Why Time Was of the Essence in Netflix' Deal With Disney

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

When the content deal between Neflix (NASDAQ: NFLX) and Disney (NYSE: DIS) was announced earlier this week, the first thought that entered my head was Amazon (NASDAQ: AMZN) and how bad it must be feeling. There's no love-lost between the two companies.

Although Amazon’s Prime streaming service has been gaining some traction and is considered a legitimate threat to Netflix, this new deal means that Amazon won’t be getting a Disney ticket any time soon. On the other hand, Netflix needed this deal to happen much more than Amazon. But what did Netflix really get?

Growth is Good, But Show Me the Money

The more that I think about it, I realized that this exclusive deal with Disney only serves to buy Netflix more time – at least for now since it won’t actually take effect for 3 years. Nonetheless, it is certainly encouraging news for the company and investors as it allows Netflix subscribers to stream not only Disney movies, but also those from subsidiaries such as Pixar and Marvel.

However, in the meantime, Netflix will still need to prove that it can keep current subscribers interested in the service and not venture on to other options such as Redbox and HBOGo. This has been a problem that the company has not been able to solve for three consecutive quarters - at least not to the extent that it would like.

However, the company has been doing a decent job growing revenues. But profitability continues to be an issue. This was particularly glaring when the company reported third quarter earnings, which dropped by 90%. For the period ending in September, Netflix earned net income of just $7.7 million on revenues of $905 million.

Although revenues grew by 10%, it’s hard to overlook that net income in Q3 2011 arrived at $62.5 million. Netflix continues to make significant investments to grow internationally, a strategy that I consider too aggressive.

It's not that I think it's a bad idea, I just don't believe aggressive expansion should come at the expense of profits, much less trying to grow in areas that has been hit the hardest by tough macro climates such as Europe. It is clear that they don't have the money, so why insist upon it? At least that's the way I see it.

On the other hand, there are some encouraging signs that these international investments will someday pay off. For instance, during the quarter, Netflix was able to add 700,000 new members, which brings its total number of international streaming subscribers to 4.3 million.

This is quite an accomplishment considering the degree to which the service was losing subscribers at this point last year following the company’s ill-timed price increase. Likewise, the company was able to gain 2 million streaming members in the quarter, which has now brought its worldwide total to 29 million.

This is in addition to U.S. subscribers, which grew to over 25 million – up more than 20% year-over-year. Still, this type of growth does not come without a cost, which I alluded to earlier. I wonder at what point investors will begin to demand more bottom line returns for their investments. This means now is the perfect time to take a closer look.

Time to Cash in Early

In that regard, although the shares have been doing well of late and the company appears to be making the right moves, the stock is certainly not cheap – especially at a P/E of 107. Also, that the company has guided for a loss in the fourth quarter due to more capital investments, it may be an opportunity for investors to take some profits now and take their chances after Q4’s announcement. Why not?

This is not a slight against Netflix though. It just seems a bit too much to ask at this point to expect shares to continue to rally after the stock has already gained 60% over the past two months. After all, I doubt that there is another “Disney-type” deal waiting to be announced. If nothing else, it just might be time for a slight correction. Why would you want to hold?

Bottom Line

Although Netflix deserves a considerable amount of credit for this deal, I’m going to reserve judgment until there is more clarity on how much Netflix is paying Disney for exclusivity. Estimates suggest the deal is worth close to $300 million per year. Netflix has yet to confirm this. But if it is true, it would likely eat a great chunk of the company’s $800 million in cash, at least close to 40% of it.

The good news is that although it would be a considerable premium to pay, but (as noted) Netflix has 3 years before it has to pony-up. This is another example of what I mean by saying that what this deal has bought Netflix, is time. For the company’s sake, it should use it wisely.

rsaintvilus has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com, Walt Disney, and Netflix. Motley Fool newsletter services recommend Amazon.com, Walt Disney, 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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