One Great Opportunity for Streaming Larger Profits

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

Marriage is always sweet, and the marriage of Dreamworks Animation (NASDAQ: DWA) and Netflix (NASDAQ: NFLX) could make those investments even sweeter. On Monday, these companies announced an agreement to stream over 300 hours of original content on Netflix that Dreamworks will make.

For Netflix, Dreamworks will make a series based on its upcoming movie Turbo. Turbo is an animated kids movie about a failing family restaurant that can't seem to get any business. That family ends up finding this snail that can race as fast as a car and enters the snail into a NASCAR race to help save their restaurant. That movie will be made into a TV series called Turbo: F.A.S.T. Other content will be made as well, with a speculated Shrek series, which could be huge.

For the children

Netflix has two different options for viewers when you start it up; you can watch either the normal service, or the "just for kids" one. The kids service is there so that parents can feel safe knowing that their kids aren't watch R-rated movies and so Netflix can easily showcase all of its cartoons and shows for a children's audience.

In May, the streaming deal between Netflix and Viacom (NASDAQ: VIA) expired and wasn't renewed. Viacom owns Nickelodeon, which makes shows such as SpongeBob SquarePants and Fairly Odd Parents. These are very popular kids shows, and families were angered that they weren't there anymore.

The streaming deal between Dreamworks and Netflix can help remove those kind of situations, as the content Dreamworks makes for Netflix is exclusive for Netflix and will most likely be there for a very long time. This will reduce subscriber churn and lower the amount of subscribers leaving Netflix because their favorite show isn't on it anymore. That creates a far more stable revenue and profit stream for Netflix, which will be very big for its stock price.

The content makers

Dreamworks also benefits because it will have more leverage over the control of its TV content. If it receives a deal that it views as too low, it can always turn to Netflix. So far, Netflix has said it wants to spend 10% of its content acquisition costs on original content, which right now is $200 million ($2 billion total content costs).

As Netflix buys up more content and content costs up go, that $200 million will grow. Plus, if the original content works out and draws in more subscribers (like House of Cards and Arrested Development did), then Netflix could increase the 10% threshold up to 15% or 20%. Dreamworks will be able to take a large share of that cash, especially if it makes a Shrek TV series, which would be huge on Netflix.

Viacom isn't going to miss out on the streaming binge watching craze either. The company signed a deal with (NASDAQ: AMZN) to stream tons of its children's shows on Amazon Prime, from SpongeBob SquarePants to Blues Clues. This is good news for Amazon's Prime service, as it allows the company to show the world that it is a true competitor to Netflix. It also is good news for Viacom, because it allows the company to keep making money off of the content that it has already made. 

Margins from streaming

Netflix has quite a high PE (trailing-12 months) of 516, which puts it valuation up there next to the social-networking companies. But its forward PE is 70, as EPS is expected to grow by 121% over the next year. If Netflix can meet those targets, then its high valuation will seem more reasonable. It looks especially realistic when you look at Netflix's increasing margins and shrinking negative margin for overseas subscribers.

Trefis sees Netflix's streaming margin in the US rising to 30% by 2019, which is a significant improvement from 19% today. This as marketing costs as a percentage of revenue decline and more subscribers sign on. I wouldn't be a major buyer as of right now, but taking a speculative position in Netflix could be a great long-term play as it becomes far more profitable over the next two years.

Dream of this working

Dreamworks used to just make movies, which made its profit stream very volatile as it only made money when movies were released and for a period of time after that. If Dreamworks can start making more TV shows, which it already has for Cartoon Network and is going to do for Netflix, then it can increase its profits and smooth them out. The less volatile the profit stream the happier the investor.

Keep in mind that Dreamworks' revenue is $748.5 million (trailing-12 months), so if it can grab a large chunk of Netflix's original content spending then it can boost its revenue by 7% to 12%. I'm bullish on the Netflix-Dreamworks deal and would also recommend a speculative position in this stock for the next few years. 

Dual wedding

The addition of Viacom's content on Amazon Prime is a good move for both companies, as it enables Viacom to keep making money off of streaming and gives Amazon Prime a competitive edge in the children's viewing experience. That deal was the largest in Amazon Prime's history and shows that Amazon is aggressively trying to get into Netflix's turf.

As far as Viacom goes, it trades at a PE (trailing-12 months) of 16 with an expected growth rate of 13% to 16% over the next several years. If it can hit those targets, then combined with its 1.8% dividend yield a case could be made that this company is slightly undervalued by 5% to 8%.

Amazon is a company with explosive growth just like Netflix, with its EPS expected to grow by 146% over the next year. While Amazon has no PE, this company trades more around its prospects than it does its fundamentals. Amazon dominates the online-retail space and is moving into the cloud and into your living room with Amazon Prime. I'm bullish on Amazon in the long term, but I would wait for a pullback to around $240 to buy in.

Final thoughts

As the battle for the living room rages on, it is important to keep up to date on which content provider is providing content to who so you can see how shifts in subscriber and viewer bases might happen. This way you can stay one step ahead of the curve and have market-beating returns.

The tumultuous performance of Netflix shares since the summer of 2011 has caused headaches for many devoted shareholders. While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why The Motley Fool has released a premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. The report includes a full year of updates to cover critical new developments, so make sure to click here and claim a copy today.

Callum Turcan has no position in any stocks mentioned. 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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