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Will Netflix’s Original Content Strategy Work?

Wall Street Expects Netflix Growth in 3Q15 Earnings Release

(Continued from Prior Part)

Impact of expenditure on original content

In the previous part of this series, we looked at Netflix’s (NFLX) focus on original content. In this part of the series, we’ll look at where Netflix stands financially concerning this strategy.

According to Netflix’s 2Q15 letter to shareholders, citing the company’s internal forecasts, Netflix is expecting total streaming revenues to be ~$1.6 billion in 3Q15 with a contribution margin of 17.1%. The company expects a contribution profit of $272 million for its streaming business in 3Q15.

As Netflix expands rapidly into international markets and spends on content acquisition, it expects content acquisition costs to impact its EBITDA (earnings before interest, taxes, depreciation, and amortization). As the above graph shows, Netflix had an EBITDA of $119 million in 2Q15. Netflix’s EBITDA excludes amortization expense of the streaming content library.

There’s a possibility that these content acquisition costs could impact EBITDA in 3Q15 as well, as Netflix is expanding into four more Asian markets as well as Italy and Portugal this year.

Original content: The future for Netflix?

In the previous part of this series, we saw how Netflix is producing original content by acquiring office and pre-production space in Hollywood. However, producing original content could expose Netflix to more expenses in terms of studio equipment and other infrastructure.

It’s interesting to note that when Netflix enters into exclusive content licensing deals with other studios or content providers, Netflix’s payment obligations to these studios are solely related to the titles acquired or theatrical exhibition receipts for movies. These content licensing deals don’t define payment terms related to the number of streaming memberships for Netflix or how many Netflix members are viewing a particular production studio’s content.

This means that content licensing costs for Netflix are “fixed” in nature, and an increase in these costs could directly impact Netflix’s operating results in the long term.

Another point to note is that Netflix has had a negative free cash flow, or FCF, for the past four quarters. This means that Netflix is spending more cash on acquiring content at a rate that’s greater than the rate of amortization for its streaming content library.

It appears that Netflix is walking a tightrope between increasing content acquisition costs and still maintaining profitability. It remains to be seen how the company weighs in on producing content and acquiring it from outside sources.

You can get a diversified exposure to Netflix by investing in the iShares Core S&P 500 ETF (IVV), which holds 0.26% of the stock. IVV also holds 3.7% of Apple (AAPL), 2.2% of Microsoft (MSFT), and 1.2% of Facebook (FB).

Continue to Next Part

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