The amount Netflix (NASDAQ:NFLX) spends on its content has grown from less than $2 billion in 2012 to a projected $5 billion this year. Next year, the company expects to spend $6 billion on content, and its long-term and off balance sheet obligations indicate that those costs will only continue to climb in the future.
Over the past four years, however, the company's content library in the U.S. has actually shrunk about 40%, from over 9,000 titles to just 5,100. The proliferation of competing streaming services such as Amazon.com's Prime Instant Video, Hulu, and a stand-alone HBO service from Time Warner (NYSE:TWX) have put pressure on Netflix's ability to keep its service stocked with an attractive library of movies and TV shows for subscribers.
So why is Netflix paying more than twice as much for nearly half the content?
International expansion doesn't explain it all
Now that Netflix operates globally, a much larger portion of its content budget goes toward securing rights to stream content in foreign countries. International cost of revenue has grown from $475 million in 2012 to $1.78 billion last year. That's an increase of about $1.3 billion, but it includes streaming delivery, customer service, and payment processing fees that all increase with subscriber count.
What's more, HBO operates internationally as well, but it has managed to keep its content costs in check. International HBO subscribers grew from 42 million to 82 million from 2009 to 2015. In that time, Time Warner's total network programming costs (including Turner networks) increased from $4.26 billion to $5.84 billion -- a little more than 5% per year. Keep in mind that a lot of that rise is tied to the increasing costs associated with sports rights.
Part of HBO's ability to keep its programming costs down is its heavy reliance on original programming. In fact, nearly all of its TV series are originals, and it mostly licenses films. Netflix is moving toward a similar approach, but subscribers still expect it to license some TV series and movies from other content producers. A shift away from third-party licensing could result in subscriber losses, especially considering the options available on Hulu and Amazon Prime.
Increasing its effective catalog size
Netflix developed an internal metric it calls "effective catalog size", which measures how spread out viewing is across its catalog. The metric is maximized by optimizing individualized recommendations, and Netflix found that its recommendation engine boosts its effective catalog size by four times compared with suggesting the most popular videos on the platform.
In this way, Netflix is able to get the most out of its shrinking library. It can generate value out of niche programming, since it knows which subscribers to recommend it to. And the company can reduce its reliance on the most popular licensed content for which networks are starting to charge a lot more. Netflix can then funnel those savings into its original programming, which incurs higher upfront costs, but the contracts never expire and are more easily extended globally.
While Netflix might not be able to completely put a lid on its content costs as HBO has managed, its shift to more original programming and the continued development of its recommendation engine allow it to mitigate the costs of licensing content while maximizing the appeal of a smaller catalog.
Adam Levy owns shares of Amazon.com. The Motley Fool owns shares of and recommends Amazon.com, Netflix, and Time Warner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.