• Netflix's Original Content and International Expansion Plans Create New Risks

    Netflix made waves in its recent Q4 earnings report by announcing a massive acceleration of its international rollout, with its goal to now be in 200 countries by the end of 2016, up from 50 today (note there's some murkiness around counting to 200 countries as well). One of the keys to Netflix's successful international expansion is offering a robust content library, which in turn means owning the worldwide distribution rights to marquee programming.

    But a new note from analysts MoffettNathanson observes that studios are increasingly resisting Netflix's proposed global license fee structure, which only allows for a 20-30% markup on the actual cost of producing the shows. Instead, studios are biased to retain international distribution rights because of the potential for far more lucrative distribution deals.

    This resistance, coupled with the need to differentiate its programming in an intensely competitive landscape - where original TV series have skyrocketed from just 26 in 1999 to over 200 in 2014 - have led Netflix to dramatically increase its own original content production agenda. Netflix itself said that it will roughly triple the number of original programming hours in 2015 to 320.

    As MoffettNathanson notes, in moving from aggregator of licensed programs to producer of original series, Netflix is pursuing a well-worn path previously - and successfully - followed by both premium cable networks (e.g. HBO and Showtime) and ad-supported ones (e.g. AMC, USA, FX, etc.).

    The big challenge in making this shift, however, is the hit to Netflix's earnings, which the higher content spending drives. MoffettNathanson estimates that Netflix's cash spending for originals increased from $133 million in 2013 to $243 million in 2014 and will increase further, to $450 million in 2015. Even while tripling its original hours, Netflix is somewhat containing its expenses by introducing lower cost series and comedy specials.

    But overall, Netflix's content expenses as a percent of its revenues already surpass those of cable TV networks, in some cases quite significantly. MoffettNathanson estimates Netflix's ratio in 2014 was 59%, vs. 45% for 21st Century Fox, 42% for Disney and 41% for Turner. As Netflix's spending ramps in 2015, its ratio will move still higher than its cable peers. Overall, Netflix is estimated to have cash content acquisition costs of $4.3 billion in 2015, up 36% vs. 2014.

    These higher content costs, combined with estimates of increased marketing, will lead to international losses. Adding in increased technology development costs, MoffettNathanson has now slashed its estimate for Netflix's 2015 earnings before interest and taxes from a 51% increase vs. 2014 to an 8% decrease.

    There's one other aspect to Netflix's shift from licensing content to producing originals, which MoffettNathanson doesn't delve into, but which I believe is quite significant: the risk that despite the significant financial outlays for new, original programs, they could flop.

    This is a risk that studios and networks have always borne, but which Netflix has mostly avoided by focusing mainly on licensing. By using its vaunted data-mining insights, Netflix has been a disciplined licensee, in some cases deciding to pass on renewals when it believes viewership didn't warrant increased costs (e.g. Starz, Discovery, A&E, Scripps content).

    However, producing originals is a different ballgame entirely. While the data insights matter a lot, as I've noted in the past, there are still limits to their value. For example, data clearly contributed to the success of "House of Cards," yet the reception for "Marco Polo" has been lukewarm at best (note Netflix still renewed it for a second season). Clearly, the human touch still has value when creating new programs (arguably Netflix's "Orange is the New Black" and Amazon's "Transparent" both innovative bets that have succeeded, underscore this point).

    Absent a clear and consistent data advantage, Netflix is essentially assuming the same hit-or-miss risk as have other studios and networks - and arguably even more so if it employs its straight-to-series model to enable binge-viewing, rather than Hollywood's more traditional and cost-effective piloting process.

    Bottom line, between Netflix's accelerated international expansion, which will take it into much more unique markets than those it operates in currently, and the jump in original content spending, which carries uncertain payoffs, the company's risk profile has dramatically changed.

    Netflix has proven mostly adept at navigating high-risk situations in the past, so it will be very interesting to see if it can continue to do so over the next couple of years. With the stock back in nosebleed range, investors are clearly betting it will succeed.

     
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