3Q raises new obstacles: Epix, TV Everywhere

Gorging on new content will help Netflix shake off its troubles, but as CEO Reed Hastings signaled during the company’s third-quarter earnings call Monday, even that strategy comes with challenges.

While investors were disappointed with the reported decline of 810,000 streaming subscribers in the second quarter, some equally depressing projections for the final months of 2011 also contributed to a 27% drop in after-hours trading, sending the stock to $85. It had opened the day at $119.37.

Netflix foresaw a continued decline in the fourth quarter, with streaming subs possibly slightly below the 21.45 million registered at the close of the third quarter. That’s down from 24.59 million from the quarter before.

DVD subs are also expected to decline in the fourth quarter, even though the holiday season is typically a healthy period for Netflix.

In addition, Netflix indicated trouble ahead on the international front. While Hastings announced the streaming service’s long-awaited push into the U.K. and Ireland, he signaled that domestic profits would not be able to cover losses generated by overseas investments in the first quarter of 2012. Netflix will subsequently freeze further international expansion until that shortfall is corrected.

“We put a pause on international expansion until we get back to global profitability,” Hastings said.

With a pair of decisions that drove up Netflix pricing and caused confusion with regard to its DVD business, it’s no wonder Wall Street turned up its nose, given the issues that could compromise the company’s returns over the next two quarters.

But on the call with analysts and in the letter to investors that preceded it, Hastings clearly pinned Netflix’s hopes on increasing its content holdings. While he didn’t specify numbers, he projected a doubling of spending on streaming rights in the U.S. for 2012.

“It’s exciting that we’re filling out this content,” said Hastings, who also drew direct comparison to spending levels at HBO.

Wedbush Securities analyst Michael Pachter has already pegged Netflix’s 2012 content bill at $2 billion, up from just $180 million in 2010. But that’s a global projection that takes into account everywhere from Canada to Latin America. Hastings said Netflix has been in these regions long enough to gauge the local tastes, and he intends to spend more there.

In his letter to investors, Hastings talked up the succession of recent deals that have pumped 3,800 new episodes into Netflix’s streaming vaults, including pacts with Discovery, AMC and the CW. He also noted that its current roster of output deals will drive some relatively fresh theatricals to Netflix, including “The Rum Diary” and “The Immortals.”

He also pointed to the example of AMC series “Mad Men” and “Breaking Bad” as a precursor to more deals that will drive programming exclusive to Netflix at a time when competitors are starting to get into the market. “We’ll end up doing more and more exclusives over time, and that has been witnessed in what we’ve seen to date,” Hastings said.

But the content facet of the business won’t be without its challenges. For one thing, Hastings declined to comment on reports that Netflix’s $1 billion deal with Epix, which grants streaming rights to titles from Paramount, Lionsgate and MGM, may be coming up for renegotiation as soon as next August.

With Epix Netflix faces the prospect of a repeat of its recently dissolved deal with Starz, which delivered Sony and Disney movies deemed critical for putting Netflix on the map. Netflix could have been forced to pay Starz exponentially more than the estimated $30 million it originally paid for the rights, but the two sides failed to come to terms.

However, Hastings repeated his assertion that the Starz movies amounted to only 6% of total hours viewed on Netflix. It’s unclear whether Epix would present a bigger problem — and how big a paycheck would be required to keep the deal intact.

Hastings also touched on the competitive landscape, from new entrants like Amazon and Hulu Plus to entrenched pay TV players like HBO.

While he discounted the former for currently having a fraction of the content Netflix has been able to amass, he acknowledged that while there’s room for multiple pay TV options in U.S. homes, the sluggish economy is forcing consumers to establish a “pecking order” that could leave some channels with fewer subs.

Hastings also said the TV Everywhere model bears watching because if the operator-driven model like Comcast’s XfinityTV takes precedence over individual channel strategies like HBOGo, that could keep Netflix on the sidelines.

Even the core competency Netflix is throwing itself into with renewed intensity — content licensing — has its limits: There’s only so much programming that can be bought in a video business fragmented by exclusive arrangements.

Hastings said: “We have dramatically more content than any other subscription service or network, but given the existing licensing structure of the cable network industry, the total content available will likely remain carved up between Netflix, Showtime, HBO, Hulu and others.”

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