Netflix’s quest to become HBO

“It’s not beginning the story that I fear, it’s not knowing how it will end”

Francis Underwood, House of Cards

Since August 2012 Netflix’s share price has increased 850% from $53 to $450. This astronomical return can be attributed to Netflix’s success in creating original content for its subscribers. House of Cards, in particular, made Netflix the first ever non-TV network to win awards at the 2013 Emmys. Bolstered by the early success and industry validation of this strategy, Chief Content Officer Ted Sarandos recently outlined Netflix’s future: “The goal is to become HBO faster than HBO can become us.”

Does the transition to HBO’s model make sense for Netflix?

HBO is the fully owned subsidiary of Time Warner. The parent company recently released HBO’s financials for the first time.

HBO Netflix
US Subscribers (m) 28 33
International Subsribers (m) 100 10
Revenue ($ million) 4,900 4,400
Operating Income ($ million) 1,700 228
Margin (%) 35% 5%
Original Content Spend FY13 ($ millions) 1,000 200 – 300

From the comparison above we can see that HBO is hugely profitable compared to Netflix and that the margins of producing original content are too attractive to pass on.

Netflix needs to transform its business model also to curb its rising content licensing costs, which are up 700% over the past two years. The ever-increasing cost of licensing is a huge issue for Netflix, and it’s the main reason why its original business model is a very tough one: any time that Netflix builds up a profit margin, the studios will simply raise their prices until that margin disappears.The move into original content will save Netflix from being hostage to the studios.

Netflix spent $150 million for the first seasons of House of Cards and Orange is the New Black. To recover this investment Netflix required atleast 1.5 million new subscribers (assuming a monthly spend of $7.99). Based on preliminary results it seems like this bet is paying off as in FY13 the company added around 4.1 million new subscribers, much more than it needed to break even.

However, the original content strategy increases the risk profile of the business. Blockbusters are by definition very hard to predict and just because Netflix started off on a strong note with House of Cards does not mean the future content will be as successful. Case in point is Starz, whose CEO Chris Albrecht had great success developing original series for HBO but he is still waiting for a breakthrough series. Netflix’s counterpoint to this argument is that they are in a position to make their own luck. Through the immense amount of data they have around customer viewing preferences, Netflix claims that it can better predict the winners. HBO and other studios still rely on their gut instinct while commissioning new shows.

Even if Netflix perfects the content strategy, it still has a huge original content gap vis-à-vis HBO, which cannot be overcome in the short term. HBO has a stable of proven hit TV shows (past and present) in addition to its pipeline of new original series. HBO currently invests around $1 billion per year to produce original content as compared to $200 – $300 million for Netflix. HBO’s cash rich parent will make sure that they continue to outspend Netflix in content development for the foreseeable future.

Netflix will never become completely similar to HBO. The main reason is that HBO owns its original content while Netflix does not. HBO can air or stream reruns of The Sopranos or The Wire whenever it wants to, for no additional cost. In contrast, if Netflix wants to keep House of Cards long-term, it needs to keep paying! A company named Media Rights Capital owns House of Cards and it licensed the show exclusively to Netflix for 4 years.

So what does the future of Netflix look like?

As a consumer, I am very excited about Netflix’s push for original content as it gives me more high quality content to choose from. As an investor, however, I am wary of the lofty valuations that the market is ascribing to the future growth potential of the company. Netflix earnings potential is lower than that of HBO due to several reasons – firstly it does not own its original content and secondly there exists headwinds on the distribution front as well. The US court recently passed a judgment against net neutrality and allowed ISPs to differentially charge companies based on bandwidth usage. Netflix and Comcast recently entered into a deal wherein Netflix has to compensate Comcast for the increased bandwidth consumption from its subscribers. Market estimates that this deal would cost Netflix approximately $25-$50 million annually. And this is just the beginning. Other ISPs will soon demand their own share from Netflix as well.

I believe that Netflix is hugely overvalued at its current market capitalization of $27 billion. Time Warner as a whole is worth $76 billion with $7 billion of operating profit. HBO makes up 24% of the total profit of Time Warner. If we were to apply the same P/E multiple as the parent to HBO’s earnings, we arrive at a market capitalization of $18 billion for HBO. This implies that the investors think that Netflix is already more valuable than HBO!

In the long term, it will be interesting to see how this story plays out. The industry is rapidly changing and if the Comcast, Time Warner merger goes through it will make the dynamics even more interesting and potentially very negative for Netflix. In the short term though, I can’t wait to watch the Season 3 of House of Cards.