When Netflix (NASDAQ:NFLX) released its fourth-quarter earnings results, CEO Reed Hastings noted something very interesting. "Last year our original content was some of our most efficient content," he told investors in the company's letter to shareholders. He labeled the phenomena a "real shocker," but for people who've been paying attention to Netflix's content costs, it shouldn't be much of a shock at all.
Licensing content from other media companies is becoming increasingly expensive as companies like Amazon and Hulu enter the bidding for content. Moreover, Netflix's negative impact on television ratings isn't going unnoticed, which is leading media companies to ask for more in exchange for the ratings hit they're sure to take.
As such, Netflix plans to triple the amount of new original content it releases this year, but that's not going to save it from the rising cost of content from other media companies.
Taking a look at the "most efficient content"
Hastings defines the most efficient content in terms of dollars per viewer hour. It makes perfect sense for Netflix's originals to receive more viewers than the content it syndicates from other producers. It's able to easily promote them when viewers are looking for something to watch, and it's the exclusive place to watch those shows.
Even if Marco Polo costs $9 million per episode, Netflix has the rights to stream it everywhere it operates. And Marco Polo is a major exception to how much Netflix tends to spend on its original content.
Content Officer Ted Sarandos' budget for original content in 2014 was $300 million, which means Netflix spent around $210 million on 100 hours of new original content outside of Marco Polo. So, Netflix is paying closer to $2 million per hour-long episode and $1 million per half-hour episode outside of Marco Polo.
Compare that with recent deals to license shows like Gotham for $1.75 million per episode or The Blacklist for $2 million per episode. With those shows, it's competing with the original broadcasts and digital sales on iTunes or Amazon as well as DVD sales and reruns. It's no doubt those shows won't receive as many viewers on Netflix as their originals.
The freedom to take risks
Netflix (and Amazon) are also in a position to produce excellent original content. Unlike a traditional television network, Netflix doesn't have to dedicate a time slot to a new show. It just puts it out on the Internet and sees what happens. If FX releases a new show, it's dedicating a Sunday night time slot to it for three months or so. There's an opportunity cost there, since it could have put another show in that time slot.
On Netflix, there's little opportunity cost for releasing a new series. This leads to more risks, which ultimately leads to better shows (like Transparent on Amazon). That's another reason Netflix's shows perform well compared to its licensed content.
Of course, Netflix isn't immune to a flop. And in that case, viewers will look for something else to watch. At this point, its back-catalog of originals isn't strong enough to support a bad release, so Netflix still needs to rely on other content companies for content in order offset risks from producing its originals.
Funding shows with debt
In 2014, Netflix produced free cash flow of negative $128 million. A lot of that has to do with its rising content costs, which it's able to amortize over the lifetime of its license agreement, so actual costs may not show up on the income statement. But cash is king, and Netflix's cash situation isn't great.
At the end of 2014, Netflix had $1.6 billion in cash. With $9.5 billion in future content obligations and an acceleration in original content investment, Netflix is turning to the debt markets to raise another $1 billion. In fact, Hastings plans to continue financing its original content with long-term debt in the future as well. Presumably, the cash flow from subscribers will be invested in its global expansion and more licensed content deals.
The rising cost of content isn't something Netflix will be able to escape in the next year or two. As it expands to more territories, it needs to invest upfront in content before it can attract an audience. While analysts believe Netflix's earnings growth in 2015 will be flat, they see it rising significantly in 2016. But Netflix needs to put a cap on content costs first, and four years of originals isn't going to solve that problem.
Adam Levy owns shares of Amazon.com and Apple. His favorite Netflix original production is BoJack Horseman. If Netflix produced 320 hours of BoJack, Adam might not ever get any work done. Ever. The Motley Fool recommends Amazon.com, Apple, Google (A shares), Google (C shares), and Netflix. The Motley Fool owns shares of Amazon.com, Apple, Google (A shares), Google (C shares), and Netflix. 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.