Netflix (NFLX -5.04%) has shifted a growing portion of its massive content budget to original productions. Not only that, but it's moving more of those productions in-house to Netflix Studios instead of licensing content from other studios. The shift provides Netflix more control over its projects, including the ability to stream shows globally and retain the intellectual property.
But producing content in-house also ends up saving Netflix a lot of money in the long run. "There's a 30% to 50% markup on the shows that are produced by the studio for us," Chief Content Officer Ted Sarandos told the audience at a recent investors conference.
Considering Netflix eventually wants 50% of its content to be original productions, and it has a content budget that could reach $8 billion this year, we're talking a savings of billions of dollars per year in content expenses over the long run.
Netflix Studios will be the largest supplier by 2019
The transition to more in-house productions is happening quickly. Sarandos noted Netflix Studios will be the company's largest single content supplier by the end of next year.
Of course, Netflix has dozens of suppliers of many sizes from all over the world, so being the largest doesn't mean it's close to a majority of content. That said, Sarandos also mentioned that "85% of all new spending is on originals."
That implies about $1 billion to $1.5 billion in incremental spend on originals this year alone, based on its forecast 2018 budget of $7.5 billion to $8 billion, so it's certainly getting close to 50%.
Burning cash to get there
While Netflix can save 30% to 50% on the price of original content just by producing it itself, Netflix has to pay for the production upfront, which burns cash.
When another studio produces a show for Netflix, it simply licenses that content similarly to how it licenses content that first aired on television or in theaters. Netflix doesn't have to pay for the entire production, instead opting for ongoing payments to the production studio. That reduces the pressure on cash flow.
Producing content with Netflix Studios requires a significant cash outlay from the start. The upside is there's no ongoing licensing fee, so if Netflix creates a hit that's very rewatchable, it pays out dividends over the long term.
With the growth of in-house productions, Netflix has seen its free cash flow crater. The company burned $2 billion in cash last year, and it expects to burn as much as $4 billion this year as it steps up its originals and its marketing efforts.
Those cash expenses don't show up on the income statement all at once due to the way Netflix amortizes the cost of its original content over its useful life. That's how Netflix can show a profit while burning cash. Ultimately, spending the cash now should result in lower content spend in the long run than if it kept licensing originals from other studios.
Other long-term benefits of in-house productions
Aside from the long-term cost savings from producing series and films in-house, Netflix gains a lot of benefits from owning the content itself. Owning the intellectual property gives Netflix the ability to do things like licensing and merchandising, which can create an entirely new source of revenue for the company. It's already experimented on that front with Stranger Things.
Netflix also benefits from a more streamlined approach to renegotiating contracts for successful series. Sarandos points out those negotiations are a lot more complicated when a third-party studio is involved than when it's just Netflix and the showrunner and top talent. That can save a lot of time and money for Netflix over the course of a series' run.
Perhaps most importantly, owning the creative rights to a series and its characters allows Netflix to be more creative with its marketing. This can help Netflix achieve its marketing goal mentioned in its first-quarter letter to shareholders about growing the "density of viewing":
We're investing in more marketing of new original titles to create more density of viewing and conversation around each title (i.e bigger hit in a nation or demographic). We believe this density of viewing helps on both retention and acquisition, because it makes our original titles even less substitutable.
Marketing campaigns around specific shows, using the characters and other intellectual property in a creative way, can drive that density of viewing, turning the show into an even bigger success.
So not only does Netflix stand to save a lot of money by producing originals itself, it can make a lot more money, too.