A Look At Netflix’s Downside From Rising Content Costs

Content costs are one of the biggest components of Netflix‘s (NASDAQ:NFLX) expenses and the major factor driving its contribution margins. The costs have risen steeply in the last few years primarily driven by the increased competition and content owners realizing the value of streaming services. In essence, it is becoming increasingly expensive for Netflix to gain and retain its subscribers.

Although the contribution margins have shown consistent improvement, there is no guarantee that the trend will continue as content gets more expensive and subscriber growth slows down. If Netflix does not continue improving its margin, there could be more than 30% downside to our price estimate.

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How Are Overall Costs Trending?

Netflix’s content costs have risen substantially over the last few years thanks to the company’s efforts to expand its streaming library both in the U.S. and international markets. Back in 2011, Starz was demanding as much as ten-fold increase in payments for the renewal of its content contract with Netflix. This would have amounted to annual payment of around $300 million, compared to its original deal of close to $30 million. ^[1] This is classic example demonstrating how streaming content costs have skyrocketed in the recent years as competitors are bidding up the prices and media companies are realizing the value of their content.

Netflix hasn’t shied away from spending to keep its subscribers hooked. The company stated that its content advantage was the biggest driver of its U.S. streaming subscriber growth in the first quarter of 2013. ^[2] Netflix has been adding some original and exclusive programming to its streaming library which seems to be paying off. TV series such as House of Cards, Lilyhammer and Arrested development are drawing lot of audience and attracting customers to sign up. In fact, Netflix has effectively marketed these exclusive shows to maintain its subscriber momentum. ^[2] It is estimated that Netflix is paying somewhere around $4 million per original episode.

Besides some of the exclusive shows that we mentioned before, Netflix also signed a deal with Disney (NYSE:DIS) last year to gain exclusive access to some of its content once the contract between Starz and Disney expires in 2015 (see What Are The Implications Of Netflix’s Deal With Disney?). During the first quarter of 2013, Netflix continued to expand its streaming content through deals with Turner Broadcasting, Warner Brothers Television Group, DreamWorks Animation and Hasbro Studios. ^[3]

These content deals do not come cheap, which is clearly evident from the fact that Netflix’s streaming content costs, overall content costs and streaming obligations have jumped significantly over the last two years.

The table below shows this trend.

(1) Streaming content costs – This is the amortized amount that company reports in income statement.
(2) Overall content costs – This is amortized amount that includes streaming and DVD
(3) Content obligations – Total amount that the company needs to pay out over the course of next few years.

How Is Content Cost Per Subscriber Trending?

Total content cost per unique subscriber has displayed a similar trend. This essentially implies that it is getting more expensive for Netflix to keep its subscribers happy. However, a lot of this can be attributed to the company’s aggressive international expansion where the subscriber base is still small, but Netflix has to spend a substantial amount upfront to make sure the content is good enough. The picture may not look this drastic if we only look at the domestic segment, where besides good subscriber growth, Netflix has also gained operating leverage and lowered its subscriber acquisition costs.

The Real Risk To Costs

Growing Competition Could Propel Content Costs Further

Competition will not only make it tough for Netflix to gain or retain subscribers, but it will also impact its margins as competitors push up the cost of content. Netflix acknowledged that high bidding from Amazon (NASDA:AMZN) and Hulu is notably impacting content prices. ^[2] Although the company was able to grow its revenues faster than costs in Q1 2013, it may not continue to do so in the future.

While Amazon is still behind Netflix in terms of content, it is evident that the company is slowly trying to close that gap. It appears that Amazon Prime’s growing subscriber base could be a concern for Netflix in the future. We believe that as of now, Amazon presents the highest competitive threat for the company in the U.S. streaming market. Apart from Amazon, other potentially dangerous players are Comcast (NASDAQ:CMCSA), Verizon (NYSE:VZ) and Dish Network (NASDAQ:DISH). They may be lagging right now, but they can pose a significant threat over the next few years. Comcast launched its Xfinity Streampix offering in February 2012, allowing subscribers to complement their existing pay-TV packages with the additional streaming service. The service is available at $4.99 per month, $3 less than what Netflix charges, and is therefore very competitively priced. Comcast stated during its Q2 2012 earnings announcement that it had doubled the titles available for streaming Streampix since the service’s launch. The company is clearly motivated to improve its streaming content as it is charging separately for it and wants to use it as one of the methods to stem pay-TV subscriber losses.

Dish Network offers the sling DVR technology to its subscribers allowing them to remotely access pay-TV programming. Adding Blockbuster streaming is an excellent move as it gives subscribers the flexibility to watch what they want when they want and from wherever they want. The Blockbuster streaming service was launched in late 2011, and has helped Dish improve its subscriber trends. With the Federal Communications Commission (FCC) granting Dish a waiver to build a wireless network, Dish will get more aggressive in promoting its streaming service by selling streaming devices that will work on its broadband network.

It is also interesting to note that the streaming services from Amazon, Comcast and Verizon-Redbox are priced cheaper than Netflix’s, which may be a concern as their content libraries develop. Lastly, let’s not forget the efforts from media companies themselves such as the joint venture Hulu, as well as premium networks such as HBO.

Potential Downside

We currently forecast Netflix’s domestic streaming contribution margins to grow from 19% in 2012 to close to 30% by the end of our forecast period. However, if the margins don’t grow further due to rising content costs and or slower subscriber growth, we could see additional downside to the tune of 30% to our price price estimate for Netflix stands at $133.

Our current prices estimate implies a discount of about 40% to the market price as we believe the market is not adequately accounting for the risks of heightened competition from major online players like Amazon as well as other cable and satellite companies like Comcast and Dish that have shown interest in streaming.

See Is Netflix’s Stock Surge After Earnings Justified?

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Starz to Split From Netflix, The Wall Street Journal, Sept 2 2011 [↩]
2. Netflix’s Q1 2013 Earnings Transcript [↩] [↩] [↩]
3. Netflix’s Press Releases [↩]