Recently, Internet streaming video service Netflix (NASDAQ:NFLX) has been making an aggressive push into producing original content. The company dipped its toe into the water last year with Lilyhammer. This year, the company has ramped up its lineup of originals, with shows such as House of Cards, Hemlock Grove, and a new season of the cult hit Arrested Development.
Original content is by far the most expensive type of content for Netflix to acquire. With so much money on the line, it's particularly important for Netflix to invest wisely. As a result, shareholders have been looking for clues to understand whether the company's original content investments are working.
However, Netflix's move into original content is part of a long-term strategy to differentiate itself from streaming video competitors, particularly Amazon.com (NASDAQ:AMZN). Netflix hopes to increase user loyalty and dampen "churn" by providing a set of compelling content that subscribers cannot find anywhere else. Investors should be very cautious about drawing any conclusions about the success of this initiative until it has had a couple of years to play out. The long-term nature of this strategy makes it dangerous to use any short-term metrics to measure its success.
Renewals: sign of success or meaningless metric?
In the search for metrics of success, some investors have made a big deal out of the company's decision last month to renew horror series Hemlock Grove for a second season. While most critics panned the show, Netflix bulls have argued that the decision to renew it proves that it succeeded with its target audience. According to one commentator, the Hemlock Grove renewal demonstrates that the algorithms Netflix uses to inform original content decisions are working.
However, Netflix has been renewing all of its original series thus far. Last week, Netflix renewed the Jenji Kohan dramedy Orange Is the New Black for a second season, even though the first season won't be released to subscribers until next week! Lilyhammer was renewed for a second season after its debut last year, and House of Cards was picked up for two seasons from the get-go. Of the originals that have aired so far, only Arrested Development hasn't received a renewal, and that probably owes more to scheduling difficulties than anything else.
So what does a renewal really mean for Netflix? It's possible that Netflix's decision to renew virtually all of its original series is indeed a sign that they have been extremely successful. On the other hand, it's also possible that Netflix is setting a very low bar for renewing a series. After all, a series that has a single season of 10 to 15 episodes won't do much to drive long-term user loyalty, regardless of how popular it is. Users will get through all the episodes in a couple of months -- or even a single weekend -- and then need to find other compelling content to justify their membership.
Thus, in some sense, renewing a show for a second season is more of a "no-brainer" for Netflix than picking the show up in the first place. Netflix needs multiple seasons of its originals to keep users busy (and satisfied). The company's decision to order second seasons of House of Cards and Orange Is the New Black before the first seasons aired suggests that Netflix is willing to give its originals a long leash.
What to look for
Assessing the effectiveness of Netflix's originals requires patience. Ultimately, the best metric to use is subscriber growth. At this stage in the company's development, it would be natural to expect Netflix's domestic subscriber growth rate to slow down. First, the subscriber base has already become very large (with nearly 30 million members in the United States).
Second, Amazon is becoming an increasingly viable competitor. For example, Amazon has invested aggressively in top-notch content for its Prime Instant Video service over the past year or so. Moreover, as my colleague Anders Bylund recently discussed, Amazon is ramping up marketing for its video offerings.
The goal of Netflix's original content is to offset these negative factors and boost subscriber growth. As we get into 2014 and the novelty of original content on Netflix starts to wear off, investors will get a better sense of whether original content provides a significant lever to grow the domestic subscriber base. If the U.S. membership base continues to grow 20% or more year over year, that will be a true sign that original content is "doing its job" for Netflix. On the other hand, if subscriber growth starts to taper off, it will cast some doubt on Netflix's heavy investments in this area.
Foolish bottom line
Investors are understandably anxious to learn whether Netflix's recent foray into original content has been a success. However, in some cases this has led people to focus on metrics like "series renewals" that may not be very meaningful. Some observers have assumed that Netflix would only renew a series if it generated lots of viewing hours, yet the company just renewed Orange Is the New Black before a single episode had aired!
Investors should instead try to keep an open mind about the success (or lack thereof) of original content for Netflix. Later this year and next year, when the novelty of these originals has started to wear off, we will start to see whether they have the staying power to keep the subscriber base growing at a healthy rate.
Adam Levine-Weinberg is short shares of Netflix and Amazon.com. The Motley Fool recommends and owns shares of Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.