What if "House of Cards" Comes Tumbling Down?

House of Cards is a risky title.

Netflix (NASDAQ: NFLX  ) bet $100 million on two seasons of original content, hoping that it would pay back in the form of more numerous and more faithful subscribers. And after that, we'll see a bunch of follow-on lottery tickets: a reboot of long-canceled cult hit Arrested Development, horror series Hemlock Grove, women's prison comedy Orange Is the New Black, and even a children's series about racing snails in cooperation with DreamWorks Animation.

So far, House of Cards seems to be off to a good start. The show opened to good reviews and high user ratings, Netflix says (without getting too specific) that people are watching it a lot, and even third-party sources like IMDb.com have confirmed that the show attracts plenty of eyeballs.

But what if it's nothing but a quick fling? What if House of Cards attracts a bunch of curious shad flies, happy to take a look for free but gone in a heartbeat? Maybe the Netflix model of dumping entire seasons on the audience all at once simply doesn't work. Perhaps all of these original content bets are doomed to come up snake eyes every time.

Then what?

The risk
Some critics worry that Netflix stands to lose mightily if the premium series bets don't pay off. These are often the same pundits who expect the company's balance sheet to implode at any moment, and argue that every penny saved would be a penny earned here -- Netflix simply cannot afford to put any capital at risk.

I would advise these guys to calm down. The current slate of original shows is not very large in comparison to Netflix's total content budget, and the company has played this game before.

Longtime Netflix watchers might recall the Red Envelope Entertainment venture. This was an in-house production and distribution operation that Netflix ran for a couple of years, starting in 2006. It was meant to give independent filmmakers another publishing outlet while Netflix got exclusive access to some interesting films. In its short history, Red Envelope produced 12 movies and distributed another 36 films from other producers.

But that gamble didn't beat the house. CEO Reed Hastings explained it in a 2008 earnings call: "On Red Envelope, we did some experiments, tried to figure out an economic model that was scalable and sensible. Unable to do that, we decided to close it down and all the closure costs are baked into our current guidance."

You can't win 'em all. So Netflix cashed in its red chips, published a few more films to honor existing commitments, and walked away. Red Envelope is now a footnote in Netflix history, leaving a few dozen unique films in the Netflix library. They're all still there. I'm partial to Maggie Gyllenhaal vehicle Sherrybaby and indie comedy The Puffy Chair myself, and they were kind of a big deal back in 2006. Your mileage may vary. Either way, I doubt that anybody signs up just to watch these aging titles anymore.

The damage
But the failed bet didn't kill Netflix. It was a measured risk, no more than the financial platform could handle. Likewise, the House of Cards generation of fresh content is small enough that Netflix will survive a total failure -- or five.

Let's get back to a more recent comment from Hastings:

We're willing to try a little bit more riskier work than we've done with a little bit of our budget, and then we're going to see how it goes. ... I don't know if it's anything we'd bet the farm on, but we're certainly willing to try it with a small percent of the budget in House of Cards and then two or three other smaller ones that we would look for. And if we're successful with it, then we would expand our circle of confidence a little bit more, a little bit more. So we'll take it step-by-step and year-by-year.

Baby steps, buddy.

If the production cost of House of Cards comes out to $50 million in 2013, and the somewhat lower-profile shows add up to maybe $100 million all in all, you've got $150 million of new risk on the table this year. The company spent $2.5 billion on streaming licenses last year, and expects to pony up just a bit more in 2013.

The worst-case scenario
So Netflix is risking maybe 6% of its content budget on original shows, for starters. And in the meantime, this is how the revenue and working capital situation has evolved since that old Red Envelope gamble:

NFLX Revenue TTM Chart

NFLX Revenue TTM data by YCharts.

If this works out, that's great -- a solid reason for people to try the service and maybe stick around if they like it. There might be a few million long-term subscribers in it for Netflix on the upside. But if not, it's hardly an all-in bet. I'm not losing any sleep over the faint possibility that House of Cards comes tumbling down, followed by all of the other in-house series.

If worse comes to worst, Frank Underwood may never get his dream job. But Netflix will absolutely live to stream another day.

Will Netflix's original series help it fend off burgeoning competition? And will its international growth aspirations really pay off? These are must-know issues for investors, which is why we've released a new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.


Read/Post Comments (7) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 19, 2013, at 2:12 PM, AceInMySleeve wrote:

    good analysis. Netflix took a risk with HoC. It could easily have gone much worse if the show hadn't ended up as good as it did (and that's always a possibility). Likely at least one of their series this year will be a flop.

    I think the seed is planted for their release-style, but finding out how to robustly get a return on the investment for these series might take some work. That has to do with how much to spend, what genres to cover, how to vet and apply oversight to the production process, etc. Content creation is likely a competitive business. Not every 50M$ show is gonna pay off.

    At any rate, the worst case scenario is not all that bad.

  • Report this Comment On February 19, 2013, at 4:32 PM, TMFGemHunter wrote:

    Thanks for the article, Anders. I'm a big-time Netflix bear, but I don't think original content is going to put the company out of business. I just doubt that it will generate enough incremental revenue to justify the cost.

    For me, the big problem with Netflix is the stock price more than the business model. I just cannot think of any realistic scenario that could justify the current market cap, which is pushing $12 billion on a fully diluted basis. Since I don't see Netflix generating long term margins above the low teens (too little differentiation to do better), it would need to reach $10 billion of revenue (i.e. over 100 million streaming subscribers) just to bring the P/E down to 15 or so. Netflix won't get to that level of penetration for at least five years, in my opinion.

  • Report this Comment On February 19, 2013, at 5:18 PM, TMFZahrim wrote:

    Always good to hear from another Fool, Adam. That being said, I disagree with your Netflix analysis in -- count 'em -- 5 crucial ways, just going by the assumptions you posted here. The service is differentiated from the competition in many ways, including library depth and usability. Long-term margins should be very rich, given the rather static nature of its content deals and near-zero streaming overhead otherwise (plus the moats I just noted). Fully mature, I expect stable net margins in the 20%-plus range. Which leads to far lower revenue requirements, and that's not a problem anyhow because the global growth juggernaut should produce more than 100 million subs with ease in 5 years.

    I stand by my thesis, which points to the most exciting and misunderstood growth stock on the market today. $11 billion is cheap, cheap, cheap.

    Anders

  • Report this Comment On February 19, 2013, at 5:59 PM, nyc314 wrote:

    Just finished binge-watching all 13 episodes. Really good stuff.

    As a media consumer, was really happy with the bargain (I instantly started thinking of Netflix as another HBO Go, which I also love).

    As a long-term investor (bought almost 4 years ago at a little under $40) am just as happy.

  • Report this Comment On February 19, 2013, at 6:08 PM, Irmag wrote:

    I loved it. I hope they come up with more originals!

  • Report this Comment On February 20, 2013, at 3:07 PM, jesantoro wrote:

    House Of Cards with Kevin Spacey was terrific!

    Will there be more episodes?

  • Report this Comment On February 21, 2013, at 1:17 AM, johnnymiami wrote:

    House of Cards has to be one of the best series made in the USA. Only a few Masterpiece Theater series come close. I have doubled my money on Netflix ---twice. Nuf-said.

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