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A lot has been made about Netflix's (NASDAQ:NFLX) move to original programming. As content costs have risen and the content library battle rages on, streaming names like Netflix and Amazon (NASDAQ:AMZN) have started to develop their own shows. Netflix's blockbuster "House of Cards" was launched a few months ago. Netflix recently launched another "original" series, the re-launch of Fox's hit "Arrested Development". With great fourth quarter 2012 and first quarter 2013 results, Netflix shares have soared from $53 to $214, and recently just missed the $250 level. With another Netflix "original" now out, I'll explain today a few reasons why original programming could backfire for Netflix.

1. The "Arrested Development" gamble:

Netflix thought going after the cult-like following of "Arrested Development" was a great idea. But there was a problem with this line of thinking, evident in the following quote from a Marketwatch article.

One of the issues facing "AD" this time was getting its main cast members to record the series together. That shouldn't have come as a surprise to anyone; remember, it has been seven years since "AD" last aired on the Fox television network. "AD" cast members such as Jason Bateman, Jessica Walter, Jeffrey Tambor, and Will Arnett have all moved on to other TV shows or movies, and it was impossible to do "AD" with the entire cast involved at all times for every episode.

Which is why each new episode of "AD" centers around one of the show's nine main characters.

Oh, there are other cast members involved in each episode, but if you go into the new season expecting to see every character in every episode, you will be highly disappointed.

The issue here is that Netflix is trying to revive a show that has not aired since 2006. Sure, the show might have had a lot of fans then, and they might be willing to give this restart a chance, but seven years is a long time. Here's what was going on since the last time this show was seen:

  • In 2006, the New York Mets were actually good. They won 97 games and won the NL East by 12 games. In recent years, they've been one of the worst teams in baseball.
  • Some of the top movies in 2006 included "Casino Royale", "Cars" , "300", "The Departed", "The Fast and the Furious: Tokyo Drift", and "Pirates of the Caribbean: Dead Man's Chest".
  • Billboard's Top Song was "Bad Day" by Daniel Powter. Justin Bieber, Taylor Swift, and Katy Perry had 0 songs of the Top 100.
  • Apple (NASDAQ:AAPL) had not launched the iPhone yet!
  • The top news story searched for was the death of "Crocodile Hunter" Steve Irwin.

I think that's enough proof that it's been a while since this show was last seen. The point here is that it is unusual to see the restart of a show, not counting new versions of older shows, like "Hawaii Five-O" on CBS. Fox is even trying this strategy out on a smaller scale with my favorite show of all-time "24", but that show only ended in 2010. "Arrested Development" went off the air four years before that.

It will be interesting to see how this gamble pays off for Netflix. Maybe the better solution is to restart shows that were recently cancelled, ones that are current. Cult shows that are ending or have ended might be a good start, and two examples could have been Syfy's "Eureka" and "Warehouse 13". That may not be possible now after Amazon gained streaming rights to those shows. Other networks and streaming services will surely be looking to see if this works. But just remember this one fact: the last time "Arrested Development" was aired was more than two and a half years before President Obama was originally elected. That's an eternity these days.

2. Finding a balance / something for everyone:

One of the hardest things for any network or streaming service is trying to cater to the most people. Should you spend more on dramas, comedies, science fiction, etc.?

Just look at "Arrested Development" as one example. It's a pure comedy, which doesn't fit for all viewers. I for one have never watched the show, and if I were to sign up for Netflix today (which I'm not planning on currently), it wouldn't be for this show. Netflix has launched "House of Cards", a political drama, as well as some other comedies so far. If you don't like comedies or drama, you won't be watching any of this. Sure, Netflix will move into other genres over time, but if you're only watching Netflix for the originals, you may not find content to your liking.

3. There has to be a trade-off:

Netflix does not have an unlimited budget with which to purchase content. Current estimates call for $4.34 billion in revenues this year and $5.06 billion next year. Netflix's budget is obviously a bit less than that, as other expenses are involved and the company is profitable.

That being said, we don't know exactly the dollar amount of their budget, but Netflix has been more selective in its content deals lately. Other players are entering the space, which is pushing up content prices for all. That's why Netflix is moving to original content, because it is yours only, and they may not be winning bids for other content. Amazon will not be streaming "House of Cards" anytime soon, although they will be selling the DVD and Blu-Rays of the show!

Let's look at "House of Cards" for example. The show has an estimated cost of $100 million for 2 seasons, or $50 million per season. Because Netflix is increasing revenues, the company has more room to expand its content budget. But I don't think that they are at the point where all $50 million of that is covered. Some of that has to be taken away from other content that could be purchased. Even if only $10 million is "lost" because of "House of Cards", what could that money have gotten them? If Netflix loses a couple key movies, or even a large package of older movies or TV shows, they must make "House of Cards" work. If I were to hypothesize that Netflix cost themselves 50 movies from the 1990s because of "House of Cards" or some other original, which is better for subscribers? One 13-15 episode show that you may only watch once, or a variety of other content that could cater to a larger audience? It's something to really consider, but only Netflix will know what the true trade-offs are.

4. DVDs! More importantly, profits:

Everyone knows that Netflix is migrating towards a streaming-only business model. Eventually, there will be no DVD business, and it could be sooner than some expect. But getting rid of the DVD business has cost Netflix profits, and that is something that streaming cannot totally make up for.

When Netflix spends all of this money on original shows for the streaming service, the DVD business goes into further decline. As I've shown in the article above, DVD revenues were down 24% year over year, and DVD contribution profits were down more than 22%. Even with a great Q1, domestic streaming contribution margins were just 20.6%, while DVD contribution margins were 46.65%. Even if Netflix gets streaming contribution margins into the 25-30% range, it would still be well below what the DVD business was generating.

Netflix is trying to convert some of those DVD subscribers to streaming ones, but that hurts profits. Also, I've heard from some subscribers who have both services that could potentially cancel their streaming service if the DVD plan goes away. Netflix doesn't consider the DVD business part of their future, evidenced by the fact that they've stopped providing subscriber and revenue guidance for that segment. However, one must wonder why Netflix is all of a sudden spending heavily on DVD marketing. After spending just $1.51 million on DVD marketing in Q3 of 2012, Netflix spent $2.58 million in Q4 2012 and $4.47 million in Q1 of 2013.

Netflix may be trying to hold up the DVD business for an eventual sale, and they obviously know that Coinstar (CSTR) and Verizon's (NYSE:VZ) Redbox Instant has launched. Q2 that we are in now will be the first full quarter of that hybrid streaming and DVD service. By spending more on original content, Netflix shifts further away from DVDs, and for the time being, that means profitability as well.

5. The Amazon strategy:

Netflix is betting big on every show. They are releasing an entire season at once, which means they are throwing a large pile of money into a series. If "House of Cards" had flopped, their $50 million bet could turn out to be rather foolish.

On the other hand, Amazon went a slightly different way with its original programming. Amazon's service had pilot episodes produced, let them be viewed for free, and allowed viewers to vote on them. The company could then decide which shows to pick for an entire season. In this situation, you are letting the viewing public decide on what they want to see, instead of "forcing" an entire season on them.

In the end, it might be that both approaches work, or maybe neither do. Maybe the solution is to release two or three episodes, see how they do, and then go from there. One thing is certain. Netflix is throwing down a lot of money on a big gamble, while Amazon is trying a more selective approach upfront. Additionally, Amazon is reportedly targeting lower budget shows, ones that may only cost $1 million to $2 million per episode, unlike some of Netflix's shows that appear to cost $4 million an episode.

6. All at once versus over time:

There has been some debate over Netflix's choice to release all episodes of a series in one shot. Critics argue that this leads to more "binge viewing", as you could easily watch an entire season in a day and then never come back to it. Some investors seemed worried with "House of Cards" that viewers would take advantage of the free trial, watch all of the show, and then cancel. In their investor letter, Netflix pointed out that less than 8,000 subscribers did this in Q1 out of millions of free trials.

Will this happen more though with "Arrested Development" however? If I were a fan of "Arrested Development", I might not care to see "House of Cards" or any other Netflix show. Also, in the free month's trial, you could easily watch all three Netflix original shows and then cancel. While Netflix says it wasn't a big deal in Q1, it might be a bigger problem as time evolves. Just think, those nearly 8,000 subs that cancel could have provided another roughly $750,000 million in annual revenues. Netflix doesn't seem worried, but a dollar lost is a dollar lost.

The other issue is a huge dropoff. If you've already watched the entire "House of Cards" series, you probably aren't watching it again and again. I wouldn't be surprised if the number of daily viewings of "House of Cards" is down tremendously from where it was right after launch. Having a weekly release brings people back over time and builds more of a brand to your show. Right now, Netflix is just encouraging you to binge view in my opinion.

7. An eventual price range:

If you surveyed 100 Netflix subscribers out there, I would assume that almost all would say that they expect a price raise from Netflix sometime in the future, maybe the next year or two. But at the same time, a lot of those Netflix subscribers say that they would be willing to pay more, because Netflix provides such a great value.

Obviously, it seems like a no-brainer at first for Netflix. If you raise streaming prices from $8 to $10 a month, that's a 25% raise. Do you really think 25% of Netflix subscribers would cancel because of the extra $2 a month? Probably not. Even if Netflix had to spend a little more on marketing to save some of those subscribers, they still would see a huge revenue boost from a price raise. It would seem to work perfectly for Netflix, but it probably would be a short-term boost. If Netflix boosts prices, you can bet that content providers will too. It might take a few extra quarters for content providers to get more, but you know they will get it.

Netflix spending more on original content makes a price raise more likely in most people's opinion. But at the same time, once Netflix raises prices, content providers will too. If Netflix raises streaming prices by 25%, the $50 million cost for one season of a series down the road could be $60 million.

How these can be interconnected:

I don't think any one of these issues can take down Netflix. Original programming is probably good for the company, if done in the "best possible way". What that is remains to be seen, and opinions may vary on how to best make it work. You may think that the all in one release is an issue, while another person might want to take the Amazon approach to a series.

Many of these issues can be related though. If Netflix has a big gamble on a show, it may cost them other pieces of content. Thus, they may not be able to cater to all viewers. If they have problems attracting some viewers, a price raise could occur. A price raise to the DVD service would be extremely unattractive, as it would probably signal the death of that segment. If the DVD segment dies off, it's less profits and less cash flow, and that forces more trade-offs in terms of originals versus packaged content.

You may not think that any one issue is large, and I would probably agree with that. But if one issue above causes a second and third to impact the business, things could quickly escalate.

Conclusion:

Original programming is in its infancy at Netflix, and I don't think anyone can measure its true success just yet. It might be a few years before that is possible. Until then, questions will arise over how original program will impact Netflix, and I've addressed some possible concerns here today. It remains to be seen how gambles like "Arrested Development" will turn out, as the last time that show aired, Apple had not launched the iPhone yet.

It's not just one issue that could be a problem for Netflix. A strikeout on a $50 million show could lead to several other issues. For that reason, this article is presented as a "short idea" for Netflix on the basis that original programming could backfire. If original programming doesn't work as well as expected, it would be a negative for Netflix shares. But don't take that as a personal recommendation to short Netflix shares at this point.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.

Source: How Original Programming Could Backfire For Netflix