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The Biggest Factor Driving Netflix Subscriber Growth

By Adam Levy – Oct 20, 2016 at 9:08PM

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And Netflix's plans to maximize its impact on the business.

Image Source: Netflix.

After a dismal second quarter, Netflix (NFLX -1.26%) bounced back in the third quarter. The streaming video service added 370,000 subscribers in the U.S. and 3.2 million international subscribers last quarter. Those numbers came in well above its initial outlook of 300,000 and 2 million for the U.S. and international, respectively, when management reported its second-quarter results.

In its letter to shareholders, management said, "Our over-performance against forecast ... was driven primarily by stronger than expected acquisition due to excitement around Netflix original content." Original content will play an even bigger role for Netflix going forward, and management laid out several plans for its originals in the third-quarter letter to shareholders.

Here are the details investors need to know.

1,000 hours

Last month, Netflix CFO David Wells said its goal is for 50% of its content to be original productions. It will move closer to that goal next year when it debuts 1,000 hours of original content on its platform. That's a 67% increase from the 600 hours it has set to release by the end of this year. It's also a huge acceleration from last year, when it increased production 33%.

One reason for the acceleration is that Netflix expanded to 130 new countries at the beginning of last year. It's in the process of localizing content in several important markets, and it's producing original productions in over a dozen different countries.

Additionally, because Netflix isn't constrained by a linear TV schedule, it can continue to grow its original content production for years to come without seeing a decline in cost efficiency. Netflix uses algorithms to surface different content for each subscriber. It can use its algorithms (AI) to put its originals in front of the people most likely to watch its shows. It doesn't have to worry about viewer ratings on Sunday night to get a good return on investment.

Getting an even better return on investment

This year, Netflix started bringing production of its original programming in house. For most of its series, Netflix has a typical television production studio produce the series, and it pays upon delivery. But Netflix is cutting out the middleman on some series, for example, Stranger Things, and doing the production itself.

Netflix believes producing more content in house will be more cost effective, as it's able to "work directly with the creative community and eliminate additional overhead and fees." Netflix says its original productions are already some of its most efficient from a cost standpoint. If it's able to reduce its costs by making a somewhat larger investment upfront, it'll eventually show up in the company's cash flow.

Additionally, producing content in house allows Netflix to retain the intellectual property. It can license that for toys or games, and it's able to exercise more creative control over its series. That opens up an entirely new revenue stream for Netflix.

Getting some revenue out of China

Netflix CEO Reed Hastings told the audience at the New Yorker Techfest earlier this month that the likelihood of Netflix launching its service in China "doesn't look good." But in the company's letter to shareholders, management said it's going to explore licensing its content to existing online streaming services in the country.

Management says it expects the revenue from licensing to be relatively modest. Still, it presents a way for Netflix to maximize the revenue it sees from its original productions -- making them even more cost efficient.

While Netflix plans to launch its service in China eventually, the current regulatory environment doesn't allow for it. Getting the market hooked on its original series and movies through sublicensing will allow it to grab significant market share if and when it launches its own service in the country.

The growth of Netflix's original content has been one of the biggest factors driving subscribers to the service and keeping them subscribed. Netflix is also looking at ways to lower the effective cost of originals by cutting costs or producing extra revenue. That will help reduce the impact on cash flow, but Netflix expects its ramping original productions to burn cash for at least several more years.

Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Netflix. 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.

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