Video Content Distribution Investing in Digital Streaming and DVD Distribution

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- Jan 18, 2012 -

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WebTech Research Overview

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Investment Universe + Report Focus

Content

Video

Traditional Publishers

Studio Compatible

Devices End Consumers

Video Content Distribution Value Chain

Our Universe of Web Technology

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Music

Warner Bros., Paramount, Fox, Walt Disney / Touchstone,

Columbia / TriStar, Universal

Digital: Cable/DBS, Netflix, HBO Go, iTunes, Hulu, Amazon

Physical: Amazon, Wal-Mart

Digital: PC/tablet/smartphone, Gaming Consoles, TV+Cable/DBS

Physical: TV + DVD/BlueRay

E-COMMERCEADVERTISING

INFRASTRUCTURESOCIAL

MEASUREMENT

AGENCY /DIVERSIFIED

SEARCH

IDENTITY

LOCATIONSERVICES

PLATFORMS

MERCHANTS

CONTENT

TRAVEL

CONTENTDELIVERY

SOFTWARE &SERVICES

DATACENTERS

GOVERNMENT

POLICYGames

Focus of this Report

Content

Distributors

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The Content Flow (chronological order)

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_____

Source: Canaccord, November 2011

1) Release windows are prescribed time gaps between which films are aired over different media

Medium of Distribution

Release Windows(1) Studio Economics Incentive to

Studio

Theatres/ Box Office

Tentative Duration: 4-5 Months

~80-100% of ticket price (~$7.50) in the first week, dropping to ~20% after one month

4

Pay-per-View/ Video on Demand

2-8 Weeks ~60-70% of PPV Price 3

DVD (Purchase, Rental &

Streaming) 6 Weeks

For Purchase: ~20-30% of DVD price($10-$20 for standard DVD, $20-$30 for Blue Ray)

For Rental & Streaming: minimal revenue share

1

Premium Cable (HBO, Starz, Showtime,

Cinemax) 18 Months

Based on film’s box office performance ($6mm-$8mm per film, up to $25mm for a

blockbuster)

2

Free over-the-air cable 12-18 Months $3mm-$15mm per movie

(depending on title and the number of runs) 2

3

1

2

4

5

US Video Rental Market Opportunity

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NCR Estimates Screen Digest Estimates USD Billion USD Billion

7.9

9.3

6.2

7.4

-

2.0

4.0

6.0

8.0

2010 2015F

Traditional Subscription Kiosk

2

14.0%

7.3%

(14.6%)

Infrastructure improvements will facilitate the growth of digital models, while competitive pricing will drive kiosk growth.

_____

Source: NCR, Screen Digest

-

2.0

4.0

6.0

8.0

10.0

2009 2013F

Brick and Mortar Subscription Digital Kiosk

2

24.5%

13.9%

12.3%

(22.2%)

US Streaming Opportunity

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_____

Source: IDC, December 2011

Increased broadband penetration – rising from 63.2% in 2010 to 71.0% in 2015 – will contribute to driving demand for online digital content.

60.5%

63.2%

65.6%

67.6%

69.1% 70.2%

71.0%

-

20.0

40.0

60.0

80.0

100.0

52.0%

56.0%

60.0%

64.0%

68.0%

72.0%

2009 2010 2011E 2012E 2013E 2014E 2015E

Broadband Subscribers (mm) Broadband Household Penetration

Worldwide Streaming Opportunity

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_____

Source: Internet World Stats Broadband Presentation

According to Cisco’s Visual Networking Index (VNI) Global IP Traffic Forecast, video traffic is expected to experience ~48% CAGR from 2010-2015, driven increasingly by long-form video content

Broadband penetration, combined with improving internet speeds, has helped to establish internet streaming as the preferred medium for viewing video content.

Growth of Networked Devices

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_____

Source: IDC

Strong growth in networked video devices – laptops, tablets, gaming consoles – is expected to further fuel online streaming of movies/TV shows.

-

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

200.0

2009 2010 2011E 2012E 2013E 2014E

U.S. Networked Video Device Installed Base (Units in mm)

5 Key Trends

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• Successful streaming model by NFLX resulted in other technology companies (APPL, GOOG, AMZN) entering the market (primarily through a la carte models)

• However, cost advantage remains with incumbent streaming operators such as NFLX, given their focus on older content

Growing Competition

• Decline in theater attendance (~90% since mid-1970s) and DVD sales (~50-70% of studio revenue) has forced studios to reevaluate existing release window schedules

• PPV/VOD/OTT window will offer the biggest opportunity for studios to maximize their profits

Studios Evaluating Changing Release

Windows

• As VHS was superseded by DVD, it is expected that DVD will ultimately be superseded by digital/streaming models

• However, the tail of DVD is TBD

Content Moving Digital

• Could prove to be a powerful new subscriber acquisition tool (especially in international markets)

• Will facilitate improvements in recommendation engine by employing users’ social data

Integration with Social Networking

• ISPs – especially those with significant cable distribution businesses, such as Time Warner and Comcast – could spoil the party, as they control the pipes which businesses such as NFLX rely upon

• The ability to implement data usage caps will be ultimately decided in the courts

Internet Service Providers?

Competitive Analysis

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_____

Canaccord, November 2011

1) Street date is the date the movie is to be released for sale to the general public

Brand Offering Pricing Library Content

Availability Subscribers (mm)

Online Streaming + DVD-by-mail

• Unlimited Streaming: $7.99/month (+$2 for Blu-ray)

• DVD-by-mail: $7.99-$11.99/month

• Streaming and DVD-by-mail: $15.98/month

• Unlimited Streaming - 20K+ Titles (50% movies, 50% TV Shows)

• DVD-by-mail - 125K+ titles (80% movies, 20% TV Shows)

28-Day delay for Fox, Universal and Warner

Bros. titles; street date(1) for other studios

23.8

Automated DVD vending kiosks for movies & games

$1.20/night (Blu-ray – $1.50/night)

~200 titles on average to browse on each kiosk

28-Day delay for Fox, Universal and Warner

Bros. titles; street date(1) for other studios

na

Available free with HBO subscription

Free with HBO subscription (HBO subscription is

~$10.00/month, incremental to a cable package)

1400 + HBO Shows Within 24 Hours of

Broadcast HBO Subs = 28.2

HBO Go Subs = na

Online streaming for Movies and TV Shows

Available free with Comcast Cable TV Subscription

75K+ Movies and TV Shows

na Comcast Subs = 14.0

xfinity Subs = na

Unlimited, commercial-free, streaming-only

offering for Amazon Prime members

$79.00/year 12K+ movies and TV

shows na 5.0

Competitive Analysis

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Brand Offering Pricing Library Content

Availability Subscribers

(million)

Streaming-only offering for TV Shows

$7.99/month

• 1.5K seasons of TV Shows (comprising 33K+ episodes)

• Hundreds of movies and documentaries

na 1.0

DTO or VoD for movies and TV Shows

• $4.99 to $14.99 for DTO movies

• $0.99 to $3.99 for VoD movies

• $0.99 to $2.99 for DTO TV shows

100K+ movies and TV Shows

na na

STO or VoD for movies and TV Shows

• $9.99 to $19.99 for DTO movies

• $0.99 to $4.99 for VoD • $0.99 to $1.99 for DTO TV

Episodes

50K+ TV Shows, 8K+ movies

Street date(1) na

DVD-by-Mail and unlimited streaming

• $10.00 for 1 DVD out at a time

• $15.00-$20.00 for multiple DVDs out at a time plans

• 100K+ movies and TV shows by mail

• 4K streaming titles to computer

• 3K streaming titles to TV

Street date(1) na

DTO or VoD for movies and TV Episodes

• $9.99 for DTO movies • $3.99 to $4.99 for VoD

movies • $1.99 for DTO TV Episodes

30K+ movies and TV Shows

Street Date na

_____

Canaccord, November 2011

1) Street date is the date the movie is to be released for sale to the general public

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Content Distribution Comps

Key Statistics Takeaways

• Data Availability

o Considering most players in the content

distribution space have diversified business

mixes, we have focused on NFLX and CSTR.

• Key Metric(s)

o Subscribers / Same-store Sales Growth: Given

the intense competition, will the company be

able to grow subscribers or same-store sales

through attractive pricing and content

acquisition?

• Market Valuation

o Based on 2013E P/E, NFLX trades at a premium

to both the market and CSTR due to position of

strength in online streaming space – the

primary long-term growth segment in video

rental market. CSTR trades at a discount to the

market due to its reliance on DVD rental kiosks,

a distribution medium with questionable long-

term prospects (and despite its high margin

coin business).

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_____

Source: Company Filings, Company Press Releases, Bloomberg Estimates and WebTech Research Estimates

Company Netflix Coinstar

Ticker NFLX CSTR

Share Price $94.72 $44.93

Market Cap $5,225.0 $1,387.7

Less: Cash $365.8 $255.3

Plus: Debt $234.7 $397.9

Enterprise Value $5,093.9 $1,530.3

Revenue

2013E $4,162.3 $2,209.2

Y/Y Growth 16.2% 1.8%

2012E $3,582.0 $2,170.2

Y/Y Growth 12.4% 19.1%

LTM $2,924.9 $1,715.7

2013 EV/Sales 1.22x 0.69x

2012 EV/Sales 1.42x 0.71x

LTM EV/Sales 1.74x 0.89x

EBITDA

2013E $395.3 $406.5

Y/Y Growth 147.3% (2.3%)

2012E $159.9 $416.1

Y/Y Growth (64.7%) 17.6%

LTM $432.6 $341.1

2013 EV/EBITDA 12.9x 3.8x

2012 EV/EBITDA 31.9x 3.7x

LTM EV/EBITDA 11.8x 4.5x

EPS

2013E $3.60 $4.01

Y/Y Growth 370.5% NM

2012E $0.77 $3.92

Y/Y Growth (83.7%) NM

LTM $4.40 $2.62

2013 P/E 26.3x 11.2x

2012 P/E 123.7x 11.5x

LTM P/E 21.5x 17.1x

Subscribers / SSS Growth

2013E 28.9% (14.4%)

2012E 26.3% 7.3%

0.0% 9.5%

10/24/11: NFLX Q3 ‘11 beat, but subscriber & churn guidance disappoints

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

110.0%

Q2

'09

Q3

'09

Q4

'09

Q1

'10

Q2

'10

Q3

'10

Q4

'10

Q1

'11

Q2

'11

Q3

'11

Q4

'11

Mar

ket

Shar

e

Online/By Mail Rental Provider National B&M Rental Chains (Includes .com) All Other B&M (Includes Local) Redbox

-

50.00

100.00

150.00

200.00

250.00

300.00

350.00

Sto

ck P

rice

($

)

Stock Price and Market Share Analysis

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_____

Source: NPD VideoWatch data from CSTR’s quarterly filings

Note: National B&M doesn’t include Movie Gallery and Hollywood Video Due to bankruptcy liquidation

NFLX & CSTR stock performance follows subscriber / same store sales growth.

7/12/11: NFLX separates DVD and streaming packages, effectively raising prices

- Netflix

- National B&M Rental Chains (Includes .com) - Redbox - CSTR (annotations in bottom row)

- NFLX (annotations in top row) - All Other B&M (Includes Local)

1/27/10: NFLX Q4 ’09 beat, guidance for Q1 & 2011 exceeds expectations

4/29/10: CSTR Q1 ‘10 beat, guidance for Q2 & 2011 exceeds expectations

2/3/11: CSTR misses consensus after preannouncement

2010: NFLX continues to deliver strong subscriber growth in ‘10

1/13/11: CSTR negative preannouncement for Q4’ 10

7/25/11: NFLX Q2 ‘11 miss, guidance for Q3 below expectations

2/3/11: CSTR misses consensus after preannouncement

2/3/11: CSTR raises DVD rental price in response to Durbin related expenses

Netflix [NASDAQ: NFLX]

KEY SEGMENTS

• Online Streaming: Provides access to TV shows and movies streamed over the Internet to TVs, computers and networked devices. Subscribers = ~21.5 million. Priced at $7.99/month. Contribution margin = ~8%

• DVD-by-mail: DVDs are sent by US first-class mail and returned using pre-paid mailers. NFLX’s library currently contains over 125K DVD titles. Subscribers = ~13.9 million. Priced at $7.99/month (hybrid plan priced at $15.98/month). Contribution margin = ~50%

CONSENSUS CONCERNS

• Increasing Content Spend: NFLX announced a marked increase in 2012 content spend (~100% y-o-y)

• Our view: We share the concern, and believe NFLX will continue to face rising digital content costs given its focus on streaming. Note that high quality movie content (Sony/Columbia, Warner Bros., Universal, Fox Searchlight etc.) is locked up next few years under current pay TV window and the contract with Starz is ending in Q1 ‘12. We believe that certain studios will continue to limit NFLX’s access to given its value proposition to studios. This coupled with international expansion will impact 2012 profitability

• Continued Sub Loss: NFLX lost ~800K subs in Q3 ‘11 due to the increased pricing / Qwikster debacle

• Our view: We don’t share this concern – the pricing change was appropriate, but not the way it was communicated. Pricing related sub losses have subsided and NFLX will return to sub growth

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NFLX, the market leader in content distribution, saw shares fall ~50% LTM due to a price increase and intense competition.

Netflix [CONTINUED]

WHAT WE LIKE

• Market Leader: NFLX leads the market with a subscriber base of ~24 million in the US. Given its penetration at ~30% of broadband subscribers and revenue at ~13% of the home video market, Netflix has room for growth. Additionally, NFLX holds a scale advantage not easily replicable without significant investment

• Monetization Channel for Catalog Content: Much of the content consumed on NFLX is 1-2 year old catalog content. NFLX’s ability to generate demand for catalog content through its rating system and recommendation engine gives NFLX leverage with studios who are all seeking to monetize older content

WEBTECH RESEARCH RECOMMENDATION = BUY under $80.69, aggressively under $77.78

• Price Target: We arrive at a price target of $112.77 based on valuing the earnings potential of the streaming business (we disregard the more profitable, but contracting DVD business in our valuation). We assume NFLX exits 2013 with a streaming ARPU of $8/month, streaming contribution margin of 14.5% (up from 8%) and 34.5mm total subs (up from 25mm). We then tax affect (35% tax rate) the 2013E contribution dollars to arrive at 2013E net income, and apply a 20x P/E multiple (consistent with our view of near-term sub CAGR of 20%)

• Price Support: Capital infusions by T.Rowe at $70.00 (equity) and by TCV at $85.80 (zero coupon convertible) will provide support for shares in the event of a pull back

• Short: The risk reward ratio for a short trade becomes favorable (at >4.5x) above $107.72. We would consider a fundamental short position if the long-thesis is “over-confirmed” (if shares rise above $124.05)

• Stock will move after… a) Q4 earnings (Jan 25th); b) acquisition rumors; c) positive data from and/or further international expansion; d) DVD window extension by other studios

Price Target = $112.77 (19.1% appreciation). Accumulate under $80.69.

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Coinstar [NASDAQ: CSTR]

KEY SEGMENTS

• DVD Rental (Redbox): Operates 34,400 self-service DVD rental kiosks. Rentals priced at $1.20/night. Contributes ~84% of revenues. Operating Margin = ~18.7%. Market Share = ~34.7% in US DVD rentals

• Coin Services: Owns and operates fully automated network of 18,900 self-service coin-counting machines across the US, Canada, Puerto Rico, Ireland and the UK. Charges 9.8 % processing fee. Contributes ~16% of revenues. Operating Margin = ~36.2%

CONSENSUS CONCERNS

• Impact of Price Hike: In October 2011, Redbox increased daily rental rates from $1.00/night to $1.20/night, citing increased operational costs due to the Durbin agreement

• Our view: We do not share this concern as pricing remains competitive relative to other rental options (PPV or VOD). Management guided to incremental $10-$14mm (~3% of Redbox revenues) of expenses on account of the Durbin agreement. The 20% price increase will provide sufficient cushion for additional costs and any loss in rental volumes. We expect our lack of concern to be confirmed when Q4 numbers are released

• Lengthening DVD Windows: Recently Warner Bros. doubled DVD window from 28 days to 56 days. While NFLX has agreed to this, both Blockbuster and Redbox are opposing the move

• Our view: We share this concern. Without prior agreements, Redbox may have to purchase the DVDs from retail outlets on the street date (first-sale doctrine), which will pressure margins

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CSTR, the cheapest DVD rental provider, has plummeted on concerns of the long term viability of DVDs. We believe these concerns are premature.

Coinstar [CONTINUED]

WHAT WE LIKE

• Platform to Launch Streaming Business: Redbox customers rent DVDs from over 30K points of presence (kiosks). Management is taking a captious approach to leveraging its customer base to launch a new streaming business

• Low Cost and Geographical Footprint: Capital requirements tend to be low (~$15,000- $20,000 to install a kiosk). Marketing costs are minimal and moreover, ~68% of households are within 5-minute drive-time of a Redbox kiosk

• Market Share Gains: VOD prices tend to be $4.99+ for new releases. Until these price points come down, Redbox remains the low price leader for a la carte rentals at $1.20/night. Redbox reported ~20% growth in unique credit cards and ~60% growth in unique email addresses at kiosks in Q3 2011

WEBTECH RESEARCH RECOMMENDATION = BUY under $44.00, aggressively under $42.70

• Price Target: We arrive at a price target of $59.31 (32.0% upside). Given the distinct margin and growth profiles of CSTR’s two business lines, we assign a 3x EBITDA multiple to the coin business (high margin, but limited growth) and a 6x multiple to the DVD business (prospect of leveraging existing customers if a streaming business is launched). Our EBITDA estimates are based on annualizing the last 9 months for each business segment

• Price Support: We recommend closely watching $39.00-$40.00 – a key technical level

• Short: The risk reward ratio for a short trade becomes favorable (at >4.5x) above $55.61. We would consider a fundamental short position if the long-thesis is “over-confirmed” (if shares rise above $65.24)

• Stock will move after… a) Q4 earnings (Feb 6th); b) announcement of a streaming plan (may include partnership with Verizon); c) DVD window extension by other studios

Price Target = $59.31 (32.0% appreciation). Accumulate under $44.08.

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For questions and comments, please contact: Brian Murphy Indaba Global Research 617-571-1550 brian@indabaglobalresearch.com www.indabaglobalresearch.com