TEXT-S&P discusses potential credit effects of Disney/Netflix deal

Fri Dec 7, 2012 11:26am EST

Dec 7 - On Dec. 4, 2012, Netflix Inc. (rated 'BB-' with a stable
rating outlook) and The Walt Disney Co. (A/Stable/A-1) announced a
licensing agreement that will make Netflix the exclusive U.S. subscription
Walt Disney Studios, starting with films released in 2016. We believe this is a
groundbreaking agreement, as it is the first such arrangement between an online
subscription video-on-demand (SVOD) operator (Netflix) and one of the major U.S.
studios. (Netflix already has first-run distribution agreements with a number of
independent studios, including DreamWorks Animation SKG.) It is also a
significant loss to Liberty Media, owner of the Starz LLC
(BB/Stable/--) premium movie service and the current U.S. pay TV distributor of
Disney films through 2015, because of the high profile of Disney (including
Pixar and Marvel) films.

The Netflix/Disney deal has no immediate impact on the credit quality of the 
participants, .given the three-year lead time before this agreement starts and 
the contractual delay between theatrical release and pay television 
availability (nine-plus months after theatrical release). Over the long term, 
however, our credit ratings on certain of the participants, as well as other 
entertainment companies, could be affected.

We believe that the Netflix transaction could be a minor credit positive for 
Disney, but is unlikely to move the rating. Based on press reports, Netflix 
will be paying Disney significantly more than what Starz is currently 
paying--and more than what Starz was offering to renew the contract. In 
addition, there could be some minor upside to our 2013 revenue estimates for 
Disney, as some of the company's direct-to-home videos will be made available 
on Netflix beginning in 2013. Lastly, in a separate agreement, Disney is also 
making available immediately selected titles from its library. Despite these 
positives, it is highly unlikely that we'll raise our rating on Disney, as we 
expect the company to use the incremental cash flow for acquisitions, share 
repurchases, or dividend increases.

In our view, the cost of the licensing agreement with Disney could cause some 
intermediate-term earnings pressure for Netflix, though we think it is a 
longer-term business positive for the company. The Disney deal will give 
Netflix access to very attractive family-oriented content, especially animated 
Disney and Pixar films. This will likely aid Netflix's efforts to acquire new 
subscribers (especially as we get closer to the launch of the Disney contract 
in 2016), and could lay the groundwork for Netflix expanding its service 
offerings beyond its traditional streaming service.. We think this will be 
increasingly important as 2016 approaches, because the majority of the Disney 
agreement cost will begin to accrue and become payable in 2016. In the shortr 
term, the agreement places added pressure on Netflix to accelerate subscriber 
acquisition or possibly increase prices in order to preserve its EBITDA margin 
and cash flow. Netflix will need to significantly expand its subscriber base 
over the next three to four years in order to afford this and other potential 
content contract renewals.

The Disney/Netflix deal is a credit negative for Starz over the longer term, 
in our opinion. The agreement will deprive Starz of a significant portion of 
its live action and family movie content beginning in 2016, and could reduce 
its negotiation leverage in carriage agreement renewals with cable operators. 
Several cable operators have aggressively communicated their focus on reducing 
subscriber fees to cable networks. We believe that the agreement between 
Disney and Netflix also could push Starz to further increase its investment in 
original programming. The success or failure of its original programming 
efforts will take on greater importance in the absence of Disney content being 
available in 2016. 

We believe the agreement could have a long term negative impact on the three 
other premium television channels (HBO, owned by Time Warner Inc. 
(BBB/Stable/A-2); Showtime, owned by CBS Corp. (BBB/Stable/A-2); and Epix, a 
joint venture between Viacom Inc. (BBB+/Stable/A-2), Metro-Goldwyn-Mayer Inc. 
(B/Stable/--) and Lions Gate Entertainment Corp. (B/Positive/--)), as it could 
lead to more aggressive competition from a stronger Netflix, a weakened Starz, 
and additional SVOD players, such as Amazon and Apple, which would want to 
keep up with Netflix.

In our opinion, the deal with Disney elevates Netflix to the same competitive 
position as the premium television channels. Historically, Netflix focused on 
television shows and older film libraries, but this contract, along with its 
recent contract with DreamWorks, will give Netflix access to a film slate that 
rivals those of the other channels. The upside potential is that Netflix may 
be able to increase subscriber fees, eventually putting the company on 
stronger financial footing and enabling it to use its improved financial 
flexibility to pursue other studio distribution deals as they come up for 
renewal. The downside scenario could be one of insufficient subscriber growth 
amid increased competition, leading to pressure on credit measures.

Starz, on the other hand, would be left with only its existing Sony 
distribution agreement and would need to aggressively pursue other studio 
deals and possibly increase its original programming efforts to remain 
competitive. Even if neither Netflix nor Starz were to land those contracts, 
they could certainly push up pricing for the eventual winners.

In addition to Sony's agreement with Starz (which expires in 2016), the other 
significant agreements are 20th Century Fox with HBO (recently renewed through 
2022), Warner Brothers with HBO (expires in 2014), Paramount with Epix, and 
NBC Universal with HBO (expires at the end of 2015). Both HBO and Showtime 
have increased their strategic emphasis on original programming content, with 
significant success, which could provide downside protection against the loss 
of a studio distribution agreement.

We believe the Netflix/Disney agreement could be a positive for all the film 
studios if competitive bidding does materialize from SVOD competitors, leading 
to higher pricing for the studios.

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