Will Rising Content Costs Depress Netflix Stock In 2016?

  • Shares of Netflix have sold off after the company talked about rising content costs during a presentation at UBS Media Conference.
  • The company said that it was facing rising content costs across global markets.
  • After enjoying a roaring year in 2015, will rising content costs depress Netflix shares in 2016?

Netflix (NASDAQ:NFLX) recently presented at the UBS Global Media and Communications Conference where the company’s chief content officer, Ted Sarandos outlined Netflix’s future roadmap. Sarandos noted that Netflix stock’s incredible success where stock is up 160% YTD has been spurred by the company’s original programming such as Jessica Jones and Narcos which he said were continuing to disrupt the traditional TV industry. The COO spoke at length about Netflix’s 31 original series and 10 feature films that the company plans to incorporate into its streaming menu come 2016. He added that comedy specials will also feature prominently in next year’s menu.

Mr. Sarandos had the audience glued to the edge of their seats when he hinted that Netflix would at some point in the future consider getting into sports streaming. The announcement should hardly come as a surprise given the popularity of sports channels such as ESPN, NBC Sports, CBS Sports, NFL Networks, among others.

Content conundrum

It was Sarandos’ next comment, however, that sent the investing world reeling and Netflix stock crumbling. In no uncertain terms, Sarandos talked about Netflix’s rising global content costs, including global licensing and the cost of original content. Netflix stock sold off more than 5% after the presentation, a clear indication that the investing universe understands the full implications of those comments.

One of the key reasons why Netflix is the most popular video streaming channel, and why the company has been able to maintain impressive subscriber growth even in the face of heightened competition from the likes of Amazon (NASDAQ:AMZN) Prime Video and Hulu, is because of its vast array of original programming. Netflix finished the last quarter with more than 69 million subscribers vs. an estimated 40M-50M for Amazon Prime Video and 9 million for Hulu.

But high quality content comes at a price. Netflix’s has found itself in severe conundrum where its content costs as a percentage of revenue have been defying standard economies of scale and have been expanding even faster than the company’s top line. Netflix’s content costs as a percentage of revenue rose from 79.6% in 2012 to 89% in 2014. This has been orchestrated by the fact that Netflix now has to compete fiercely for content with other leading video streaming services.

Hulu has especially become a thorn in Netflix’s flesh. Hulu is backed by three of the six largest media companies in the U.S., and that number could soon rise to four if Time Warner (NYSE:TWX) joins the fray as planned. These cable companies have traditionally been Netflix’s most important content partners. But they have increasingly been preferring to license content to Hulu instead of Netflix due to Hulu’s better rates, and of course because Netflix presents a much bigger threat to their cable TV business compared to Hulu. Netflix has had little choice other than to continually bid up its content costs to stay competitive.

But according to Mr. Sarandos, Netflix is not just facing rising content costs in its domestic markets but in international markets as well. This is not very encouraging considering that international markets have become Netflix’s most important growth frontier. More than 75% of the 3.6 million new subscribers that Netflix added during the last quarter came from international markets.

Netflix can of course counter rising content costs by hiking its monthly subscription fee. But the situation is not that straightforward. A survey conducted by YouGov/Huffington Post in 2014 found that no less than half of Netflix’s subscribers would cancel their subscriptions if Netflix increased its monthly fee by just $2, which illustrates a rather extreme case of price elasticity. Netflix is therefore left with little choice than to use grandfathered plans by increasing rates only for new subscribers.

It’s quite unlikely that Netflix would consider streaming live sports channels such as ESPN while the company’s content costs remain so high. Sports channels sport some of the highest affiliate fees, and this would only inflate Netflix’s already bloated content costs.

Subscriber growth to overcome content worries

In the final analysis, Netflix’s impressive international expansion is likely to eventually overcome content worries and keep the Netflix stock hot in the coming year. As long as the company keeps growing its subscriber base at an impressive clip, high content costs are not likely to keep off eager investors. The company’s foray in most international markets has so far been very encouraging. Netflix plans to soon enter China, a major foreign market and one that could prove to be a game-changer for the company.

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