On Monday morning, Netflix (NASDAQ: NFLX ) and DreamWorks Animation (NASDAQ: DWA ) announced a multiyear agreement for Netflix to air several new original animated series. This marks another step in Netflix's evolution. The company is becoming increasingly focused on original and exclusive series in order to differentiate itself from rival services like Amazon.com's (NASDAQ: AMZN ) Prime Instant Video.
Netflix and DreamWorks had already partnered up recently. In February the two companies announced that Netflix would offer a new original series called Turbo: F.A.S.T., a spinoff of the DreamWorks movie Turbo, which hits theaters next month. However, this week's deal is much bigger, encompassing more than 300 hours of programming.
Netflix shares surged higher following the announcement, adding as much as $1 billion to the company's market cap. However, while these DreamWorks series could eventually help with subscriber acquisition and retention, the price tag is likely to be substantial. Is this new deal really a game changer for Netflix, or rather a sign of the company's desperation?
Amazon vs. Netflix: A slugfest
Earlier this month, I noted that Amazon had launched another shot across the bow of Netflix when it signed a big licensing deal with Viacom (NASDAQ: VIA ) . Netflix had recently allowed its broad licensing agreement with Viacom to expire due to Netflix's new focus on acquiring exclusive and original content. Netflix hoped to exclusively license a few top shows from Viacom, such as SpongeBob SquarePants and Dora the Explorer, rather than paying a similar amount for nonexclusive access to a broader array of shows.
However, Netflix and Viacom were not able to come to terms, and shortly after the relevant shows were removed from Netflix, the Viacom-Amazon deal was announced. While Netflix still has a very robust library of children's programming, the loss of some popular shows to the company's biggest rival created the risk that some frustrated parents would switch to Amazon's Prime Instant Video service. It also highlighted a broader theme: Amazon is rapidly catching up to Netflix in terms of breadth and quality of its streaming video content.
Offense or defense?
In the context of Viacom's defection to Amazon, the new Netflix-DreamWorks deal looks more like defense than offense. Netflix had probably budgeted money to renew some of the Viacom series on an exclusive basis. When that fell through, Netflix had "extra" money available, which it is using to plug the gap in its children's content library.
The DreamWorks deal makes plenty of sense from a strategic perspective: The studio has created several successful franchises, like Shrek, Madagascar, and Kung Fu Panda. However, due to the long lead time for original content, the new DreamWorks shows won't begin arriving on Netflix until next year (and probably late in the year). In the meantime, will people who subscribe to Netflix primarily for its children's content -- of which there are reportedly many -- keep the service?
At best, the answer is maybe. Some subscribers will keep Netflix out of habit, because it remains a relatively cheap form of entertainment. However, others will find that Amazon's Prime service -- which is even cheaper on an annual basis, and also includes other perks like free two-day shipping on Amazon purchases -- is more appealing. Customer defections could create a serious drag on growth for the next year, and winning those users back could require higher spending on marketing when the new DreamWorks content arrives.
This could get expensive
Lastly, while financial terms of the DreamWorks deal were not disclosed, Netflix is probably writing a big check to get this content. Netflix reportedly spent $100 million for the first two seasons of its signature original series House of Cards. That works out to more than $4 million per hour.
The DreamWorks deal covers more than 300 hours of content; at the same cost per hour as House of Cards, it could cost more than $1.2 billion over the license period! This appears to be in the general ballpark of production costs for popular animated series on network TV. But even if the Netflix shows cost half that amount, it will still represent a significant chunk of the company's content budget during the license period; in 2012, Netflix spent just over $2 billion on content.
Netflix is boldly moving to capture high-quality original children's series in order to offset the loss of similar programming from Viacom. However, this agreement will add significantly to Netflix's content costs going forward, and the payoff is uncertain at best.
If Netflix can get kids hooked on its shows, their parents will be less likely to quit the service, reducing churn for Netflix. On the other hand, Netflix faces a bit of a gap in children's programming right now, whereas Amazon has just beefed up its offering and is better positioned to steal customers. As a result, this deal is very risky for Netflix. If a substantial number of families have already switched to Amazon Prime by the time that the DreamWorks shows arrive on Netflix, it will be hard for the company to justify the high cost of this original content.