On June 18, Netflix, Inc. (NASDAQ:NFLX) and Dreamworks Animation Skg Inc (NASDAQ:DWA) announced that they had struck a deal to bring exclusive, original content to Netflix. Ostensibly, this fills the void left by the lapse of Netflix’s deal with Viacom, Inc. (NASDAQ:VIAB). It represents the next step in Netflix’s push for original content, which is designed to differentiate it from competitors such as Amazon.com, Inc. (NASDAQ:AMZN)’s Prime Instant Video.
Netflix, Inc. (NASDAQ:NFLX)’s market cap surged by about $1 billion on the news, but the price tag of the deal is going to be hefty. Will this be a game changer, or is it simply a sign of Netflix’s desperation?
Why make this deal now?
The deal with DreamWorks is mutually beneficial. Netflix, Inc. (NASDAQ:NFLX) gets access to a vast library of titles, including DreamWorks’ franchises and the Classic Media library, while DreamWorks gets to diversify its revenue.
Dreamworks Animation Skg Inc (NASDAQ:DWA) has been pushing its way into the television market, but it is primarily reliant upon a few movies each year. This means that its revenue tends to fluctuate a lot. The deal with Netflix will provide a more consistent stream of revenue, especially since the deal involves original content. As a result, DreamWorks will move closer to being a TV studio rather than just licensing its rights to television.
As for Netflix, Inc. (NASDAQ:NFLX), it is essentially cutting out the middle man and getting its content straight from the source. Instead of paying Cartoon Network, for example, it will now license content directly from DreamWorks. This also allows the company to partner with the studio to create original content, which it finds essential to maintaining a customer base. More importantly, all content from DreamWorks, original or not, will be exclusive to Netflix. On top of this, the deal helps fill the void in its children’s library, which was left gaping by the break with Viacom, which licenses series’ such as SpongeBob SquarePants.
Netflix vs. the competition
Shortly after Netflix, Inc. (NASDAQ:NFLX) and Viacom declined to renew their agreement, Amazon.com, Inc. (NASDAQ:AMZN) signed a huge licensing deal with Viacom. Netflix allowed its agreement with Viacom, Inc. (NASDAQ:VIAB) to expire when it was unable to secure exclusive rights to shows such as SpongeBob and Dora the Explorer. This was a very dangerous move—the company ran the risk that angry parents would switch over to Prime Instant Video even though Netflix still maintained a large children’s library.
There will undoubtedly be some lag time before DreamWorks’ titles begin appearing on Netflix, so will people who subscribe to Netflix primarily for children’s content stay? The answer is a soft maybe. Some subscribers will keep the service out of habit and convenience, while others will be drawn to the allure of Amazon Prime, which also offers perks such as free two-day shipping and is actually cheaper than Netflix.
Amazon is rapidly catching up with Netflix, Inc. (NASDAQ:NFLX) in terms of the quality and scope of its library. It now has over 40,000 titles and is rapidly growing, showing a 35% increase in titles from December. By contrast, Netflix lost over 2,000 titles in May while adding only 500. Furthermore, Amazon is starting to beat out Netflix in bidding wars for content, whether that content is exclusive or not. Amazon’s financial muscle should allow it to win more and more of those deals in the future, which does not bode well for Netflix.
A big price tag
Netflix, Inc. (NASDAQ:NFLX) is moving to capture and produce more and more high-quality children’s series. However, the cost for this will be very high, and the return is uncertain at best. Financial details of the deal with DreamWorks have yet to be released, but if history is any indication Netflix is shelling out big time. The company spends roughly $4 million per hour of content when producing House of Cards, its first original series, and the DreamWorks deal covers about 300 hours of content. This adds up to a price tag of about $1.2 billion. This is inline with industry standards, but for Netflix it represents over half of its 2012 spending on content. That’s a significant chunk, and the jury’s out on whether or not it’s worth it.
Foolish conclusions
Netflix, Inc. (NASDAQ:NFLX)’s valuation multiples are drastically higher than those of its competitors, which is a cause for concern. Its revenue multiple is roughly 3.8, and its EBIT multiple is 32.5, both of which indicate that the stock is overvalued. Consequently, if Amazon continues to push Prime Instant Video and eats into Netflix’s market share, that could spell trouble. In that case, I’d expect to see a dramatic correction in Netflix’s stock price.
That possibility seems more and more likely as Amazon continues to acquire content that rivals Netflix’s. Amazon’s service is cheaper and offers more perks than Netflix’s, so expect customers to begin jumping ship. Netflix’s best bet is to hook consumers on exclusive content, but as Amazon wins more bidding wars that will be more and more difficult. Keep an eye on content deals—the more Amazon wins, the worse for Netflix. For now, I’d rate Netflix a hold, but if Amazon continues its charge, it’s time to get out. In the long term, it looks like Amazon will be a winner.
As for DreamWorks, it comes out a winner as well. It gets to establish itself as a television studio, and produce series on Netflix’s dime. The deal is in the books, and now DreamWorks gets to cash in. The company’s P/E ratio outpaces the industry average, and the multi-billion dollar content deal with Netflix, Inc. (NASDAQ:NFLX) should only boost it. Although it has a relatively small market cap, DreamWorks is a safe place to have your money. As it continues to diversify its revenue, it becomes a better bet.
Hunter Hillman has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, DreamWorks Animation, and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. Hunter is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article Why You Should Be Wary of Netflix originally appeared on Fool.com and is written by Hunter Hillman.
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