growing streaming business. In fact, in December, the Netflix CEO recognized HBO Go as a worthy adversary in the streaming business.
However, Netflix remains a force to be reckoned with in the streaming market. In the fourth quarter of 2011, Netflix clocked more than two billion hours of movies and TV shows. Netflix signed a number of licensing deals in 2011 with big Hollywood production houses providing varied content.
Netflix has been under pressure from the loss of subscribers in the previous quarter and expects to witness further subscriber loss in the quarter, albeit at a slower rate. Netflix’s DVD rental subscribers are expected to average at 10.3 million to 11.3 million in the current quarter.
Cost escalation in the form of license and renewal fees has emerged as a major near-term challenge for Netflix. Analysts predict that the company will have to shell out $2 billion in licensing fees to content providers in 2012. Netflix said in a regulatory filing that it has impending payments of more than $3.5 billion over the next few years for the content under contract. To keep the company afloat, Netflix has to bank on subscriber growth, both domestic and international.
Moreover, the company raised $400 million, $200 million of which was through stock offerings at $70 per share, with the balance in zero coupon convertible bonds through a private placement. The move to raise capital was prompted by increasing cash outflows owing to streaming content commitments and the recent exodus of domestic customers.
The raising of capital in these trying times is not an indication of financial health and increases the risks of investment in the stock. Moreover, raising capital through stock offerings would dilute the EPS going forward.
Recommendation
We maintain our Neutral recommendation over the long term (6-12 months). Despite the higher costs, we think Netflix will probably see sales strengthening, as subscribers take note of its improving portfolio. This would ultimately enable the company to build a position for itself over the long term.
However, we believe that increasing costs related to licensing and renewal fees and higher capital expenditure due to international expansions can hurt growth in the near term. We currently have a Zacks #3 Rank on Netflix, which translates into a Hold rating in the short term.
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