Why Content Matters (for Netflix)

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The second half of 2011 through the first several months of 2012 was a tumultuous period for Netflix (NASDAQ: NFLX). The stock seemingly changed from the belle of the ball to persona non grata.  I sold Netflix during its meteoric rise ($220/share) because of concerns about content & incremental subscriber costs as well as competitive pressures.  While I do not identify myself with the contingent that disparages Netflix’s product and future, I was not onboard with many uber-bulls that dispelled Netflix's challenges, especially in light of its then nosebleed valuation, that seemingly was pricing in hyper-growth in perpetuity.

As a Netflix user, I find the monthly fee of $7.99, which costs little more than a couple cups of Starbucks coffee, offers significant value.  As an investor, I recognize that for Netflix to justify the growth that is priced in to the stock (even today at significantly lower prices), it needs to evolve to become a player in the increasingly competitive media landscape. While some investors have not acknowledged that reality, it was encouraging that Reed Hastings has.

In 2011, Hastings made some strategic errors with the proposed Qwikster spin-off and the poorly communicated pricing debacle.  However, I believe that the Qwikster move, while ill planned and executed, came from the realization that the future for Netflix is streaming, and that the capital-intensive DVD business was the past. The proposed spin-off might have been an attempt to capture the value of the profitable DVD business by selling it before its inevitable decline.  The mistake was in not considering the side effect on the user and the brand.

Mistakes aside, Hastings has not ignored NFLX’s challenges.  In an interview in 2011 he was asked who was their biggest competitor and he said without hesitation, HBO.  His reasoning was simple: content.  He acknowledged content generation and acquisition would be a challenge in terms of costs, but also an opportunity.  While some analysts were opining about the demise of the company, he was planning the next iteration.

In short order, Netflix announced that it would revive the Arrested Development series, it released Lilyhammer (which was well-received), and announced the production of House of Cards, which is scheduled for release in February. You should expect the push towards quality original content to continue.

Not only is Netflix spending a lot of money to create these shows and attract quality creative production teams, but they are also spending a lot of money on promotion.  Hastings noted upfront that international expansion and content costs would hurt profitability in the short term. Wall Street did not approve. During the stock's precipitous slide, everyone is quick to say that Netflix was a fad, a company that was whistling past the graveyard. Detractors of Netflix, who see no value in the company, don’t understand the story. 

Content Warriors

HBO is one of the original forces behind quality, original cable TV programming.  Their success brought on a new wave of innovative television from premium channels like Showtime, and even general cable channels like AMC networks, which arguably has produced some of the best original content in the last couple of years. 

HBO has built a wall around their content, refusing to become “frenemies” with NFLX, seeing their content as a strategic advantage, not to be shared. Alternatively, they have invested a lot into HBO GO, their own streaming service, which offers a wealth of content and a user-friendly mobile interface for HBO subscribers. This expensive strategy won’t make sense for everyone. AMC (NASDAQ: AMCX) has taken a different route. They specifically noted that they value their relationship with Netflix. AMC recognizes Netflix as not only an additional revenue generator, but also as a marketing tool because it provides buzz for subsequent seasons of fledging programming, and thus higher advertising revenue.  These divergent strategies show the power that NFLX has had in changing the face of media consumption and distribution.

The Evolution of Media Consumption

The advent of the smart phone, and, more importantly, the tablet has made visual media part and parcel of our mobile lives.  As data bandwidth continues to increase in speed and cloud services become more powerful, the lines between traditional television and the Internet have become increasingly blurred.  The next battle will be the evolution of the TV, as the hardware has not caught up with mobile technology or user media consumption habits.  Social networking, computing and personal media consumption (music, photos, video) will be controlled via one’s living room.  As this trend continues, cable companies will have to be more creative about how they bundle their channels and content providers will have to consider multiple distribution streams.   Netflix is in the sweet spot of that evolution especially when you consider their marketplace is increasingly global.

Disney (NYSE: DIS) is a primary example of Netflix’s power to change the distribution landscape. Disney’s exclusive content deal with Netflix starting in 2016 is a lucrative deal for Disney, but in my opinion, Disney is also making a big-picture strategic choice. Management realizes that Netflix is becoming a global platform that stretches across several distribution channels and that this deal will provide exposure for all their global product lines -- movies, theme parks, toys, etc. For Netflix, this partnership is also a significant coup.  Netflix users will be able to watch original content from Walt Disney Animation, Pixar, Marvel, and because of Disney’s latest acquisition of Lucas Film, the deal will include the Star Wars franchise.  This is content that cable users won’t have access to -- do you (or your kids) want to miss Iron Man 4 or the adventures the next Jedi Master? Not me.

Tuning in to Netflix’s Future

As Netflix expands internationally, it will expand economies of scale, mindshare, and profitability.  As it builds it own quality, original content along with top-flight original content from Disney and other partners, it will be able to expand its value proposition and pricing power.  With the evolution of the TV, increases in bandwidth, and market share of mobile gadgets, Netflix will continue to expand its foothold and (if it is not acquired) become a major entertainment hub.

Reed Hastings might have deservedly been lambasted for his past mistakes, but credit him for forgoing short-term profits in order for the company to successfully evolve, compete, and redefine itself.   The future for Netflix will be defined by content generation, the evolution of the TV, successfully executing global expansion, and further applying competitive pressure to the conventional cable television business model. In short, Netflix seeks to establish competitive advantage in areas that dubious investors have perceived as Netflix’s Achilles heel.  Tune in. 

James Fantaci is long Netflix and Disney. Please follow James on twitter. The Motley Fool recommends Netflix and Walt Disney. The Motley Fool owns shares of Netflix and Walt Disney. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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