Why Netflix is producing original content

By Felix Salmon
June 13, 2013
Matthew Ball has a long examination of the economics of Netflix's original content, looking at it on a show-by-show level.

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Matthew Ball has a long examination of the economics of Netflix’s original content, looking at it on a show-by-show level. He starts with the cost of producing something like Arrested Development, and then works out how many extra subscribers Netflix would need to attract in order to justify that cost. (Or, how many extra months existing subscribers would have to keep their subscriptions for, compared to when they would unsubscribe otherwise.) He writes:

I’d argue that it is unlikely that Arrested Development will convince millions of users to stay an extra month in 2014 and 2015. If this is the case, the show would need to achieve its return in the immediate future. Therefore, if we don’t see Netflix adding four to five million new subscribers during the quarter, one of two things are true. One, the show was a poor investment whose draw was a fraction of those anticipated, or two, the show is instead intended to convince many of the million subscribers currently churning away each month to defer their cancellation. This would be telling.

While Wall Street analysts are assessing the success of original content in terms of new customers, I believe Netflix’s primary goal is on imminent service cancellations.

Ball lists three reasons why Netflix is making original content. There’s the way in which that content keeps people subscribing for longer; the way in which original content will allow Netflix to raise its prices in the future; and then there’s this:

Hedging against rising content licensing costs, which are up 700% over the past two years. While per-show licenses will never surpass the cost of original producing a series, their increases will make ongoing investments in House of Cards less expensive on a differential basis.

The ever-increasing cost of licensing is a huge issue for Netflix, and it’s the reason why its business model is a very tough one: any time that Netflix builds up a profit margin, the studios will simply raise their prices until that margin disappears. Netflix had to pay a whopping $1.355 billion in licensing costs just in the first quarter of this year; that number is only going to increase, unless Netflix can find some other way of finding content. Like producing it in-house. At the margin, the more material that Netflix produces on its own, the less it needs from third parties, and the easier that Netflix finds it to say no to ridiculous demands.

But what Ball misses, I think, is that Netflix is playing a very, very long game here — not one measured in months or quarters, and certainly not one where original content pays for itself within a year. Netflix doesn’t particularly want or need the content it produces in-house to make a profit on a short-term basis. Instead, it wants “to become HBO faster than HBO can become Netflix,” in the words of its chief content officer Ted Sarandos.

Most importantly, the thing that Netflix aspires to, and which HBO already has, is an exclusive library of shows. If everything goes according to plan, then the Netflix of the future will be something people feel that they have to subscribe to, on the grounds that it’s the only place where they can find shows A, B, C, and D. That’s what it means to become HBO — and Netflix is fully cognizant that this is a process which takes many years and billions of dollars.

If Netflix gets there, then it becomes a license to print money, just as HBO is today. Shows like Arrested Development and House of Cards may or may not pay for themselves over the short term — in fact, they almost certainly won’t. But that doesn’t matter. In the long term, they will become part of a library which has massive value on two fronts: the shows can be licensed out in jurisdictions where Netflix doesn’t want to compete, and they will also help make Netflix a service that can guarantee you a great show that you want to watch, whenever you want to watch it.

Ball says that “Arrested Development is an established brand that’s intended to be a one-off event to convince its fanatical (and tech-savvy) followers to give Netflix’s broader streaming service a try.” That’s true — narrowly. But the series is much more than that: it’s also a way for Netflix to signal to all its current and potential subscribers that it is home to high-quality exclusive content, if and when they ever feel like giving it a try. In a weird way, Arrested Development is worth more as the number of people who haven’t seen it goes up.

No one today is likely to subscribe to Netflix just on the grounds that they think they might like to watch Arrested Development at some point. But when there are dozens such shows — none of which are available anywhere else — that begins to add up. At that point, not only does Netflix provide something for everybody; it also becomes the only place to watch certain shows with cultural-touchstone status. And presto, the decision is no longer whether Netflix is worth the subscription price; rather, the question is whether you can afford not to have it.

There’s no guarantee that Netflix is going to succeed at this strategy: many have sailed into the treacherous waters of Hollywood video production, and few have thrived there. And in the first instance the strategy just means that it’s no longer just the content companies managing to extract enormous rents from Netflix; it’s the production industry and the talent as well. The old argument still applies, mutatis mutandis, to the new strategy: as high-quality original content becomes increasingly important to Netflix, Hollywood will find ever more ingenious ways of forcing Netflix to pay through the nose for it.

Still, for viewers, this can only be good. The viewing audience doesn’t care whether Netflix makes money: they just want great shows to be produced. If they like House of Cards and Arrested Development, they should be very heartened: there’s going to be a lot more new shows where those ones came from.

12 comments

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Interestingly, House of Cards appeared this week on DVD Blu-Ray on online services such as Vudu.

Posted by aforkosh | Report as abusive

The argument Felix is making is akin to: well hybrid cars offer a negative financial return when compared to similar gas only cars… but the reason buyers are flocking to them is because as gas prices rise the large negative return will shrink to a smaller negative return.

See that’s the thing about never, it NEVER makes sense for NFLX to do original content. NFLX could have bought CBS when they were at 300/share. Today they should still try to do a deal with Sony to get forever access to that library.

Posted by y2kurtus | Report as abusive

personal channel check – we took the Netflix free trial to watch the new Arrested Development season in a weekend… but we’ll probably keep the subscription: at $8 there is plenty of content to consume for now… (I watched House of Cards, and now i’m on to non-NFLX-original: Louie

Posted by KidDynamite | Report as abusive

Thanks Felix. You’re right that Arrested Development and House of Cards are just the first step to creating an HBO-style portfolio of content. The problem here, as I discussed in an earlier piece in the series here: http://goo.gl/68Op6, is that the original content space is increasing crowded and its value as a differentiator is diminishing. Since 2002, there was been a 700% increase in the number of new scripted shows premiering in the United States. The 2013-2014 season will likely blow through this 14% compound annual growth rate, as the likes of Hulu, Microsoft (which has been silently hiring broadcast executives) and Amazon enter the original content space, and those with recent success, such as History, transition more fully to the model.

In this environment, it’s not clear that having great content will deliver viewers – or that even excellent content will reach “cultural-touchstone status”. Digital distribution, tablets and SVOD services such as Netflix have gone a long way to increasing the amount of television we can consume, but at some point, there really will be too much good TV to watch. As a result, consumers will no longer need to subscribe to any given service to satiate their appetite for content, however good that service’s shows might be. In this scenario, “free” or embedded services (such as the nascent Amazon Instant Video, Microsoft’s as-yet unannounced Xbox service or Comcast’s StreamPix) may have inherent advantages that Netflix may struggle to overcome. Original content will always drive subscriber gains and is certainly an important signal to the marketplace. At the same time, it’s also moving from a leading differentiator to a cost of playing the game.

Posted by MatthewBall | Report as abusive

@y2kurtus I’m not following your point?

I don’t see Sony ever offering “forever” access to their content. Aside from eliminating their ability to raise rates, I’m sure someone important there thinks they’re going to launch their own NetFlix/HBO at some point.

Posted by Harpstein1 | Report as abusive

Isn’t the question what the buy vs build cost is? What is HBO worth?

Posted by MyLord | Report as abusive

In this environment, it’s not clear that having great content will deliver viewers – or that even excellent content will reach “cultural-touchstone status”. Digital distribution, tablets and SVOD services such as Netflix have gone a long way to increasing the amount of television we can consume, but at some point, there really will be too much good TV to watch. As a result, consumers will no longer need to subscribe to any given service to satiate their appetite for content, however good that service’s shows might be. In this scenario, “free” or embedded services (such as the nascent Amazon Instant Video, Microsoft’s as-yet unannounced Xbox service or Comcast’s StreamPix) may have inherent advantages that Netflix may struggle to overcome. Original content will always drive subscriber gains and is certainly an important signal to the marketplace. At the same time, it’s also moving from a leading differentiator to a cost of playing the game.

Posted by ballmatthew | Report as abusive

I agree with Harpstein1 and Felix. In reply to y2kurtus, I would say that a streaming-only Netflix – owning neither content nor distribution (wired or wireless network) – would be so relentlessly squeezed on margins that it wouldn’t earn enough money to justify its current $12 billion market cap. If Netflix produces its own proprietary content, it at least a has a chance to be worth more than that. (Or, as Felix says, it may fail).

The streaming business model is far worse than Netflix’s dying DVD by mail business model. Lower barriers to entry because a competitor doesn’t have to set up distribution centers. Higher content cost because Netflix can’t rely on the first sale doctrine to acquire streaming rights relatively cheaply.

Posted by realist50 | Report as abusive

Netflix can decide how to spend it’s billions on content. Eventually it will come to the youtube conclusion. It is a far better business model to deliver low cost content to the masses for a low price than best in class content for a premium price. Youtube is free (for now) and survives only on ad rev to support their service. Obviously you have to make some assumptions about what % of Google’s market cap you attribute to Youtube but it’s a safe bet in my mind that if Google spun out Youtube it would be worth more than NFLX even without original content or distribution. The money is in the aggregation.

NFLX could easily stream 90% of the current menu for 10% of their current content budget. The catch is the 10% you would lose are the hit movies and tv shows that all their customers want to watch. That’s why the best 10% of their content cost them 90% of their content budget.

NFLX could flip that coin if they so chose. Producing House of Cards and Arrested development is an attempt at doing just that. They would be far better off spending their money on permanent streaming rights to content than a time limited license. Lets say I am a direct netflix competitor like Comcast. I own content say 30rock, Netflix is willing to pay dearly for it… but only if they can run it forever not just for a year or two. Just because NFLX can play it dosen’t mean Comcast can’t play re-run it, or syndicate it to other parties. Selling NFLX streaming rights to content is incremental revenue that Comcast would just assume collect.

If Netflix simply refused to spend money on time limited licenses they would absolutely lose access to some of their most desired content. They would not however lose all of it; some content owners just wouldn’t refuse millions in revenue. They would pay more money for less new content but they would get off the treadmill of having to constantly replace a billion dollars of licenses that expire. Every month their pool of content would grow. Now that would be a recipe for long-term wealth creation.

Posted by y2kurtus | Report as abusive

There are four reasons I subscribe to HBO, and NONE of them are their movie library. It’s in descending order:

1. Game of Thrones
2. True Blood
3. Boardwalk Empire
4. Real Time with Bill Masher

This is very harmonious with the Netflix strategy. The key assumption is that they will stagger when seasons of different shows begin so binge viewers can’t simply binge, cancel, binge, cancel.

That requires having the “typical” viewer watch 2-4 series, as in the case of Showtime, Homeland is the **only** content I care about on that channel so I cancel between seasons.

Posted by hypermark | Report as abusive

It’s less about building a catalog and more about becoming known for original content as a brand. Is there really a meaningful number of HBO subscribers that are watching The Sopranos or Six Feet Under in 2013? Probably not. Do people think of HBO as a leader in original programming? Yes but it didn’t happen overnight.

That brings the pressure for Netflix to constantly produce top-level shows. It also means they have to continue to grow their sub base in order to fund these programs and make it to that point at which they are known for original programming. I would argue it can happen a lot faster now than when HBO started out.

It will be interesting to watch the effect of allowing people to ‘binge’. Currently it plays as a pop and fade. But as @hypermark points out, once they have enough series, they can stagger them rather than draw out episodes.

Another issue is whether Netflix continues to spend gobs of cash on series but don’t secure the long-term, exclusive rights (e.g. House of Cards). But that may have been a deal done to jump start originals.

Posted by Antiococo | Report as abusive

Nice article, thanks