Netflix's Strategy Plays Out: If You Build It, They Will Come

Netflix (Nasdaq: NFLX  ) is enjoying a content bonanza right now. Will it make a difference to the bottom line? Read on for the answer.

Is Netflix the next HBO?
Let's start with the obvious: Netflix just announced yet another original series. Hemlock Grove puts an award-winning horror novel in the hands of director Eli Roth, who specializes in horror movies that make a small fortune on shoestring budgets. The first season of 13 episodes will debut in 2013, starring X-Men alumna Famke Janssen and Swedish actor Bill Skarsgard, son of international superstar Stellan Skarsgard.

This is Netflix's fourth original series, following Mafioso-in-Norway dramedy Lilyhammer as well as upcoming political drama House of Cards and comedy Orange Is the New Black. The company is also producing new episodes of beloved but canceled comedy Arrested Development, slated for streaming next year. This lineup may not quite measure up to the Emmy-winning power of Time Warner's HBO, but it beats any basic-cable channel you'd care to mention.

Like Lilyhammer, Hemlock Grove is produced by an independent studio and Netflix simply pays for exclusive rights to the pay-TV first-run window. That's a low-risk strategy that reduces Netflix's financial exposure in case these projects turn out to be total turkeys.

On the other hand, the company also gets left out of the profits if other online movie outlets or -- shock, horror -- cable channels and the Big Four networks pay up for later distribution rights. Syndication is an important part of the strategy for HBO and other premium cable networks. But Netflix isn't going for content-production paychecks: All that matters today is sucking new subscribers into the streaming experience by the millions. The company may become an outright producer one day, but that's simply not important right now. Check again in five years.

Dead can dance
Hemlock Grove is one of several gambles on unproven shows that may or may not bring in new subscribers. That's not the case with The Walking Dead, which has been available to Netflix customers since last October. That zombie drama's second-season finale set basic-cable records this week, with 9 million viewers. That's nearly enough to land on Nielsen's list of the 10 most watched on-air network shows.

Now, Netflix has to wait until AMC releases that season on DVD before airing that record-breaking season. But if AMC sticks to the three-month delay pattern from season one, that means raising the curtains in June or July. Meanwhile, Amazon.com (Nasdaq: AMZN  ) will let you watch the entire season online today.

That'll cost you $1.99 per episode, though, or $20.99 for the entire season. That's something like three months' worth of Netflix streaming service. You're trading cash for convenience. We're talking about two very different business models here.

Either way, both Amazon and Netflix should enjoy the record-breaking interest in The Walking Dead. Expect Netflix to build entire marketing campaigns around zombies when the second season draws closer to becoming available.

Stay hungry, feel the fire
And that's not all. Through its content agreement with Epix, Netflix has early dibs on Lions Gate Entertainment (NYSE: LGF  ) productions such as The Hunger Games. That adaptation of another best-selling novel hits theaters at midnight Thursday, and even the studio is shocked at how quickly tickets are pre-selling. Lions Gate's shares have jumped 16% in the past five days and nearly 90% year to date, largely thanks to expectations on this particular film.

"Exactly how much the studio can gross for the first weekend depends on how many screenings each theater can pack into 72 hours by finding enough staff willing to work the extra hours and keep the pic running continuously," says famed Hollywood watcher Nikki Finke. That includes 270 large-format IMAX (Nasdaq: IMAX  ) screens, where ticket prices also come supersized. Even in these cash-conscious times, IMAX can sell out midnight screenings at premium prices for this title.

Even Microsoft (Nasdaq: MSFT  ) wants to cash in on this guaranteed blockbuster's popularity by making an immersive online 3-D tour of the Hunger Games Capitol. And you know that there are big bucks on the line when Redmond gets personally involved.

In other words, here's another eyeball magnet that will be worthy of special promotion when it hits the Netflix streaming library. Hunger Games is another Twilight-class hit, except with fewer vampires and better storytelling. And if that's not enough, consider that The Hunger Games is a trilogy. It's the gift that keeps on giving.

If Huger Games and The Walking Dead don't motivate a significant influx of new Netflix subscribers in the second half of 2012, I'll buy a hat just so I can eat it. Many prospective Netflix investors have been scared away by the large off-balance-sheet content costs, but that's what it takes to build a library that's worthy of attention and subscriptions. I'm as comfortable owning Netflix shares as ever, and this week's movie magic just underscores how healthy this business really is.

Netflix has its fair share of critics these days, but you always get better buys when everyone else is selling. Buying when there's blood in the streets is a winning strategy.

Fool contributor Anders Bylund owns shares of Netflix but holds no other position in any of the companies mentioned. The Motley Fool owns shares of Microsoft and Amazon.com. Motley Fool newsletter services have recommended buying shares of IMAX, Microsoft, Amazon.com, and Netflix and creating a bull call spread position in Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Check out Anders' holdings and bio, or follow him on Twitter and Google+. We have a disclosure policy.


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  • Report this Comment On March 23, 2012, at 1:57 AM, JH2010 wrote:

    >>> Many prospective Netflix investors have been scared away by the large off-balance-sheet content costs, but that's what it takes to build a library that's worthy of attention and subscriptions.

    Trouble is the "library" runs out of things to watch very quickly. Bottom line is they are losing content like Starz which had HUNDREDS of movies. Six episodes of Lilystammer just isn't going to cut it.

    >>> I'm as comfortable owning Netflix shares as ever

    Good. You'll have a front row seat when it hits below $100. Get yourself some popcorn.

  • Report this Comment On March 23, 2012, at 7:53 AM, pauldeba wrote:

    "That'll cost you $1.99 per episode, though, or $20.99 for the entire season."

    There are 13 episodes in a season, Netflix charges $24 for 3 months. So, 14.3

    How many people will watch Netflix 14.3 times in the next 3 months? I am guessing at least 25-30% do not watch it more than once a week, so it is cheaper and more convenient for them. What the other 70-75% are also finding out is that they could pay $8 and watch the whole thing and then sign up for netflix again in 2-3-4 months for the next new releases.

    So, Netflix is probably more expensive for 25%

    and the other 75% could limit thier Netflix subscription by 50%-75% to only times they are interested in the new content.

    A rational consumer could 50% or more of its subscribers. The long term viability of this is ZERO.

  • Report this Comment On March 23, 2012, at 2:57 PM, foodoo wrote:

    I own nflx, I subscribe to netflix. I have HD antennae TV, and skip buying cable. I've found that the movie library is not that big of a deal for netflix. Between Amazon ppv, netflix, local hd tv, and my nhl package - that's all the content I need.

    I think it's pretty smart to build up episode content. Once I find a good series to watch - it fills weeks of occassional watching (as my recent interest in "Monk" has). I enjoyed the Lilyhammer series (although was not enthrawled in it) and look forward to more exclusive content.

    Eventually, they'll come across a "Dexter" level series and once Netflix wins an award for something - I think that will really shake up the industry.

    Or millions of customers could stop watching and netflix goes out of business.......hmmm, nah.

  • Report this Comment On March 24, 2012, at 6:52 PM, TMFZahrim wrote:

    @pauldeba, your argument makes sense if consumers typically behave like this:

    1) Decide to watch a certain show that's only/mainly/cheaply/conveniently available on one service. Let's say Netflix for the sake of discussion.

    2) Sign up, log in, search for that one particular show, and watch absolutely nothing else with laser-like precision.

    3) Cancel when done.

    In reality, I think people are more curious and penny-pinching than that. Somewhere around step 2, most people will stumble over something else that looks interesting and watch it because it costs $0 extra. Or, look around at what else this service that I'm paying for can provide. Squeeze some more value out of your entertainment dollar.

    Do that, and chances are that you'll eventually stumble over something else you like. If it's just one movie, well, I guess it's back to step 3 next. But if it's an entire movie genre, a different TV series, or perhaps the discovery of a ton of kids' content that never gets old, perhaps you'll delay that third step a while. Or skip it altogether.

    That is the point of those free 1-month trials after all: Try it, maybe you'll like it and want to pay for some more. Or in more streetwise terms, the first hit is free and then you're hooked. Why else would the company spend literally billions on building the content library? That's the drug that turns you into a reliable, paying customer.

    Anders

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