Is Netflix About to Crash and Burn?

by Jonathan Berr | June 18, 2013 10:41 am

How much longer Can Netflix (NFLX[1]) CEO Reed Hastings keep membership and revenue growing faster than content spending?

In the company’s last quarter, revenue rose 18% to $1.02 billion, total members rose 37% to 36 million, and marketing spending was little changed at $129 million.

The secret to Netflix’s success? Two words: public relations.

“ … as our reputation improves from the service improvements we are making and we get great PR around the original content, then that is what gives us a larger presence despite steady paid marketing spend,” Hastings said during last quarter’s conference call.

Indeed, Netflix has gotten some phenomenal press. Critics have largely liked its drama House of Cards. And although its new season of the beloved cult comedy Arrested Development has disappointed some fans, the company is getting kudos for giving it is best shot. To some investors, the Internet streaming and DVD rental service has come to be the Little Engine That Could — one that keeps challenging much larger media companies.

After some customer service missteps, Netflix found itself in Wall Street’s doghouse late in 2011 and for most of last year. But shares of Netflix have surged 147% since the start of 2013 as investors began to root for the company.

The one flaw in investors’ logic, however, is that Netflix keeps spending money — lots of it — to lock in exclusive content deals, such as the one announced Monday with DreamWorks Animation (DWA[2]), and to produce new shows.

But creating original shows is not easy … or cheap. Netflix has reportedly spent about $200 million on Arrested Development and House of Cards when marketing costs are considered. The network’s horror show Hemlock Grove was described as “Scary Bad” by The Daily Beast and not in a good way. Lillehammer, a comedy-drama about a New York gangster that escapes to Norway, didn’t set the world on fire either.

Those investments haven’t exactly paid off, either. The company netted less than $3 million in profits last quarter, underscoring how much these costs are weighing down the company.

Given those numbers, the deal with DreamWorks makes perfect sense. The Glendale, Calif.-based company brings the Shrek and Kung Fu Panda franchises to the table along with 300 hours of original programming, which should help it attract younger viewers. Terms of the deal were not released, though it’s safe to assume they were in the range of the $300 million it reportedly is paying for its multiyear deal with Disney (DIS[3]).

Whether these agreements will make up for the defection of Viacom (VIAB[4]) to Amazon (AMZN[5]) is tough to say. Viacom’s kid’s shows such as SpongeBob SquarePants are long in the tooth and have lost viewers.

But Netflix has more tricks up its sleeve. Under the DreamWorks deal, Netflix also will get programs from Classic Media (acquired by DWA last year for $155 million) with classic characters such as The Lone Ranger, which it recently licensed to Disney for the upcoming film. Weeds creator Jenji Kohan’s new comedy Orange is the New Black, which debuts next month, looks promising. And an upcoming special by comedian John Hodgman will be available starting June 20.

In theory, the potential for Netflix is huge. Market researcher Convergence Consulting Group estimates that the number of cord cutters will reach 4.7 million this year — nearly another million people on top of the 3.74 million who already defected from cable and satellite companies between 2008 and 2012. Bloomberg News[6] notes that the quitters represented 1.1% of pay-TV accounts last year.

The problem with Netflix’s strategy is that Amazon and Hulu, two of its biggest rivals, are ready to spend big on content as well, and the incumbents aren’t standing still, either.

For instance, in the latest quarter, Comcast (CMCSA[7]) reported 21.9 million video customers, a drop-off of less than 2%. The Philadelphia-based company added 583,000 combined video, high-speed Internet and voice customers.

Created content will always carry the risk of flops — and occasional gargantuan stink-bombs. For Netflix, it’s probably only a matter of time. The question that investors need to consider is how easily Netflix can rebound after one of these failures. Since most television networks are part of larger media companies, one flop isn’t the end of the world. Netflix, however, doesn’t have that flexibility.

So far, people still believe Netflix has the coolest content at the best prices. Whether that perception will last is hard to say. Until the picture becomes clearer, investors should sit on the sidelines.

As of this writing, Jonathan Berr did not hold a position in any of the aforementioned securities.

  1. NFLX:
  2. DWA:
  3. DIS:
  4. VIAB:
  5. AMZN:
  6. Bloomberg News:
  7. CMCSA:

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