Making the Right Bet in Online Video

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

We are in the midst of a major shift in the way we consume video, just like internet revolutionized the books and music industry, video is going under a similar transformation due to the online streaming boom. There will be many opportunities for different players to profit from this revolution over the next years, but investors need to consider major industry trends in order to position themselves in the best possible way.

It´s about content

Netflix (NASDAQ: NFLX) and Amazon (NASDAQ: AMZN) have positioned themselves as industry leaders when it comes to subscriptions, and they are aggressively competing against each other for the most valuable resource in the business: high quality exclusive content.

Both companies offer a wide selection of video for a convenient price: while Netflix charges a flat a $7.99 per month for unlimited consumption, Amazon Prime subscribers pay $79 a year for unlimited streaming and free two day shipping on Amazon products. There seems to be little room for price competition at these levels, especially considering that content is becoming increasingly expensive.

With more than 75,000 movies and TV tittles, Netflix has a bigger library, but Amazon has been closing the gap over the last months, aggressively bidding for content and building its own collection with more than 40,000 titles. Besides, quantity for a good price is not enough at this stage, viewers are demanding quality, and this means that streaming companies are fighting each other for this valuable asset.

Original content is the new frontier in this competition. Netflix was the first mover with its much successful House of Cards, and Amazon is venturing into this terrain too with the company producing its own series through its Amazon Studios division. The race is on as original content will ultimately be the biggest differentiating factor in this harsh competition, and this has important implications for investors.

High quality original content requires enormous amounts of capital, House of Cards reportedly cost more than $100 million and, even if it was a big success, Netflix can hardly recover that kind of money with new subscribers in the short term. This is a marathon, not a sprint; Amazon and Netflix are smart enough to understand that they need to focus on gaining customers in the long term as opposed to short-term profit margins, and they are acting accordingly.

Investment implications

Netflix announced on Monday a deal with DreamWorks Animation (NASDAQ: DWA) to bring several original series to Netflix, the financial terms of the deal were not disclosed, but it seems like there is a lot of money involved, since Netflix said in its press release that it´s “the largest deal for original first-run content in Netflix history.”

DreamWorks is making a smart move and adapting to the new opportunities that online video provides. The company behind blockbusters like Shrek, Madagascar and Kung Fu Panda has the opportunity to capitalize its valuable properties and bring more stability in its business model.

Theatrical releases can be enormously profitable, but they can also lead to huge losses like DreamWorks painfully learned with Rise of the Guardians last year. Deals like the one recently announced with Netflix will likely provide a much more predictable cash flow stream for DreamWorks, and it shows that content producers stand to gain from the new paradigm.

Netflix was in need of this content after it lost key children programming to Amazon when its deal with Viacom (NASDAQ: VIAB) expired in late May. Children are crucial when it comes to streaming subscription, according to Amazon, kids’ shows are one of the most watched TV genres on Prime Instant Video, and parents usually give a lot of consideration to children's content when choosing a subscription service.

Viacom owns tremendously popular characters like Dora the Explorer and Sponge Bob, and many Netflix subscribers complained when they learned that their kids were not going to be able to continue watching those shows via the service. The financial terms of the Amazon-Viacom deal were not disclosed, but Huffington Post reported that it was the biggest amount of money Amazon has spent on a deal for Prime content.

It must have been a very convenient deal for Viacom, the company was in a comfortable position to negotiate knowing that both Netflix and Amazon were competing for its valuable content and thinking beyond short-term profits to consolidate their competitive position in streaming. When streaming companies fight each other for content, content producers win.

Bottom line

I´m not saying that streaming companies like Netflix and Amazon won´t be winning bets in the long term, but the competition for content means that their profitability will most likely suffer in the middle and short term, it could take a very long time until they build a large enough audience to justify those investments. Investors in these companies need to be fully aware of the risks.

When it comes to content producers, on the other hand, they stand to win from rising prices for their products as the competition between streaming companies becomes more intense.  At the end of the day, streaming is a more efficient and convenient way to distribute content, and this makes this content more valuable.

Andrés Cardenal owns shares of The Motley Fool recommends, DreamWorks Animation, and Netflix. The Motley Fool owns shares of and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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