Andrew Kotliar
Dec 22, 2017 · 4 min read

It’s an expression we hear a lot at MEP Capital as we work with amazing content creators to bring their projects to life. The allure of birthing the next Stranger Things or GoT is exhilarating and Netflix/Amazon/HBO/etc have certainly demonstrated the appetite to take risks on new concepts and teams in their quest for dominance of our free time, (or as Robert Kyncl of YouTube calls it “the race to become the favorite middle child”).

But I would argue that a) the risks these distributors make are highly calculated ones, and b) remarkably, those gargantuan content budgets you’ve heard about are becoming ‘cheaper’ by the day.

Whether we’re speaking to a young, independent content studio or a seasoned Wall Street media analyst, the perception seems to be the same: “these streaming video players are paying crazy numbers!”. And while there are certainly off-market examples that have been reported (e.g. the “Get Down” reportedly costing $16M per episode), the pricing of an average show tends to follow a familiar pattern: cost plus 10–30%.

Put yourself in the shoes of that independent content producer on the “cost” side of this equation:

You came up with a concept, put in time, human resources and probably out-of-pocket cash to come up with some early stage development assets. You’ve been told the dream of reaching consumers directly without the need to deal with old school Hollywood. And then…the gross margin you’ll get once you labor for two years to create 10 episodes is 10%. Meanwhile, your distributor…you know, that “dumb pipe”…is seeing its gross margins quietly creep up from 20% a few years ago to 35% and 40%.

Imagine if record labels had lower gross margins than Spotify? Or if Kellogg’s had lower gross margins than a supermarket chain?

Source: SEC and Luxembourg filings, MEP research

The counterargument is that the creators typically have other ways to monetize the IP on the back of a successful distribution deal — toys, video games, international sales, etc. That’s where the real upside is, the story goes.

The challenge here is that each of these formats, in turn, either requires an army of qualified experts to move the needle (e.g. sales agents, brokers, etc) or once again the sale of rights to an intermediary (e.g. a merchandise licensor). To top it all off, Netflix won’t even share the data of who is watching your show and where! Talk about no free lunch…

But let’s now go back to the shoes of the distributors. The debate of whether Netflix and the rest of the streaming gang are overpaying for content is not a new one. In a 2010 letter, Netflix CEO Reed Hastings addressed criticism from investor Whitney Tilson:

“Investors sometimes see the content cost threat as an issue around our margins. But we have no intention of overspending relative to our margin structure, and there is no specific content that we “must have” at nearly any cost. In our domestic business we spend 65–70% of revenue on COGS (which is mostly content and postage). So if content costs rose faster than we expected, then in practice we’d have less content than otherwise, rather than less margin. This would ultimately show up in less subscriber growth than we wanted from a not-as-good-as-it-would-otherwise-be service; it would not likely show up as a sudden hit to margins. Management at Netflix largely controls margins, but not growth.”

At the time, Netflix still generated a significant portion of its revenue from DVD’s, was just scratching the surface internationally, and had not yet dove into original content production. But the philosophy has remained: since 2012 (the year that Netflix went full speed into Europe + licensed House of Cards), margins within the streaming business went from 16% to 37% in the latest quarter.

The industry is dynamic and this post may not age well. But, the argument that content spending has become “random” seems too simplistic.

(Netflix)

What’s the takeaway? If you’re an independent content producer expecting Netflix, etc to save the day with one of those “crazy numbers”, rethink your strategy. Despite the noise, the platform and its peers are laser focused on improving profitability in their more mature business segments and, therefore, are quietly setting the ceiling on prices/margins that their content suppliers can generate. Welcome to the new old Hollywood.



MEP Capital

We invest in content creators and their projects. Music, film, TV, digital. www.mepcap.com

Andrew Kotliar

Written by

MEP Capital

We invest in content creators and their projects. Music, film, TV, digital. www.mepcap.com

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