August was my third one-month subscription to Netflix over the past year. As was the case with the first two, I rejoined to watch the service’s newest original series – this time Orange is the New Black. While I have doubts that original content can be a sustainable differentiator for OTT aggregators, it is quickly becoming the primary – and sometimes only – reason why Netflix’s newest users are joining the service.It is also at the core of Netflix’s stated strategy of “becoming HBO faster than HBO can become us”. While the company surpassed the Pay-TV giant’s 28.9M domestic subscribers in March, CEO Reed Hastings has since declared “that (Netflix) can be two to three times larger than current linear-HBO, or 60-90 million domestic members.” With that in mind, I wanted to do some further economics to assess what “becoming HBO” would look like, what Netflix will need to do to achieve its domestic targets and how this will impact its cost structure and contribution margins.
As of Q2 2013, Netflix’s contribution profit (an unaudited metric reported by the company) per domestic streaming subscriber month was $1.80 – or 23% of the $7.99 monthly due. Interestingly, this figure is up 80% since Q4 2011 and 40% year over year. As the company’s subscribers are up 42% and 26% over those same periods, it’s clear that the company is achieving significant operating leverage as it scales. This is either due to exceeding the growth estimates assumed by content owners when negotiating licensing agreements, or by gaining considerable bargaining power over them through this same growth. The answer is likely a mix of the two, but this advantage is likely to diminish as growth rates stabilize and new market entrants such as Microsoft and Intel begin outbidding Netflix. (This further reinforces the strategic imperative behind original content tailored to its customer base.)
Today, Cost of Services (i.e. content) remains Netflix’s largest cost driver at approximately $5.35 per subscriber. By amortizing this year’s original content budget of $150M equally across 20132, we can determine that original content currently represents only 8% of the total Cost of Services, or $0.45. Keep this number in mind – it’ll be important.
What it takes to “become HBO”
In a February interview, GQ reported that Mr Hastings “suggests Netflix must be making at least five new shows a year in order to outdo the big boys”. Yet, while network “Big Boys” such as HBO and Showtime are best known for their marquee scripted productions such as Game of Thrones and Homeland, their slates of original content count more than 15 other programs. While several of these are talkshows, live sporting events or reality TV, this diversity (in terms of both genre and scheduling) enables the networks to appeal to such a large, diverse subscriber base. Furthermore, HBO and Showtime still offer a total of 10 original scripted programs per year.
Netflix is securing exclusive (and valuable) streaming rights to content from the likes of Disney and Dreamworks, however, it’s hard to see how it could grow 2-4x larger than the “Big Boys” (or even “be” HBO) with less than a third of their original content. This is especially true as other OTT competitors, including Amazon, Hulu and Microsoft, begin releasing their own slates of original programs.
However, Netflix may need comparatively more original programming in order to grow several times the size of HBO or Showtime. While 15 programs a year would mean one and a quarter a month (on average), they would not be of interest to all users. Without subscription contracts (cable companies often offer 6 or 12-month promotions for premium cable channels), many customers would be tempted to put their accounts on hold while they wait for specific shows to be released. Even if a subscriber was interested in two thirds of Netflix’s 15 original programs, they could conceivably find themselves without a new program to watch for 2-3 months a year. Genre-based subscribers, such as those joining for the horror-thriller series Hemlock Grove, would be particularly challenged. It’s worth reiterating that this isn’t an issue faced by typical cable channels due to their one-episode-per-week release schedules. If we assume that Netflix will need to offer 15 programs per year, its annual original content costs would increase from $150M to roughly 775M3,4. Depending on the number of subscribers Netflix is able to attract, original content costs per subscriber would increase to between $0.72 (at 90M subscribers) and $1.08 (60M subscribers) from $0.45 today.
Of course, this doesn’t mean these subscribers would cancel, as they can still enjoy Netflix’s broader content library. However, some churn seems likely – especially when you consider that many will also have access to a similar library through another OTT service, such as Xfinity StreamPix, Amazon Instant Video or the (as yet unannouced) Xbox Live service. For that reason, I’ve also modeled out 17.5 and 20 shows a year (1.46 and 1.66 shows per month).
An expanded slate would increase original content costs per subscriber by between 62% to 224% (+$0.28 to +$1.00 per subscriber per month). Assuming Netflix’s licensed content and marketing costs remain flat on a per-user basis, the company’s push will likely increase total contribution profit – so long as it can deliver Mr. Hasting’s subscriber targets (see table below).
However, increased original content serves another strategic benefit:hedging against the company’s fast-rising content costs. A recent survey by RBC Capital Markets found that 64% of subscribers had viewed original content from June through August. A third of these viewers (or 20% of all subscribers) said it constituted at least half of their total viewing. Using this data and a few assumptions, I’d estimate that Netflix’s cost to serve is approximately 1.7 cents a minute for original content and nearly 4x (6.6 cents) that for licensed content (a cost the company also has limited control over).
Quadrupling or quintupling the size of its original library could therefore provide the company with two highly profitable outcomes: (1) Original content grows overall Netflix usage per subscriber per month, or (2) Original content displaces licensed content consumption. The first case would signify an increase in the value of a Netflix subscription to a subscriber, which would help the company raise prices over time. What’s more, it would cost the Netflix 75% less to ‘buy’ this increased usage compared to their current strategy of acquiring new, often exclusive content licenses. In the second case, Netflix would be shifting its user’s consumption towards less expensive, proprietary ‘products’ – enabling the service to reduce the size of its licensed library (and therefore its largest cost) without significantly affecting customer satisfaction or viewing habits. The benefits of either of these outcomes could be significant – so much so that they may exceed the benefits attained purely through subscriber growth.
Hitting 60-90M Subscribers
As I discussed in the first part of this series, original content is rapidly moving from a point of differentiation to a table stakes feature for distributors. Over the past five years, DirecTV, Microsoft, Amazon, Hulu, YouTube and Netflix have all begun producing original content. As a result, the 2013 season included some 125 new shows – 267% more than a decade ago (and growing 14% annually). There is so much content that viewers may not need multiple providers in order to fulfill their entertainment needs – and several of these OTT services can be accessed for free, such as Xfinity’s StreamPix or Amazon’s Prime-bundled Instant Video. This makes original content a necessary, but not sufficient requirement for growth – especially for a service looking to triple its userbase.
There’s also a second concern that there’s a lower ceiling for total subscriptions than Mr Hastings believes. Despite considerable increases in its original content slate and brand recognition over the past decade, HBO’s subscriber base has remained flat at just under 30M . While Showtime and Starz have had more success as they’ve ramped up their own programming, they remain under 23M today. Given that there’s significant overlap between these subscribers (cable companies often bundle these channels), market evidence suggests that there is limited headroom above the 30M base. While HBO would undoubtedly add more subscribers by offering a web-only service (as Mr Hastings’ expects), it’s doubtful this would double or triple subscriptions (there are fewer than 4M cord cutter households after all).
If Netflix hits a ceiling lower than Mr Hastings is targeting, the costs of their increased original content spending would be spread across fewer subscribers. While 45M domestic subscribers would still represent 50% growth from today’s numbers (and over market-leader HBO), total contribution profit would decrease significantly by $185M-$445M a year.
Does that mean that Netflix should not expand its original content offering if it can’t reach 45M+ domestic subscribers? Not necessarily. In Arrested Economics, I argued that the business case behind House of Cards and Arrested Development had likely assumed significant subscriber loss without Netflix originals, rather than just pure subscriber additions. If this is true, then the outcome above may still be a best-case scenario: without these new series, the company may not be able to retain its 30M current subscribers two years from now, let alone grow it to 45M+. Furthermore, original content will still help Netflix reduce its licensing costs per subscriber or potentially increase its prices:
At these assumptions, Netflix would still be faced with either a nominal increase or potentially a decrease in total contributions profit. However, were the company able to achieve licensed cost savings of at least 17% or increase prices by a dollar, it would increase overall contribution with 15, 17.5 or 20 original series per year. Either of these scenarios seem possible. RBC’s survey, for example, found that just 16% of subscribers would be “extremely likely” or “very likely” to cancel following a $1 hike – a figure likely to go down as Netflix produces more original content. Furthermore, Netflix’s already provides more value per hour than all competing video entertainment alternatives.
While its role as a differentiator will likely diminish, Netflix made the right call entering the original content game. The offering is rapidly becoming a necessity of competition and, per usual, Netflix’s ability to get out in front of a trend will be instrumental in its survival. Yet, if Netflix hopes to meet Mr Hastings’ goal and truly “compete with the big boys”, they will need to expand their original content offering to at least 15 shows per year – not five. In doing so, the service would be positioning itself as a comprehensive (and inexpensive) solution for all video entertainment needs and continue its immense subscriber growth. This would likely deliver a significant increase in contribution profit, especially after taking into account the ability to reduce its (fast-growing) licensing costs or even increase monthly subscription prices. Still, 60M-90M subscribers may be unreachable. However, Netflix would still benefit from added cost and pricing flexibility, as well as provide a more differentiated offering in the increasingly competitive OTT marketplace. Original or not, that’s a story management would find hard to resist.
[accordion][acc title=”Key Notes and Assumptions”] While Arrested Development will have value internationally, I’m going to assume that payback should be achieved domestically – and therefore I will allocate 100% of production costs to US-subscribers. There are two reasons for this. First, content is more region-specific than is typically recognized. House of Cards, for example, is an adaptation of a British BBC series (which Netflix also offers). The US series’ appeal is therefore unlikely to be widely consumed in European markets (where the bulk of Netflix’s non-US, English-speaking subscribers reside). NBC’s (rather different) remake of BBC’s The Office also shows that cultural differences can significantly temper the popularity of content outside their home market. Secondly, Netflix’s US-based competitors (be they ABC or HBO) are able to receive profitability before taking into account international licensing. As such, while many of these shows will be watched outside of the United States, Netflix should not rely nor need to rely on this consumption.
 The logic here is a little complex. Netflix currently amortizes its content licenses using the straight-line method. This makes sense when licensing second-run content, as a four-year license to AMC’s the Walking Dead includes three annual refreshes after the first release, for example. However, this makes less sense for Netflix’s original content, in which the bulk of total viewership occurs shortly after release – and only really picks back up after another season is produced and made available. Netflix noted as much in its Q2 2013 filing: “We are in the early stages of original content, and continue to monitor whether the viewing pattern is higher than initially expected in the first few months to suggest that we amortize at a faster initial rate.” Given this, and the fact that original content spend is a recurring charge, I’m going to consider the effective quarterly cost of original content as 25% of annual expenditures on the category. For example, that would mean capitalizing the full amount of this year’s $150M in spend in FY 2013.
 Though higher than normal cable production costs, my per show per season estimates are largely in line with Netflix’s current original content spending. According to Wired, Arrested Development’s fourth season cost $45M. While the company has confirmed that House of Cards cost $100M (pre-marketing) for two seasons, the Co-Head of Television Packaging at CAA recently told a symposium that Executive Producer David Fincher took costs “way above this”. According to Deadline, Mr Micelli also claimed Netflix’s “cheapest show is $3.8 million an episode ($50M a season)… Hemlock Grove is costing $4 million an episode ($52M), while Orange Is The New Black is just under $4 million as well”. As Netflix expands its content offering, I would expect this number to average down. However, for the purposes of this projection, I’ve assumed a blended average cost of $52M for all hour-long and half hour series. Furthermore, as House of Cards demonstrated, the increase in the number of bidders (such as Netflix and now Hulu, Amazon et al) can considerably increase ticket price of top quality content.
 While this may seem excessive, Netflix has said that its original content spend is likely to grow from 5% to 12-15% of annual content spend. Content spending (originals + licensing) has grown at 7.5% per quarter over the last year and more than 15% over the past two. As a result, this cost could almost double to $4B for FY 2015. A change in amortization rules, per the above, would mean increasing that range from 10% to 24-30%. That would make FY 2015 original content spend between $960M and $1,200M (US + Global). For reference, Time Warner spends $3.5B on original content and sports for HBO, Cinemax, TBS, TNT, Cartoon network and TruTV, and another $1.75B on content licenses.[/acc][/accordion]