Look Out, HBO — Netflix/Epix Deal Creates a Pay-TV Threat

ANALYSIS: Less than three years since the subscription rental company launched its streaming service with less than 2,000 titles of dubious quality, Netflix is clearly gambling that the future is digital

A new pact between cable channel Epix and Netflix to stream movies online makes the video rental giant a pay TV player, whether it admits it or not.

After Tuesday's agreement, Showtime and HBO should start looking over their shoulder, because make no mistake, Netflix is playing on their turf.

Under the agreement, Netflix subscribers will get to stream box-office hits such as "The Last Airbender" and "Iron Man 2" 90 days after their premium pay TV and subscription deals.

And Tuesday's move only builds on a similar arrangement the company made last month with Relativity, which gives Netflix the licensing rights to all movies on which Relativity controls distribution. That amounts to some 14 movies over the next 12 months.

All of this dramatically increases the number of titles that Netflix offers its customers digitally at a time when the company is trying to encourage subscribers to migrate away from by-mail delivery and towards online distribution.

Less than three years since the subscription rental company launched its streaming service with less than 2,000 titles of dubious quality, Netflix is clearly gambling that the future is digital. By turning its subscribers onto streaming, it will dramatically reduce its overhead. The company plans to spend $700 million on postage next year, on its way to $1 billion in postage fees in the next few years.

And last quarter, it reported that 61 percent of its customers streamed all or part of a movie, up from 37 percent in the second quarter of 2009.

"This is part of who we are — a low priced unlimited subscription company, and our customers are reacting to an economic proposition and the completeness of value they get for their nine bucks," Ted Sarandos, Netflix's chief content officer, told TheWrap on Tuesday.

The flat rate that Netflix offers may not give customers first run episodes of "Weeds" or "True Blood," but it comes with enough movies available for streaming and at a steep enough discount to put the rental service in heavy competition with premium cable movie channels.

"It represents a very big threat to HBO. They aren't serving different markets, they're competing for entertainment dollars on a subscription basis," Edward Woo, an analyst with Wedbush Morgan Securities, told TheWrap.

"I wouldn't say it cuts the [cable] cord, but it definitely shaves the cord," Tony Wible, an analyst with Janney Montgomery Scott, told TheWrap.

On Tuesday, however, Sarandos and Netflix chose to downplay their recent incursions into the pay TV market.

"You don't have to cancel anything or cut your cord," Sarandos told TheWrap. "Streaming provides a reason to have broadband, which cable needs, because you don't need faster internet to send email, but you do need it for great video service. It's a win-win and there's no evidence that it represents a threat.

"You can subscribe to Showtime and see every past episode of 'Dexter' while you watch the current season, so it actually gives you a reason to subscribe," he added.

Betting that its customers will be willing to give up its signature red envelopes will cost Netflix a pretty penny. The company declined to comment on the financial terms of the deal, but according to the Los Angeles Times it will pony up close to $1 billion over five years for rights to the films. That translates into $200 million a year, or 20 percent of the total amount that Netflix spent on content the previous year.

"It's expensive," Sarandos told TheWrap. "We plan to measure the payback in subscriber growth and retention."

For Epix, the exclusive deal with Netflix instantly pushes the fledgling channel — launched by Paramount, Lionsgate and MGM a year ago — into profitability.

"It's purely about money, " Woo said.

Of the three studios in the Epix consortium the big player, at least as far as Netflix is concerned, is Paramount. The studio offers a range of popular titles from "Transformers" to "Indiana Jones" that are bound to appeal to a broader clientele.

Netflix, which currently has 15 million subscribers, has said it anticipates having over 20 million by the beginning of next year. As its customer base grows, its identity as the preferred brand of cinephiles must change, too.

Though 70 percent of Netflix's business is for catalogue titles, analysts say that the new customers are expected to be more casual movie watchers, interested less in Eric Rohmer's ouevre than in the latest releases.

The upside for Netflix is clear, but analysts questioned the wisdom of Epix's move.

In the short term, the deal provides much needed cash flow for a cable channel that only draws 3 to 4 million subscribers and has yet to ink deals with major cable providers such as Comcast and DirecTV. Over the long term, the risks to Paramount and its parent company Viacom may outweigh gains.

"It poses a long term hazard to Viacom's business model," Wible said. "There is cannibalization potential. There's a finite amount of entertainment dollars and consumer time, and by offering these options more cheaply, Netflix could cut down on over-the-counter video sales."

But Paramount almost alone among the major studios has shown the greatest willingness to dip its toes in alternative and cheaper distribution channels. The studio decided to sit out the recent war between the movie companies and Netflix and Redbox over release windows. And in June Paramount announced that it had concluded that allowing Redbox to rent its new releases on the same day they hit stores did not harm its disc sales.

"Viacom recognizes that it's a rapidly changing universe out there and it's a great content provider," Sarandos told TheWrap.

As for Netflix, as the rental giant has increased its online offerings, it has shown enormous growth in its streaming business. "We're taking the money we save on mailing the discs and putting it into these deals," Sarandos said. "We'd rather spend money on content than postage."

Netflix claims the savings that the company anticipates seeing in shipping will allow it to keep a lid on prices. It says it does not anticipate having to raise subscription costs. But analysts questioned rather the Netflix's ledger would be able to balance out like it anticipates.

"It's not going to be the only one jockeying for content," Wible said. "Those prices are going to go up."