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Takeaway: We remain short Netflix (NFLX) in the Hedgeye Communications Position Monitor

FIELD NOTES (NFLX, AMZN, DIS) | NETFLIX'S CONTENT STRATEGY IS NOT SUSTAINABLE - 20190517 NFLX Acquisition

OVERVIEW

We spoke with a former Content Director at Netflix and Amazon Studios to better understand the economics of licensed versus original content, the competitive landscape and where the market is headed.  Our contact detailed Netflix's long history of paying 30-75% above market for licensed content and a competitive landscape that has quickly turned against them. In the case of the pay one deal with Disney, NFLX was willing to outbid anyone else, in a transaction ultimately costing NFLX $350 - $500 million per year.

"Today, Netflix's strategy is no longer a secret.  Everyone knows it. Netflix and Amazon have a multi-year lead, but that won't last"

"Whether it is death by 1,000 paper cuts, the cumulative effect of all these content owners leaving the platform is really bad for Netflix."

"The studios know that Netflix is not in a position to negotiate because they need the content. It didn't help Netflix that they set the bar so high for themselves to begin with."

"Netflix built a competitive advantage with data and it is not sustainable."

Meanwhile, in aggregate, the efficiency of NFLX's original content spend on a cost per hour basis remains inferior to that of licensed programming. In terms of acquisition, NFLX spends approximately $430 in cash content per net new subscriber per year, a number that has increased at a 10% CAGR over the last 5-years.  On a total basis, NFLX invests $90 - $100 in cash content per total member.  Our contact "was never a believer that [NFLX] will be able to scale their content spend because they already opened up this pandora's box and now users expect the same level of content generation, and the only solution for Netflix is to raise the price."

field notes

Background

  • "Until 2013, which saw the launch of 'House of Cards,' the streaming business was exclusively licensed content from studio networks and most of the usual suspects from Hollywood.  Overwhelmingly, the majority of those late 2012 deals was non-exclusive content. Netflix had it, Hulu had it and Amazon had it or could get it."
  • "A lot of the major deals Netflix had with FOX and NBC on the TV side were considered output deals.  The networks had the ability to push content through the deal. It was a good deal for the TV studios because Netflix was paying top dollar and more than Amazon. At the time, people said [Netflix was] crazy and going to be bankrupt two-years... but wall street didn't mind funding these tremendous losses."
  • "Netflix was competing for shows, whether it was from Showtime and HBO, etc. In the case of the Disney deal, however, there was no competition because [Netflix was] willing to outbid anyone else."

Licensed vs. Original Content

  • "The value of licensed deals were based on the syndication costs.  Even based on traditional comps, Netflix would pay more. It was considered crazy at the time because SVOD wasn't an established thing.  At the same time, Netflix was bidding 50-75% over the market."
  • "One anecdote... Hulu was in the market at the same time, and they have favorable access to content because they were industry owned. Netflix paid more for non-exclusive streaming rights for 'Everybody Loves Raymond', than all of Hulu's streaming deals with CBS combined."
  • "Netflix was sort of bidding against itself. A lot of the long-term bull case is that eventually, that will stop happening and that Netflix will have such pricing and content power that content costs will stabilize and you can even see content spend decline on a per unit basis, which I don't think will ever happen."
  • "It worked for Netflix in the sense that they were able to acquire lots and lots of content and use it to acquire users."
  • "Netflix was really struggling with originals, and how to account for the useful life of an original."

Competition

  • "Netflix is competing for attention and time."
  • "Most people have an affinity with talent, but they don't care what streaming service or channel it is on. If they want to see it, they will go find and watch it."
  • "A lot of content owners at the time, they would expect future deals would grow on initial deals and Netflix would still keep spending more. Cable companies were paying more with each cycle.  What Netflix started to do as a way to not necessarily manage costs, but claim leverage, in the 2nd and 3rd cycle in licensed content they would go back and say that they have all this data and know what is working and what isn't.  Netflix would try to curate the content better, be more selective in what they were buying. However, they were only marginally successful since they wouldn't actually share any of the data they were referring too and they usually ended up spending more in total anyway."
  • "In 2013-2014 Netflix original content strategy was already underway, but studios were eventually figuring out that NFLX was not going to write ever bigger checks, and was actually using viewership data to compete against them over time. The studios wanted more money, and better terms and Netflix wanted more exclusivity and pay less."
  • "Today, Netflix's strategy is no longer a secret.  Everyone knows it. Netflix and Amazon have a multi-year lead, but that won't last. If you look at the history of the entertainment business, you never see complete monopolization of content."
  • "Today the studios realize the monster they helped create by licensing all their content to Netflix. In the early years, they thought it was a no-brainer because Netflix was willing to pay so much. Now that has completely changed, and the studios know that Netflix is not in a position to negotiate because they need the content. It didn't help Netflix that they set the bar so high for themselves to begin with. Netflix has been going back to studios to try to get better terms on a per episode basis, but the studios are much smarter now."
  • "I am seeing a lot of evidence they are trying to go back now to traditional media content owners and get new deals. Whether it is death by 1,000 paper cuts, the cumulative effect of all these content owners leaving the platform is really bad for Netflix."
  • "Now it is not just Amazon or Hulu they are competing with... now they have Warner, Disney+ and others."
  • "I think Netflix needs to diversify into other forms of content. They need to get into sports and news, particularly sports."
  • "Amazon entered the market and became a higher bidder, but was more selective. Netflix was known for paying above market for everything, any category."
  • "Bezos has no specific love for the media business. It is not existential. With Amazon, it is all about the value of a prime subscriber and driving acquisition.  When we looked at the cohort of members who were video subscribers, the metrics in terms of how much they bought and consumed was really positive. So we said, let's give them more video and keep them happy."
  • "Until very recently [Netflix's] original content strategy was more about quantity, but they recently started investing heavily in acquiring talent."

Economics

  • "Least expensive content is the second window. In relative order of magnitude, let's say the second window is $1. Then there is licensed, first window content like 'House of Cards' and 'Orange is the New Black.' Those cost $1.40 - $1.50. The third category is owned originals, like 'Marco Polo' that cost $10M a year an episode.  The relative cost of owned originals is $2-3."
  • "There is always a stickiness with production costs. You get these salary increases, little scale, cost of living only goes up. Only so much talent out there.  Netflix is very much like a network in that respect."
  • "90% of Netflix's success was their ability to move quickly, and if they make mistakes cover them up and move on. They don't want long, drawn-out negotiations. They will pay 30% or more over the market just to get it done from the top down. It is disruptive in an industry where everyone else has moved so slowly for so long.  Long-term, they think they can manage those costs and monopolize the best talent."
  • "Netflix is mostly a licensed content service. They evaluated the efficacy of a piece of content based on cost per hour of viewership. The question asked was, how do we spend for one hour of viewership?"
  • "In 2015, the average show would cost about $0.12 cost per hour. Drama would be 2-3x that, but could easily go beyond that for popular series like 'Breaking Bad' and 'Mad Men'. There were other benefits of the content too, such as social buzz and marketing synergy."
  • "When they first started doing originals, they were completely inefficient from a cost per hour perspective... costs were way too high. Something like 'House of Cards' was a hit in the coasts, but not in the Midwest. Today, originals are more efficient than in the beginning, because they have better data. They have control when and where it is going to launch, marketing spend and more. With licensed content, they don't have that flexibility. Still, old licensed shows are more efficient."
  • "With broadcast and cable networks, they are dealing with a finite number of slots. There are only so many slots for shows. You are one of 5 or 7 new shows on the network, the threshold has to be much higher. You have to be more eager."
  • "Netflix spends a lot of time talking about their global reach, which allows them to fund an original content series in Italy that no network ever would. However, that is not always a good thing. 'Marco Polo' for example was an expensive, unmitigated disaster. Netflix was committing to full season kickoffs before the show was even launched. 'Hemlock Grove' is another example, it was terrible, viewership wasn't good, yet they kept it for three seasons."
  • "I was never a believer that they will be able to scale their content spend because they already opened up this pandora's box and now users expect the same level of content generation, and the only solution for Netflix is to raise the price."

Data Transparency

  • "Netflix has not been transparent about data that is actually useful. Netflix content partners in the early days, they tried. Disney, for example, wanted a very detailed report, but Netflix essentially bought their way out of it. Netflix didn't want to give Disney the data because it would give them incredible operating leverage."
  • "Netflix built a competitive advantage with data and it is not sustainable."

Disney

  • "Netflix paid somewhere between $350 - $500 million per year to Disney. There was a huge library component to the deal. Netflix agreed to take on old Buena Vista movies, not the premium Disney vault, but largely B-tiered stuff and that was half of the deal. The pay one deal was expensive, but they were getting Frozen."
  • "Disney content will be phased out over the course of 2019, with some lingering into 2020."

Management

  • "Ted [Sarandos] is fine, he is not a content or creative visionary."
  • "Reed's biggest flaw is his biggest strength. He is so convicted in his beliefs. When he is right everyone can move quickly and be aligned."

Please call or e-mail with any questions.

Andrew Freedman, CFA
Managing Director
@HedgeyeComm