How Increasing Original Content Will Benefit Netflix In The Long Run

At a UBS conference on December 7^th, Netflix (NASDAQ:NFLX) announced that it plans to have a total of 31 scripted shows by the end of 2016, which is double the 16 original shows the streaming service aired in 2015. In addition, the company is also working on 30 kids’ shows, 10 new feature films, 12 documentaries, and 10 stand-up specials. ^[1]. The market reaction to this announcement was not positive and Netflix’s stock price fell by nearly 5% on December 7^th. Although creation of original content leads to higher costs, we believe that for Netflix to differentiate itself from other players in an increasingly competitive streaming services market, quality of content will be the key factor. If the company is able to gain market share based on the popularity of its original content, and spread the creation cost over a higher number of subscribers, it should gain in the long run.

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Content Quality Will Be The Key Differentiator

Competition is increasing in the online streaming space with players such as HBO, Dish Network (NASDAQ:DISH), Sony (NYSE:SNE), CBS (NYSE:CBS), and Comcast (NASDAQ:CMCSA) entering the market, in addition to Amazon and Hulu. Earlier in December, YouTube applied for streaming rights for TV series and movies to bolster its subscription service, YouTube Red. (Read Is YouTube Red A Real Threat To Netflix). With most players offering competitive subscription rates, content compatible with mobiles and other handheld devices, and securing rights for popular TV series and movies, original content of high quality would be the key differentiator in this market to attract subscribers. However, cost of original content can put pressure on the margins and Netflix needs to offset this by increasing the number of subscribers or subscription charges.

Content Cost Pressure On Margins Can Be Offset By An Increase In Number Of Subscribers

We estimate Netflix’s domestic streaming contribution margin to increase from around 33% in 2015 to more than 40% by the end of our forecast period, as the company gains operating leverage and the marketing cost reduces. However, as the company increases focus on original content, it will increase costs and put pressure on margins.  In a scenario where margins increase gradually from around 33% in 2015 to approximately 35% by the end of our forecast period, there can be a nearly 9% downside to our price estimate.

However, this downside can be offset if Netflix is able to surpass our expectations in terms of the number of U.S. streaming subscribers. We estimate that this number will increase from nearly 45 million in 2015 to around 60 million by the end of our forecast period. Netflix will face increased competition in the coming years as evidenced by the recent crowding of the online streaming market. However, we believe that the company will be able to hold its own amongst the competition. The success of Netflix’s original content has improved viewers’ perception of the overall brand. The company is no longer considered just an aggregator of popular content from other networks, and has come of age as a provider of engaging and interesting content on its own. Netflix also tends to be viewed as a complementary service, rather than a competing service to various pay-TV operators. The end users could potentially form the same opinion of the company when it is compared to other streaming services in the future. Additionally, Netflix’s service functions more like a repository and users can access much older content which might not be readily available on other streaming services. Consequently, if Netflix is able to attract more consumers and increase its subscriber base at a faster pace, based on the strength of its high quality content, and reaches nearly 70 million subscribers by the end of our forecast period, the downside in our price estimate due to pressure on margins can be offset.

Netflix is extremely popular in the U.S. and a recent survey by RBC Capital Markets says that more than half of Americans (51%) use this service, primarily due to its competitive pricing and new content being added every month. ^[2]. While the company plans to spend heavily on creating a huge library of original content next year, the success of these shows, and Netflix’s ability to leverage its popularity in attracting more subscribers, will be a key factor to drive its valuation in the future.

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1. Netflix is doubling its number of original scripted shows next year, Theverge.com, December 7, 2015 [↩]
2. New Survey Shows Netflix Popularity In The United States, GazetteReview, November 21, 2015 [↩]