Netflix (NASDAQ:NFLX) has built a streaming powerhouse licensing content from media owners and distributing it to customers. The company's apps can be found on almost every new electronic device, giving it a leading position in the growing streaming market.
But as costs for that content rises Netflix is going to generate its own content to guarantee survival. The company has begun creating content such as House of Cards and Orange Is the New Black, but it needs to grow this segment to keep a loyal audience. To see the way all it needs to do is look at premium movie channels currently on cable as their guide, but not even that guarantees a profit for Netflix.
Showing the way
HBO showed the way for Netflix, highlighted by the wild success of The Sopranos and continuing today with Game of Thrones. The difference between HBO's parent Time Warner (NYSE:TWX.DL) and Netflix is the amount of money it's able to flow to the bottom line.
Looking at revenue and net income for Time Warner and Netflix isn't a perfect comparison, but it can give us an indication of the scale and efficiency difference between the two companies. Time Warner makes nearly as much in net income as Netflix has revenue and generates much higher margins.
The networks division shows a little better comparison, and last quarter Time Warner had $3.84 billion in revenue across networks and generated $1.27 billion in adjusted operating income, a margin of 33%. By comparison, Netflix generated $57.1 million in operating income last quarter on $1.07 billion in revenue, a margin of 5.3%.
The key to profit in the media business
One of the challenges Netflix faces competing with media powerhouses such as Time Warner and Disney (NYSE:DIS) is that it doesn't have the same downstream revenue sources. The Sopranos commanded $2.5 million from A&E for reruns and is still playing on HBO, Sex and the City is playing on TBS and E!, and Time Warner has TNT, TBS, and other cable networks to push original content down to. These outlets generate both subscription and ad revenue without adding to the content costs, revenue sources Netflix doesn't have.
Disney's film studio and networks are even more expansive than Time Warner, but it's actually theme parks that make Disney's content so profitable. It spent billions of dollars buying Pixar and Lucasfilm because it can generate long-term revenue on its cable networks and at theme parks. The upfront cost of content is paid back over and over for years to come.
Foolish bottom line
So, can Netflix become HBO? Maybe it can generate great content, but from a profit standpoint I don't think it can, because it doesn't have the extra revenue sources that Time Warner, Disney, or even NBC Universal have. These downstream revenue sources are the true profit generators, making it worthwhile to invest hundreds of millions of dollars in original content. Unless Netflix changes its model, it doesn't have the same upside.