Narrative: Netflix is Spending Too Much on Content
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Narrative: Netflix is Spending Too Much on Content (Jan 28, 2017)
Written: January 28, 2017
Netflix has undergone a dramatic change in its content strategy over the last few years, shifting its focus from licensing existing content from third parties to commissioning more of its own original, exclusive content for the service. As it’s undergone this transition, Netflix has seen its total streaming content obligations rise from a little over $5 billion at the end of 2012 to a little under $15 billion at the end of 2016. Netflix has streaming content obligations of $6.2 billion in 2017 alone, compared with the $5 billion Netflix spent on a P&L basis in 2016.
The cost of content is rising rapidly, but so is revenue at Netflix, and the cost of content is actually rising more slowly, meaning that Netflix is increasingly profitable over time. So even though Netflix’s spending is rising rapidly, it’s more than covering the increased cost with revenue. So far, so good.
However, the other big change that’s happening with the shift to original content is a very different cash spend profile. Original content requires high upfront spending, whereas licensed content is paid for over time. This means Netflix’s cash outlays have ballooned in recent years – in early 2014, Netflix had positive non-GAAP free cash flow, whereas in the last few quarters of 2016 its negative free cash flow was equivalent to around a quarter of revenue. In time, this shift will play itself out, but in the meantime it’s causing a cash crunch which requires additional financing.
At the same time, Netflix’s investment in original content is somewhat akin to Amazon’s investment in infrastructure – it started small but is quickly getting to the point where it’s very tough for all but a small number of other companies to compete. Amazon itself is one, with HBO and other more traditional TV houses are in the same category, but even then Netflix is becoming a major force in original content. What’s more, it’s producing both quality and quantity here – this isn’t just about a handful of headline series, though it has those and they’ve generally been very well received by critics and viewers. But it’s also about an increasing volume of original content – I’m constantly surprised as a Netflix customer by the long tail of original content I’ve never seen a single ad for, much of which is pretty good too.
The huge risk with all of this is that Netflix stops growing as it has in the past, because its content commitments are only a year or two behind its revenues in terms of scale – in other words, if Netflix were to stop growing for two years, all its revenue would be eaten up with content spending. There were moments in 2016 where it looked like growth was stalling, but it now appears that this was mostly due to higher churn from price increases and that effect had largely worked its way through the system by the end of the year. International growth is particularly strong, and Netflix will have more international than domestic streaming customers around mid-year, with around 100 million in total. As long as that growth keeps going, Netflix can keep spending on content, and arguably building a very sustainable advantage which will also be a useful hedge should major third party content providers start pulling back on licensing.
Netflix has confirmed that it’s raising prices for two of its three tiers of service in the US, starting this month for new subscribers and in November for existing subs. Subscribers to the $8 bottom tier won’t see an increase, but the most popular middle tier will go from $10 to $11 per month, while the premium tier will see a $2 bump from $11.99 to $13.99. I’m a bit surprised by this increase coming so soon after the company finished implementing its last price increase last year. The company’s current average revenue per paid US streaming subscriber is right around $10, and went up $2 exactly in keeping with the last price increase, suggesting that the base is dominated by that middle tier and that subscribers to the other two plans largely balance each other out. With the bigger bump to the premium tier, it’ll be interesting if we see average revenue per user rise more this time around, especially as 4K adoption increases.
I did some analysis for Variety in May last year on the last price increase and reached the conclusion that costs per subscriber were actually falling and price increases were largely about continuing to drive US margins up. That increase caused lower subscriber growth for a few quarters, though the impact was more closely tied to the timing of the announcement than the implementation for individual existing customers, which validates Netflix’s decision to push out the increase quickly this time rather than staggering it. Since I did that analysis, however, Netflix’s domestic streaming cost of revenue per subscriber has risen, which means this increase is more honestly about covering rising costs than the last one, though cost haven’t risen by nearly as much as prices will go up – monthly cost per sub has gone up by about 23 cents over the past year, so less than a quarter of the $1 price increase on the most popular tier. I wouldn’t expect as large an increase in churn this time around given that it’s a smaller increase in price, but it does mean that Q4 subscriber growth numbers in the US will take a hit and be a little lower than they would otherwise have been.
FX, a division of 21st Century Fox, today announced a broadening of its FX+ add-on service for pay TV operators to Cox Communications’ pay TV subscribers, in addition to its existing partnership with Comcast. But in some ways more interesting were comments its head made about the network’s future approach to licensing content. In essence, FX has had to pay a lot of money to undo past deals which gave various other entities rights to its content so that it could put that content back on its own streaming service, and he says he doesn’t plan to make that mistake again. Netflix was singled out in particular as a streaming service FX had licensed content to in the past but wouldn’t again, and Netflix’s shares were down around 5% today seemingly as a result. All of this of course validates Netflix’s decision a number of years ago to invest much more heavily in its own original content, which has three major drivers of which hedging against such decisions was one of the big ones. Netflix needed to control its own destiny when it came to content, and there was always the risk that it would lose its licensing deals as it increased in popularity and power. I think the 5% drop based on comments from one content owner is likely overblown – there certainly wasn’t such a strong reaction to Disney’s recent pullback, at least not right away – and in general Netflix is in pretty good shape content-wise and retains some of FX’s most popular shows for now. FX, meanwhile is pursuing a very limited strategy with its add-on network, limiting it to pay TV subscribers rather than going after cord cutters, either independently or through Amazon’s powerful Channels product, which has driven lots of subscribers for similar packages. That feels like a mistake, and something FX should rectify sooner rather than later if it wants to reach a considerably larger potential base of customers.
Hulu Will Spend $2.5 Billion on Content in 2017 (Sep 14, 2017)
Netflix is (somewhat remarkably) making its first ever acquisition, buying comic book company Millarworld, which was started by Mark Millar and some former colleagues who had all written comic books for DC and Marvel and wanted a bigger stake in their creations, nearly 15 years ago. The terms of the deal aren’t being disclosed, so it’s far from clear what the immediate financial impact on Netflix will be, either in terms of the acquisition price or the revenue or profits from adding this first bit of diversification to the business. The whole announcement from Netflix reads like a subtle dig at Marvel, which is interesting given the close relationship the two companies currently enjoy. Millar is described as a “modern-day Stan Lee”, when of course Stan Lee himself is still alive and actively involved in the community if not actively creating new content, while the release also says that Millar was behind a number of the characters whose stories have been turned into movies by Marvel Studios over the last few years. Clearly, the claim here – somewhat farfetched – is that Millarworld is the new Marvel. Several of its characters and stories have already been turned into movies in recent years, and with some success, so it’s not a totally absurd claim. But overall few of them have the mass-market name recognition of Marvel or DC’s characters, and some quick feedback from people on Twitter who are more into this world than I am suggest that as a competitor it’s a pretty distant third behind the big two. This is clearly an attempt to secure more original content for Netflix, but also something of a hedge against the time that Netflix’s deal with Disney and therefore Marvel goes away, though on the latter point the acquisition also likely raises the risk that deal does go away, so perhaps Netflix has already had signals (or has simply decided independently) that it won’t renew. But it doesn’t sound like it’s going to provide anything like the same quality or quantity of content for Netflix that the Marvel deal does.
via Netflix (PDF)
This may help explain why Netflix laid out its content economics in even more detail than usual in last week’s earnings material: it’s apparently taking out a further $500 million line of credit, with an option to extend that by an additional $250 million. The driver is clearly its rapidly growing investment in original content, which has to be paid for up front, in contrast to the existing content it licenses, which is paid for as it’s made available on the site. All of that means that shifting to original content pushes cash burn much earlier in the process and thereby dramatically increases Netflix’s negative free cash flow, something I explained in some detail in this Variety piece last month. As I’ve said before, there’s no real reason why this should be a concern for investors, as long as Netflix is able to keep up its rapid pace of revenue growth, which is currently more than enough to fund its content investments and justify its increased borrowing. But the company’s debt load continues to rise fairly rapidly and at some point it will need to ease off and see that free cash flow picture change to something more positive.
Netflix today kicked off the Q2 earnings season with the first official earnings from a company that I cover, and reported stronger than expected subscriber growth off the back of a House of Cards season launch that was pushed back from Q1. Netflix was way off on its sub growth forecast, and though it surprised on the upside this time around that hasn’t always been the case in several recent guidance misses. Even though Netflix didn’t mention it this quarter, the delayed HoC launch screwed around with lots of year on year comparisons both this quarter and last, since Q1 is usually by far its strongest quarter for subscriber adds and Q2 is usually the low point of the year. Taking a step back, though, Netflix continues on its recent tear, with international growth the major driver, and profits domestically continuing to grow nicely off the back of last year’s price increases. Importantly, Netflix is now projecting that the international business will be profitable on a contribution basis for 2017 as a whole, which will be another major milestone after total non-US subs surpassed US streaming subs for the first time in Q2. The cash flow drain continues to be rapid, with an average of over half a billion dollars per quarter in negative free cash flow over the past year, and over $2 billion in cash content costs in Q2, and $8 billion over the past year, relative to the $6 billion Netflix protected for 2017 on a P&L basis (see this Variety piece I wrote last month for why cash and P&L spending are so different). For now, the subscriber and associated revenue growth are keeping Netflix out ahead of its content spending, but Netflix absolutely has to continue to grow at close to the current rate if it’s to continue to finance massive original content costs and grow profits at the same time.
This is a good time to remind you about the Jackdaw Research Quarterly Decks Service I also offer, which provides slide decks and videos on roughly a dozen major tech companies including Netflix each quarter during earnings season. Tech Narratives subscribers get a 50% discount, so let me know if you’re interested and I’ll send you a coupon code. The Q2 Netflix deck is available now, and will be updated in a few days when the 10-Q is out with more data. You’ll find some of the charts in this Twitter thread from earlier.