Netflix and Disney Look to Break Away From Cable

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

In December, Netflix (NASDAQ: NFLX) and Disney (NYSE: DIS) announced a groundbreaking deal. Disney is searching for new distribution partners because it wants to focus on content creation rather than just broadcasting it. Broadcasting is becoming a commodity business, which has created a lot of pressure on Netflix’s stock. At times in the past two years it seems every bit of news that came out was a negative for Netflix, such as the Epix deal with Amazon (NASDAQ: AMZN). With the Disney deal that trend seems to have reversed itself. 

Previous quarter results confirmed that Netflix has turned the revenue corner on its streaming business, reporting a 10% increase in revenues -- $905 million for the quarter. Margins continue to drop, however (an 87.7% drop year-over-year) to over $7.67 million. And for most of 2012, the company performed far worse than its customer growth projections. It added just 1.2 million users in Q3.

Viewers can still watch Disney’s movies and shows on the Starz (NASDAQ: STRZA) network. However, beginning in 2016, that content becomes exclusive to Netflix.  Disney has been assiduously building an enviable portfolio of content brands, which include Marvel, Walt Disney Animation, Disney nature, Pixar and now Lucasfilm. So, now the Disney, Star Wars, Netflix circle is complete. 

Amazon, while a fantastic company, is still playing catch-up with Netflix in so many ways. While I have no doubt that Amazon will continue to evolve its Prime streaming services, as I look into the future I see a streamlined and focused Netflix determined to break the concept of the television network down and bring it into a different space. Amazon is still, first and foremost, a retailing outfit and everything it does is in support of that. 

The key to these projections longer-term falls squarely on the quality of the original programming that the streaming companies produce. The early returns on Netflix’s original series have been good. What I love about the way this is evolving is that big data will be combined into the content creation process to further refine the potential return on investment. 

Disney’s choosing to partner with Netflix gives them that conduit they were missing. The data for user chosen content when on-demand is so much more powerful than the old passive ratings model. Choosing to watch this show at this time versus the hundreds of choices available on a streaming service versus the handful available on cable or satellite – the “300 channels and still there’s nothing on!” phenomenon – gives the operators a far more direct conduit to customer preference and has a huge potential to improve the economics of content creation. 

Obviously, Disney is looking at making a break from cable, which it is currently too reliant on for revenue – ESPN, alone accounts for more than 45% of Disney’s top line. It easily could have sided with its current partner, Starz, which Liberty Media has been actively shopping for more than a year now and just recently spun off in an IPO.  Starz is working the HBO and Showtime model of having original content interspersed with theatrical releases but being tied to the underlying cable subscription model that is in the beginning stages of dying.

Additionally, Netflix will also own Pay-TV rights for new DreamWorks releases, starting from 2013 onwards which will continue to support its content portfolio. While the Quikster deal adversely affected the reputation of Netflix last year, Netflix is still a leader in content distribution with the help of its superior technology and end-user interface, and it made the entire saga of its stock dropping out of line with the underlying story. By keeping its exclusivity deals to a minimum (and Disney is a far bigger partner than Epix) Netflix freed up operating cash and can focus on worldwide expansion rather than shutting competition out of the market which is a losing business model.

Long term I think Netflix is making a lot of the right moves to have a significant first-mover advantage in the post-cable subscription landscape. This is a model that will die slowly as it is propped up by a number of well-connected players, including Disney, but the moves within the industry now are telling us where things are headed.

PeterPham8 has no position in any stocks mentioned. The Motley Fool recommends, Netflix, and Walt Disney. The Motley Fool owns shares of, Netflix, and Walt Disney. 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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