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Netflix risks studio ‘deal tax’

Content costs could rise if CBS, 20th exercise put option

If “CSI: Miami” shows up on Netflix anytime soon, it probably won’t be because the streaming service asked to carry it.

The drama series, which ended its 10-year run on CBS last month, may end up on Netflix when the licensing arm of CBS Corp. wants it there, for licensing fees that are above and beyond the estimated $200 million library content deal they inked last year. Netflix could be on the hook to carry more than 230 episodes of the show, at a cost of hundreds of thousands of dollars for each seg — no small expense for Netflix, whose content costs are already under scrutiny on Wall Street.

That move would be the result of the so-called “put option” that Netflix agreed to in its contract with CBS Corp., essentially forcing Netflix to pick up at additional cost the streaming rights to any of their canceled series. At least one other studio, 20th Century Fox, is believed to have a similar arrangement in place.

CBS and 20th declined comment. A spokesman for Netflix declined to comment but issued a statement: “Our content costs are very predictable and detailed as future commitments in our public filings. We do not comment on the specifics of particular deals, but any total cost variance would be marginal.”

Netflix chief content officer Ted Sarandos played down the significance of the put option at a recent investors conference, characterizing it as a “deal tax” that would be contained by unspecified caps that are in place on their deals. Moreover, sources on both sides acknowledge that the put option could be used as a bargaining chip for the sellers in order to extract other concessions at the negotiation table.

That’s because the studios have little incentive to squeeze a content buyer that has padded their parent companies’ bottom lines handsomely in recent quarters and could grow into a major player as it expands its original programming roster. For the studios, the put option may simply be an insurance policy of sorts to help offset lost deficit-financing for recently busted, low-cost series.

But the studios’ leverage illustrates just how delicate their dance is with Netflix, which ultimately doesn’t have complete control over the content it gets or how much it pays for that content.

In February 2011, CBS and Netflix signed a two-year deal with a two-year option. Series covered under the deal included such classics as “Cheers,” “Frasier” and “Star Trek.”

Netflix and 20th Century Fox struck their licensing deal last August, covering series including Fox’s “Glee” and FX’s “Sons of Anarchy,” as well as titles from the studio’s theatrical arm.

While “CSI: Miami” was a solid piece of CBS’ schedule for a decade, the crime-centric procedural doesn’t fit the profile for a valuable asset on Netflix. The streaming service has proved ideal for serialized dramas like Fox’s “24” that are a far cry from the self-contained storylines that made “CSI: Miami” so valuable in off-net syndication.

Cabler AMC paid an estimated $80 million-$90 million for the rights to “CSI: Miami” in 2011, but subscription VOD rights were not a part of that deal.

CBS Corp. CEO Leslie Moonves alluded to the value of having the put option in the company’s first-quarter conference call. “The significant thing about that to be remembered is if we take off a hit show that we own, which there is a good chance of happening, that automatically goes into the new Netflix deal,” he said. “So there will be an automatic big bump in terms of that.”

Nomura Securities analyst Michael Nathanson believes CBS will trigger its put option on “CSI: Miami” sometime next year, allowing the company to hold onto a revenue injection it may need to maintain a favorable earnings comparison with this year when the Eye is raking in dollars from political advertising.

Last month, UBS analyst John Janedis characterized CBS exercising the option as “likely” in the second quarter of this year, when he estimates it could raise CBS’ earnings per share by 2 cents.

“This could be pretty expensive for Netflix,” said Michael Morris, analyst at Davenport & Co, who projected the put option could drive a 5-cent earnings-per-share increase for CBS. “They’ll have to achieve the incremental subscriber growth to justify the cost.”

With a stock price nowhere near the highs achieved a year ago, Netflix’s content costs are a sensitive subject on Wall Street, where there’s concern about the company’s growing bills for streaming rights in multiple countries. Netflix declared off-balance sheet content obligations of $3.9 billion at the close of 2011, triple what that sum was at the end of the previous year. Over that time, Barclays Equity Research estimated that the amortization of streaming content costs went from 12% to 50% of its total revenues, and is on pace to exceed 80% by 2015.

The way the put option is said to work is that there are open slots among the agreed-upon number of series included in the deal, and the studios get to choose the titles and the timing of their availability on Netflix. In the amorphous new world of digital content, where it’s too early to arrive at precise valuations, a put option affords studios some cushion in case they ended up underplaying their hand.

But a put option could also conceivably be horsetraded for deal points in future agreements or other existing agreements between the companies. Netflix and CBS also have a separate deal on the international front that was also struck in 2011 said to be worth an additional $75 million. CBS also has deals covering Showtime and a joint pact with CBS and Warner Bros. for the CW. Just last month, Netflix and 20th inked a second deal to cover Latin America.

But the domestic deal with 20th has yielded signs that carrying a series chosen by the studio can ultimately be a good thing for Netflix. Sarandos disclosed at a Nomura conference last week that the short-lived FX series “Terriers,” which was distributed by 20th, has been an unexpectedly popular addition to Netflix even though it didn’t last more than a season on cable.

Sarandos also believes canceled series can be an undervalued resource considering that their failure on network TV may be a function of factors beyond its control like a tough timeslot. Replanted on Netflix, a canceled series can not only find a new audience, but could potentially be re-activated with new episodes should Netflix be able to put a deal together with a series’ producers.

Indeed, it was the popularity of “Arrested Development” episodes on the Netflix platform that spurred its deal with 20th last year to revive the show, nearly six years after it was canceled by Fox.

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