Four years ago, Netflix Inc. (NASDAQ:NFLX) CEO Reed Hastings called out HBO as its biggest rival, saying his company must become HBO faster than HBO can become Netflix.
The claim left some media pundits scratching their heads. It was like David claiming Goliath to be his equal. Netflix stock was in the toilet at the time, following the botched separation of the DVD-by-mail business, while HBO, Time Warner Inc.'s (NYSE:TWX) venerable cash cow, was the gold standard of original programming with hits like The Sopranos and The Wire.
Now, as the calendar gets ready to flip to 2016, Hastings' prediction seems more apt than ever. Netflix just announced it would double its output of original content next year with 31 scripted series, 10 feature films, 12 documentaries, 10 stand-up specials, and 30 kids shows. That amount of original production rivals any other traditional media company, signaling Netflix's transition from a middleman connecting viewers to a vertically integrated media giant.
The Internet TV pioneer is making the bet on original shows for two reasons. First, the cost to license content from other networks is increasing as media companies have realize that Netflix is a major reason why the cable empire is eroding, slashing the stocks have heavyweights like Walt Disney, Viacom, and 21st Century Fox, and sending their content to Netflix will only hasten that shift. Second, as Netflix content chief Ted Sarandos acknowledged at a recent conference, licensing content globally has been difficult as media companies are used to making individual agreements by region. Producing its own content allows Netflix to avoid the rising costs of licensing outside entertainment and the hassle of negotiating contracts region by region. As it focuses on the international market, which already makes up more than a third of its subscriber base, owning its content will become increasingly valuable.
A familiar path
HBO today is synonymous with its original award-winning shows like Game of Thrones and Girls. The popularity of its programming has allowed the company to command a premium for its service. It charges $15/month to stream HBO Now, while most Netflix viewers pay a little more than half that.
But the leading premium network wasn't always a hit factory. In the '80s and '90s, it was little different from other add-on channels like Showtime, Cinemax, and The Movie Channel, which attracted subscribers primarily by showing movies.
The competition for movie rights among the networks forced content costs higher, and HBO sought a way to differentiate itself. The network first branched into sports with pay-per-view boxing, and then with the help of talented executives like Chris Albrecht in the '90s, it began developing its trademark original programming like The Larry Sanders Show. The lack of advertising allowed the network more creative license than traditional TV, and as the hits accumulated, its reputation for high-quality shows and its ability to attract talent grew.
Netflix today finds itself at an earlier point on the continuum HBO forged, moving to original programming to allay the rising costs of licensed content. The key difference is that the market never had such high expectations for HBO.
At a market cap of $50 billion, Netflix is just as valuable as HBO parent Time Warner, which also owns TBS, TNT, and Warner Bros. studios,. Netflix's revenue, however, is just a quarter of Time Warner's, and its profits are negligible.
In order for Netflix to live up to the market's hopes, it needs to match HBO in quality programming and continue to grow its subscriber base so it can deliver material profits. HBO today is on track to generate $2 billion in operating income, a reasonable goal for Netflix considering that it will have nearly 75 million total subscribers by the end of the year.
There's at least one sign that Netflix is beginning to challenge HBO in original programming. HBO has won the most primetime Emmy nominations for 14 years in a row, but Netflix garnered more Golden Globe nominations than any other network when the qualifiers were announced earlier this month.
With double the original shows next year, there's ample reason to believe that trend will strengthen and with it, evidence that Netflix is indeed becoming HBO faster than HBO can become it.
Jeremy Bowman owns shares of Netflix. The Motley Fool owns shares of and recommends Netflix and Walt Disney. The Motley Fool recommends Time Warner. 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.