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.