Arrested Economics: Assessing Netflix's Original Content Business

Arrested Development and House of Cards aren't designed to deliver the metrics Wall Street expects, and this means a lot about how Netflix views its future

Part one of this series: Original Content: The Illusory Silver Bullet

May 26th was a uniquely exciting (and perhaps exhausting) day for TV lovers. At midnight, Netflix released a brand new season of Arrested Development – more than seven years after the show was cancelled by Fox. The show’s return represents a key component of Netflix’s emerging original content strategy and is the fourth show released by the over-the-top streaming service this year (at a total cost of more than $150M). As such, I thought it would be a good opportunity to pause and evaluate the economics of this strategy and hypothesize what success might look like. In doing so, we can also better understand the role of original content (is it intended to drive net adds, reduce churn, stabilize content costs etc.) and the impact of their controversial decision to release entire seasons at once. This will also tell us about Netflix’s future and management’s POV on this future.

The Value of Netflix to the Consumer

Though inexpensive on the whole, Netflix’s service does not offer materially cheaper entertainment than that of traditional cable TV, costing approximately $0.0024/minute versus cable’s $0.0035/minute.

This is interesting for two reasons:alt="NFLXEconomics1"

1. Despite being commercial-free and infinitely more flexible than live linear TV (in terms of time, content and screen), Netflix is unable to command a price premium for its entertainment service.

2. Average time spent watching Netflix per user is up more than 10% year-over-year. However, with prices still $7.99 a month, Netflix has not benefited from this increase in customer value (directly, at least, as it would improve word-of-mouth and perceived value). Increases in both the quality and size of its content library content quality is no doubt a major driver for increased usage, but this has contributed to a 16% increase in quarterly licensing costs ($1.355B in Q1 2013).

This matters because it means Netflix may have limited means to raise prices – and when it does, they will still lag customer value growth. As the instant decapitation of Qwickster demonstrated (among many other lessons), Netflix’s customers really do control the relationship.

The Value of Arrested Development to a New Subscriber and Netflix

For those who join solely for Arrested Development, the cost/benefit is easy. While $8 for 10 hours of high priority content is expensive compared to typical Netflix or cable usage, it’s a far better deal than other premium content distribution channels, such as a movie theater or an iTunes season pass. But was the programming also a good deal for Netflix?

For all their apparent similarities, the business cases and goals of House of Cards and Arrested Development differ quite substantially. The former is a new media property that will continue producing new content each year and whose success will be driven largely by word-of-mouth. To that extent, Netflix hopes the show will bolster its reputation for high-quality entertainment and keep its customers subscribing. Conversely, Arrested Development is an established brand that’s intended to be a one-off event to convince its alt="NFLXEconomics2.png"fanatical (and tech-savvy) followers to give Netflix’s broader streaming service a try. Through its analytics engine, Netflix would already have a clear picture as whether the shows are tracking against their expectations (many, including myself, signed-up or reactivated service the very day Arrested Development was released).

By my calculations, I’d estimate Arrested Development’s break-even to be approximately six million “incremental user months”. More plainly, Netflix must sell six million more one-month subscriptions (whether this means adding six million new users who stay for one month, driving one million existing users to staying for six more months, or something in between) than they would have without the show. With approximately 5.22% of subscribers churning each month1, the current customer subscribes for an average of 19.5 months, meaning that for every 1M new subscribers Arrested Development drives is equivalent to a monthly churn reduction of 0.17% or the average customer staying for one extra day. House of Cards payback is nearly 40% higher than Arrested Development’s, at 8.3M incremental user months. Though the business model differs (advertising and licensing revenue, versus consumer subscriptions) ABC’s Grey’s Anatomy needs approximately 7.9M regular viewers to break-even for its timeslot.

Understanding the Truth of Netflix’s Original Content

In its Q1 2013 earnings report, Netflix added more than two million subscribers, which led many analysts to declare House of Cards an initial success. The idea that Arrested Development might secure two million subscribers or more for the launch month isn’t totally outlandish, given their adoration for the show (it’s hard to estimate what percentage of the fan base that would be, as it has grown considerably since its 2006 audience of three million). Achieving the remaining four million incremental user months can be made up in a variety of ways: 10% of those 2 million additional subscribers could need to become typical Netflix customers (i.e. stay for 19+ months) or the show would be enough to keep the average customer for 0.7% longer (5 days) or 1/6 current customers would need to stay an extra month overall.

While none of these hypotheticals seem aggressive at first glance, their time horizon is instructive. 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.  Their “incremental user months” calculation is largely made up of keeping more current customers that they expect would otherwise leave. This gives us insight into Netflix’s unspoken forecasts and suggests that their original content strategy will provide neither significant, nor sustainable subscriber growth in developed markets. To this point, Netflix’s typically unchallenged market leadership is under increased pressure from new streaming competitors, many of which are free to cable or Internet customers or baked into ecosystem services (such as Amazon Prime).

Their investment strategy reinforces this subtext. The company often touts how it is using customer analytics to pick its programming decisions, yet their new programming is not about filling content gaps in the minds of non-users, it’s about catering to the specific interests of current subscribers. In 2013, the company spent $200M on original programming. By 2017, this number will likely grow to roughly $1.1 billion2. At those levels, the company would need to achieve incremental 145 million user months from new subscribers to receive a return on just that year’s content spend. Speaking to the service’s increased focus on originals, Netflix Chief Content Officer Ted Sarandos recently declared, “(Our) goal is to become HBO faster than HBO can become us.” Yet, despite HBO’s considerably increased slate of original content and rising production costs, the company’s subscriber base has remained flat at just under 30M for a decade.

So what?

Investors view subscriber growth as the only real indicator of content success, but it isn’t the strategy’s primary goal. These new originals series will bring new users to the service, but this growth will be neither voluminous nor sustainable – as I wrote earlier, they are not “silver bullets” Instead, Netflix’s original content is about three things:

1. Retaining current (contract-free) subscribers that the service is constantly on verge of losing. alt="NFLX11"

2. 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.

3. Original content will help Netflix adjust pricing. It’s difficult for Netflix to achieve differentiation when the majority of its core offering (content) is available to its competitors. If they use their customer analytics to target the right customer segments with high-valued content that isn’t available anywhere else, they should be able to extract more than $7.99 per month – especially given their current discount relative to entertainment substitutes. This is especially true if their customers increased service usage is being driven by this original content.

Netflix’s period of hyper-growth and high multiples is coming to a close, and like other maturing businesses, its focus is moving towards churn management and optimization. Their recently announced family plan, which ushers in the era of multi-tier pricing, is a testament to this fact. I’d also expect Netflix to move from being a pure play content provider and use its customer scale to build additional services, such as co-viewing, which emerging competitors such as Microsoft are likely to use as differentiators. Netflix is an amazing company who has continually disrupted the home entertainment space (and its own business model). As it transitions from a nimble start-up to mature giant, it will be fascinating to see how its strategy and tactics

UPDATE: Reply to Felix Salmon

 Over at Reuters, Felix Salmon has posted his thoughts on my piece. He rightly suggests that Arrested Development and House of Cards are just the first step to creating an HBO-style portfolio of content: “… 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.”

The problem here, as I discussed in an earlier piece in the series here, is that the original content space is increasingly crowded and its value as a differentiator is decreasing. 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 differentiator to a cost of playing the game.  More plainly put: original content is a necessary, but far from sufficient condition for competition in today’s content marketplace.

Key Notes and Assumptions

[1] Despite SEC protestation, Netflix has not published its churn numbers since Q4 2011. This decision was made as the company transitioned to an OTT-predominant service, with management arguing that the (likely high) figure would portray the service’s revenue as less stable/reliable than was actually the case. In its response to the SEC, Netflix wrote:

“approximately one-third of gross subscriber additions are former subscribers who have rejoined the service, many within the same year. This ability to freely cancel and rejoin may result in a higher level of churn than we would otherwise experience, and could be viewed as a negative business development; however, we believe that this has actually been beneficial to our operating results in the form of a lower cost of subscriber acquisition. As the Netflix subscriber base and revenues have grown and as we have shifted our service offering toward streaming content, churn has become less relevant and management has come to rely more and more on net subscriber additions versus churn to monitor and describe the business…”

Churn estimation, of course, remains a useful indicator and baseline for subscriber management and revenue flows. In Q1 2013, Stanford Berenstein estimated Netflix’s annual churn to be 40%-50% annually (3.3%-4.2% per month). From 2009 until 2011, churn ranged from 3.7% to 6.3%, with an average of 4.9% for FY 2011. This rate trended up as both the DVD-to-OTT transition accelerated and the overall user base expanded to less intensive content-lovers (hence managements growing concern about the metric). As such, there’s reason to believe the number would be at least 4.9%, if not slightly higher in 2013. Furthermore, Moffett points out that “many subscribers are often quitting and then re-joining to catch a particular series or movie”. This observation seems even more likely given Netflix’s transition into exclusive, heavily-marketed, marquee and all-at-once titles such as House of Cards.

In its April 2012 letter to shareholders, Netflix also provided an appendix exhibit entitled “Mathematical illustration of increased seasonality of net additions, given stable seasonal patterns in gross additions.” Here, they “simplified and abstracted the numbers to illustrate the principles” and used a churn figure of 5%. In the absence of another figure, and given it’s consistency with aforementioned estimates and logic, I would consider it to be an acceptable (if low) proxy.

Different companies calculate churn slightly differently. I took the conservative calculation approach, applying 5% to the average number of subscribers over a fiscal quarter and then divided it by the ending number of subscribers in the previous quarter. By averaging the resulting ‘true’ churn percentage over the prcedeeding 12 months, one comes up with a rate of 5.22%.

[2] Ted Sarandos has publicly stated that original content will grow from less than 5% of total content spending “to 10% to 12% to 15% over the next couple of years”. Given this staging, it’s reasonable to assume 15% will be achieved by 2017 – if not earlier. Were overall content spending flat, this would be at least triple original content spend over FY 2013’s figures. However, total content liabilities have been growing 25%+ each quarter as the company enters new markets, renews licenses and pursues more exclusive licenses (all stated corporate priorities). As such, this topline cost is likely to grow – thus increasing the absolute value of original content expenditures. The question is how much.

Consensus analyst estimates for Netflix’s 2017 revenues are approximately $8.125B (High: $10.5B, Low $6.5B). Over the past three fiscal years, the company’s cost of revenue has been 64%, 73% and 71% (2013 YTD). If we assume 71% remains constant, Netflix will spend $5.75B on content at the consensus revenue estimate, with 15% of this spend would represent $865M.

From there, I ran sensitivities under two hypotheses: (1) Netflix increases its planned original content investments to further differentiate from free or bundled VOD offerings domestically (e.g. Comcast Xfinity or Amazon Prime) and to establish original content for foreign markets. At 18% (a 20% increase over 15%), original content spend would be $1.05B. (2) Increased Costs of Revenues as the company begins competing with more deep-pocketed OTT competitors (e.g. Amazon and Microsoft) and pursues more exclusive licenses (a stated strategy). Should Cost of Revenues grow to the historic high of 73% of revenues (2012) by 2017, Netflix would be looking at a total of $1.1B in original content spend.