‘Arrested Development’ And ‘House Of Cards’ Are Cool, But Does Netflix’s Strategy Make Sense?

Over at Variety, Andrew Wallenstein has a very smart piece about how a central piece of Netflix’s business strategy may actually work against the company. One of the things Netflix facilitates is binge viewing, which in my case means watching an entire season of 30 Rock in a single day, but for most people means watching a couple of episodes of television at a time, instead of once a week the way they’d be released in their timeslots on television networks.

But when it comes to the shows it’s creating, rather than the ones it’s licensing multiple seasons of at once, that’s a problem. Netflix is releasing every episode of its seasons of Arrested Development and House of Cards at once. And at 14 episodes for Arrested Development and 13 episodes for House of Cards, that’s few enough episodes for people who are interested in just those shows, but untempted by the rest of Netflix’s offerings, to sign up for a free trial of the service, watch everything they want, and then quit before they have to start paying. Wallenstein explains:

A relationship with a program that might otherwise drag out over months on a linear channel is telescoped into hours. And therein lies the paradox inherent in Netflix’s business model: Allowing consumers to consume at their own speed contradicts the company’s financial imperative to keep them on the service paying the seductively cheap flat monthly fee of $8 for as many months as possible. Sure, it’s possible Netflix has assembled a library so vast — over 40,000 episodes of TV and counting — that a subscriber can fill countless months hopping from one binge experience to the next.

But let’s not forget that the whole point of Netflix embarking on an original programming strategy is to bring in new subs by offering a different value proposition. These are consumers who didn’t feel compelled to sign on to binge on library programming, but they’re interested in seeing a buzzed-about new show like “Cards,” and other originals still to come….It’s not like another original series will be waiting for them as soon as they’re done with “Cards.” The next series on Netflix’s slate of originals, Eli Roth’s “Hemlock Grove,” isn’t due until April and the revival of Fox’s “Arrested Development” doesn’t begin until May. Thus, getting new subs to pay for a second consecutive month of services becomes at least a little less likely.

This strategy gets even scarier given Deadline’s reporting that Netflix isn’t financing its original content development from original revenue streams, but at least partially from debt:

About $225M of the proceeds from the $500M offering it announced today — senior notes due in 2021 paying interest at 5.375% a year — will be used to retire the company’s $200M in 8.50% senior notes that are due in 2017. But with Netflix’s first original series, House Of Cards, making its debut on February 1, some investors wonder whether the company needs the remainder to help it handle its steep content payment commitments. Some $2.3B of Netflix’s $5.6B in streaming content obligations will come due in the current fiscal year, Wedbush Securities’ Michael Pachter says. The new debt, he believes, “is necessary to solve near-term cash flow problems, and indicates the low likelihood of positive cash flow for the year.” Netflix’s debt, along with its investments to expand overseas, make it “a risky investment.” Moody’s Investors Service also considers Netflix’s new debt to be risky, giving it a Ba3 rating. The debt assessment firm believes that some of the cash will be used to pay for “investments in original programming, which require more up-front cash payments” than library titles.

It may make sense for Netflix to bring in different tranches of customers with original and licensed programming. But to do it, I’d bet that long-term, the company’s going to have to raise its prices. And to keep up with escalating costs of licensing—particularly as Amazon continues to expand its efforts in this space, Netflix will have to pay just to keep a basic content library, rather than for exclusives—and of content production, those prices will have to keep rising. Netflix, like Hulu Plus, has largely been able to keep its prices stable, rather than subjecting customers to annual price hikes or hikes at the end of contracts a la most cable providers. Negotiating that shift may cost the company customers, too. But Netflix isn’t Amazon: it can’t subsidize its purchases and creation of content with a ton of other merchandise, or with a board that accepts essentially no profits. It’s going to have to come up with the money somehow.