Netflix, Inc. (NFLX) Pressured By Content Costs, But It’s OK

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Netflix has been dropping millions of dollars on original content, drawing both praise and criticism from investors and analysts. In the next couple of years alone, Netflix is already planning more than 30 original series. Of course all that original content puts pressure on the company’s margins, but it’s necessary for Netflix’s survival, according to Trefis analysts.

Netflix plans 2015 content

Netflix started streaming its newest original series, Marco Polo, earlier this month. Unfortunately it hasn’t been a hit with viewers like the company’s other series have been, as it was meant to target viewers of HBO’s Game of Thrones, which has been a smash hit that already has seasons under its belt. Netflix reportedly spent $90 million on Marco Polo.

Other original shows Netflix has on tap for 2015 include five seasons of four live action series to be created by Walt Disney’s Marvel Television, which Disney has been reported to spend $200 million to produce.

In addition to producing original content, Netflix has been spending out big bucks to get the rights to stream other popular TV series like Gotham, which it will shell out $1.75 million per episode to show. The video streaming company has also been said to be paying $2 million per episode to stream The Blacklist and $1.35 million per episode to stream The Walking Dead.

Netflix’s margins under pressure

Of course all this spending is ratcheting up the pressure on Netflix’s margins. The company reported another increase in streaming content obligations, which rose from $7.2 billion at the end of last year up over $8.8 billion as of the end of this year’s third quarter, reports Trefis.

Netflix’s biggest cost component for the quarter was content expenses, which according to Trefis, includes amortization on the company’s streaming content library and other licensing and related expenses. Content expenses were more than 70% of Netflix’s total expenses. The company’s cost of revenue rose about $430 million year over year to $2.73 billion, mostly due to the more than $376 million increase in content expenses, which rose from $1.6 billion to $1.96 billion.

The Trefis team notes that Netflix is feeling these rising content costs in the contribution margins of both its domestic and international segments, especially for the international segment because it did not become profitable on a contribution basis until just recently.

The analysts are expecting Netflix’s international contribution margin to be about -14.5% for this year and then break even next year. However, they think the company’s margins could remain pressured over the next couple years as the company continues to deal with rising content costs.

Why Netflix must spend on original content

The Trefis analysts note that original content has been the main reason Netflix has seen such strong subscriber growth over the last couple of years. The video streaming company continues to improve the quality of its content, which in turn has enabled it to remain at the top spot in online streaming, ahead of Amazon and Hulu.

Shows like House of Cards and Orange is the New Black have set Netflix apart because it produces content that can’t be viewed anywhere else. However, the Trefis team states that the company must keep coming up with hit shows, and it seems as if for now anyway, Marco Polo won’t do much to boost subscribership.

What Netflix must do going forward

The analysts said it’s important for Netflix management to continue having faith in the way they decide what kinds of original series to produce. The company analyzes viewer data to determine what types of shows will interest large segments of its viewers.

They point out that the apparent failure of Marco Polo isn’t any reason to become discouraged because HBO has faced similar issues in the past, which is important because many see HBO as a competitor for Netflix. The TV network has canceled six shows after a single season in the last three years. In fact, these sorts of issues are quite common in the pay-TV market.

Netflix’s big advantage

The Trefis team also note that there is one big advantage Netflix has over HBO and other pay-TV networks, which is that the “opportunity cost” is less. In other words, pay-TV networks are committing themselves to a single show in a single time slot, and if viewers don’t like the show, they change the channel. Netflix, however, offers plenty of content to choose from, so viewers can simply change to a different show on the service rather than going elsewhere.

As a result, they say Netflix can take more risks in this area than pay-TV networks can.

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