Netflix had a cracking line-up of new content last month — Season 2 of 13 Reasons Why, Season 5 of Arrested Development, and four stand-up specials, amongst others. This year they plan to spend $8 billion on content, on par with media juggernauts like Time Warner (HBO) and Disney.
$8 billion is a lot of money. Where does it all go? Well, it turns out hit shows don’t come cheap:
These are non-trivial amounts of money. Are they actually worth it?
Season 1 of Stranger Things had a price tag of $50M. With Netflix making around $100/year per subscriber, it would need to see 500,000 new signups to break even. Given that 14 million people tuned in to Stranger Things in its first month, it’s pretty plausible that ~5% of them were new users that subscribed because of the show. Not only that, but a large chunk of Season 1 fans will have renewed their subscriptions in anticipation of Season 2 — all in all, it was probably worth a lot more than $50M to Netflix.
The maths works out nicely in this single case of one of Netflix’s most successful shows. But do the numbers add up across the board?
Yes and no. In 2017 Netflix reported a profit of $500 million. But they had to take on $2 billion in debt to make it happen.
Netflix has three categories of content:
From 2007–2013, its streaming library consisted solely of licensed 2nd-run content: movies and shows that have been out for a while but still have appeal — Friends, The Office.
With the launch of House of Cards in 2013, Netflix starting exploring licensed original content — “Netflix Originals” that are produced and owned by other studios, but with Netflix having exclusive first-run distribution rights.
When this proved successful, they took the plunge to start self-producing original content — full vertical integration, where Netflix owns everything from production to release and beyond. It started with the release of Stranger Things in 2016.
Each of these categories comes with different economics for Netflix. Digging into this, we can see why the company has burned through so much cash.
In a typical second-run licensing deal, Netflix pays an annual fee in return for a collection of movies or shows. In 2010, they signed a five-year $200M/year deal to acquire a library of around 2,000 movies from Paramount, Lionsgate and MGM. Netflix will have many of these deals active at any point in time, adding up to a significant chunk of its content spend.
Deals for licensed originals often come with competition from traditional networks. Netflix had to compete with HBO and AMC, amongst others, for House of Cards, and won not just on price ($3-4M per episode) but also by making an unprecedented two-season commitment, without so much as a pilot to go on. Contrary to the widely-propagated “data can read our minds now” narrative, this bet wasn’t actually based much on viewership data.
Other licensed original deals can be highly non-standard, and not the kind of arrangement that traditional networks would consider. Netflix’s $200M deal with Marvel for 60 episodes spread over 4 shows and a crossover mini-series is one such example. The partnership was unprecedented not for its price tag — a far cry from Marvel’s Agents of S.H.I.E.L.D. with its $14M pilot — but because it gave Marvel the creative license to develop five interconnected shows, something difficult to pull off with traditional networks.
Self-produced originals can be different still. There have been an array of deals with individual showrunners, actors, and writers to produce content exclusively for Netflix, most notably producer Ryan Murphy’s $300M five-year contract, the biggest producing deal in TV history. A successful collaboration with Netflix is often what sows the seeds for these elusive deals — Shawn Levy, the Stranger Things producer who originally pitched the show, recently signed a four-year contract to develop TV projects exclusively for Netflix.
When it comes to movies, Netflix gets involved at all parts of the timeline, picking up films like Bright for $90M pre-production, and others after screenings at film festivals — Beasts of No Nation, $12M.
The economics behind movies are very different from TV, and make Netflix’s proposition interesting for studios. A film typically gets acquired by a distributor (e.g. Fox Searchlight) for a lump sum, who licenses it to movie theaters in the first instance, from which the film receives a share of box-office revenue, known as “backend”. The up-front payment from the distributor usually covers production costs and some pocket money for the studio, but it’s the backend that gives the film a shot at the big bucks.
Hollywood is governed by power-law returns — something close to 50% of films end up making a loss, with the top 6% of films accounting for half of all film profits, and the majority of that coming from the backend. Netflix’s generous lump-sum acquisitions — 200% of the film’s budget for Beasts of No Nation — bring to the table guaranteed profit and a tidy payout, but don’t come with the backend lottery ticket, a deal-breaker for some.
How do these different models affect Netflix’s bank balance?
Licensed second-run content, for Netflix, is like leasing a car — you don’t have to pay a tonne of money upfront, but instead pay a little bit every year to keep using it. The downside is that it’s never really yours so you have to use it carefully. In Netflix’s case, this often means not being able to show some content outside of the U.S.
Original content is more like buying a car — you pay a lot up-front, perhaps by borrowing a bit from your parents, but the car is yours. You can take it anywhere, and can use it for as long as you want at no extra cost.
Netflix is aiming for 50% of its content library to be original content, which comes at an upfront cost of many billions of dollars. This isn’t too worrying — many worthwhile projects have the model of “high initial cost with cheap, long-lasting utility” — factories, railroads, housing. To account for this, there are two different ways to consider “how much money a company has”: net income (profit) and free cash flow.
When reporting profit, companies can amortise (spread out) their large upfront investments to reflect that their payoff is going to be over a period of many years. With our Stranger Things example, Netflix might amortise the cost like so:
Year 1: 50% — $25M
Year 2: 30% — $15M
Year 3: 10% — $5M
Year 4: 10% — $5M
This would be on the basis that the company expects to harvest 50% of Stranger Things’ value in its 1st year, 30% in its 2nd year, and so on.
Free cash flow, however, is closer to “money received minus money spent,” and it reveals that Netflix is currently spending a lot more than it makes, funded by large amounts of debt.
This is par for the course — the economy runs in large part because people are able to spend money they don’t have, but the question is whether Netflix’s investments will help it grow sufficiently to be able to settle its debts further down the line.
The jury’s still out, but you’ll hear no complaints from me — because of Netflix’s crazy economics, we get to feast our eyeballs on $10M/hour shows for $10/month. What a time to be alive.