Why Growing Content Costs Are A Necessary Evil For Netflix

| About: Netflix, Inc. (NFLX)

Summary

Netflix plans to broadcast more than 30 original series in 2015 and 2016.

Netflix has also been shelling out some serious cash to acquire the rights to various popular TV series shown on other channels.

Increasing content costs are putting pressure on Netflix’s margins, but this spending holds merit and is vital to Netflix’s success in the coming years.

Our price estimate for Netflix stands at $299, implying a discount of about 12% to the market.

Marco Polo premiered on Netflix (NASDAQ:NFLX) on December 12, 2014. The company reportedly spent $90 million on the production of the first season (10 episodes) of the series and the show was supposed to be Netflix’s answer to HBO’s fantasy series Game of Thrones. However, the response toward the show has been tepid. Marco Polo might get a second chance to impress the audience as Netflix has a tendency of ordering second seasons for its shows regardless of the response they generate. But in its current state, it seems unlikely that Marco Polo will be able to captivate the audience in the way that Game of Thrones has done. This is not the only big bet that Netflix is making in terms of the original content. It has also announced a five-season deal with Marvel Television (a subsidiary of The Walt Disney Company) to produce four live action series and a mini-series focused on four Marvel superheroes – Daredevil, Jessica Jones, Iron Fist and Luke Cage. According to Wall Street Journal, the production of these shows will cost Disney around $200 million. [1] Both these deals are part of a roster of 30+ upcoming original series that Netflix plans to broadcast in 2015 and 2016. The spending does not end with original content either.

Netflix has been shelling out some serious cash to acquire the rights to various popular TV series shown on other channels. According to Deadline, Netflix signed a deal with Warner Bros. Worldwide Television Distribution to broadcast the show Gotham for a reported $1.75 million per episode. [2] It reportedly signed similar deals for other shows such as The Blacklist ($2 million per episode) and AMC’s The Walking Dead ($1.35 million per episode) among others. [3] Increasing content costs are putting pressure on Netflix’s margins, but this spending holds merit and is vital to Netflix’s success in the coming years.

Our price estimate for Netflix stands at $299, implying a discount of about 12% to the market.

Increased Costs Mean More Pressure On Margins

Content costs have been rising steadily for Netflix. According to its third quarter 2014 results, streaming content obligations increased from around $7.2 billion at the end of 2013 to more than $8.8 billion as of September 30, 2014, an increase of more than $1.6 billion in the first nine months of 2014. Content expenses, which include the amortization of the streaming content library and other expenses associated with the licensing and acquisition of streaming content, are the largest cost component for Netflix and account for over 70% of the total expenses. The cost of revenues came in at $2.73 billion, an increase of around $430 million year over year. This increase was mainly due to content expenses increasing by more than $376 million, from $1.6 billion to $1.97 billion, in the same period. The effect of increasing content costs can be felt in the contribution margins of both the domestic and international streaming segments. This is especially true for the international segment which has not been profitable on a contribution basis until now. We expect the contribution margin for the international segment to be around -14.5% for the year 2014 and to break even in 2015. However, the continued pressure from increasing content costs, along with the high marketing costs incurred for international operations, could result in lower margins for the next couple of years.

An Unavoidable Exercise

Improvement in Netflix’s online content has been the cornerstone of its subscriber growth for the past two years. Improving content quality has helped Netflix retain its top position in online streaming, keeping competitors such as Amazon.com (NASDAQ:AMZN) and Hulu at bay.

The focus on original programming has been paying off and the success of original series such as House of Cards and Orange is the New Black has added an extra dimension to the company’s online content. Now not only does Netflix have quality programming sourced from other studios, but it has quality programming of its own which is available nowhere else. But it needs to keep on dishing out quality original programming in the future too if it wants to maintain the air of exclusivity that it has acquired. Even if Marco Polo does not live up to expectations, Netflix needs to find another hit in the group of shows it has lined up in 2015 to keep the audience hooked. Netflix also needs to keep faith in its selection process. It chooses its content based on the meticulous analysis of its customers’ watching habits, and this strategy has yielded results in the past. The negative reaction to Marco Polo is not unprecedented either. HBO has cancelled six shows after only one season in the last three years and such cancellations are common and more widespread for traditional pay-TV networks. The advantage that Netflix has over pay-TV content providers is that it has lesser opportunity cost. If a customer does not like a TV show on Netflix, he can always move on to another show. A pay-TV channel by contrast dedicates a time slot to a TV show and faces a much bigger opportunity cost. This allows Netflix to take more chances with its content. In the end, Netflix needs to keep investing and continue buying original content, renewing content and acquiring international rights in order to produce enough quality material to keep its subscriber base interested.

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