The Business Of

Movies | Netflix | What Are Their Costs?

Morning All!

Yesterday was quite a heavy newsletter so let’s have a little recap…

• History - Netflix only got into streaming 9 years after the company was founded. Prior to streaming, the company was basically the Amazon of DVDs!

• Subscribers - subscriber growth has been 24% per year over the last decade. And international subscribers is now 2x US subscribers.

• Pricing - pricing plans vary by region and by offering (basic/standard/premium). But Netflix have been able to raise average prices by ~5% per year since 2014!

Okay now, let’s talk about costs. And in the chart below we can see how Netflix splits out their costs….

Cost of revenues clearly makes up a huge part of the company’ costs. And we’ll dive into what those costs are now. So without further ado…!

Content Is (An Expensive) King

So when Netflix says ‘Cost of Revenues’, what they really mean is cost of content. And as we saw above, the majority of Netflix’s costs are to do with getting content on their platform. As we saw yesterday, the two routes to getting this content is either (i) getting it from film studios and other creators. Or (ii) creating it themselves. And both ways cost a lot of money!

Let’s look at getting content from others first. In 2021, Netflix and Sony’s partnership gave the streaming giant the first right to distribute Sony’s films once they’d done their time in cinemas. And it also allowed Netflix to bring Sony’s film franchises onto their platform. Spider-man and Jumanji are two of the biggest franchises. Sadly, for us based in the UK, this partnership only gave Netflix the rights in the US. So UK Netflix users won’t have access to these titles!

One thing to note, is that Disney had a similar deal with Netflix that started in 2016 and was supposed to last three years… but Disney got out of it early as it decided to prioritise Disney+ and host all of its content there. But we’ll touch on this in more detail on Friday when we look at some of the challenges facing Netflix.

But back to Sony. How much did it cost Netflix to get Spider-man, Jumanji and Sony’s other content on their platform? Well, nothing official is public - but it’s reported that for this 4-year agreement, Netflix would have to pay Sony an astonishing $1bn! Over 4 years, this means that Netflix’s cost of revenues from this deal would be $250m per year. This spreading out of costs over 4 years is known as amortisation - something we looked at in The Business of Man United.

Okay, so that’s how Netflix gets content from others. What about their costs to create content themselves. Well, this superb article gives us info how just how much it costs Netflix to create some of the original content we all love! And my word, it’s a lot. The budget for the Red Notice film was ~$200m. The House of Cards series cost ~$365m. And The Crown is thought to have cost a whopping $520m so far!

But wait, you’re telling me that Netflix spent $1bn on ALL of Sony’s content. But then spent $200m on just one film?! Surely not. Well, yes. Producing your own content is incredibly expensive! And the chart below shows us how quickly Netflix’s cost of revenues (majority being content acquisition/creation) have grown from 2012 to 2022.

We should note that the $200m spent to create Red Notice doesn’t all go straight into cost of revenues. Netflix amortises these content creation costs over 10 years. Meaning that the $200m spent to create the film is shared out over 10 years. If you need a refresher on amortisation, check out our previous writings on The Business Of Man United - where we discussed its impacts!

Okay, so that’s clear. Creating content is expensive. More so than licensing it from studios. But because of the rise of streaming platforms and studios like Walt Disney not wanting to share their content with rivals. Creating content is the way forward. However, there is good news. Because whilst these costs are sizeable, they have been leveraged incredibly over time. The chart below shows how cost of revenues used to be a massive 73% of revenues back in 2012. But in 2022, cost of revenues had shrunk to 61% of revenues.

How have Netflix been able to manage their cost expenditure so well? Well, it’s something we’ll come to at the end of this newsletter!

Who Knew Netflix Paid For Remotes and Internet…?!

When we think of marketing, the natural thing to think about is advertising. Social media. Google ads. Etc. And of course, Netflix does a fair share of that type of advertising. However, when Netflix talks about marketing, they’re talking about something slightly different. They’re really talking about distribution.

On Monday, we saw the chart below - which highlighted that Netflix had relationships with both (i) consumer electronics companies (e.g. Sony, Panasonic). And (ii) internet service providers (e.g. Comcast, BT). And yesterday we touched on the importance of these relationships. Mainly due to the benefits that ease (the Netflix button) and quality (no buffering) have on subscriber growth. But what are the costs of these relationships?

Well, let’s start with the consumer electronics companies. As we mentioned yesterday, in around 2011, Netflix approached TV manufacturers about the potential for a ‘Netflix button’. And TV manufacturers like Sony and Panasonic were more than happy to agree to this deal. But did they do this out of the kindness of their hearts? Of course not. For every sale of a remote control with a Netflix button on it, Netflix have to pay $1 to that manufacturer. I had absolutely no idea that happened!

Now, $1 may seem like nothing. But according to Statista, there are over 200m smart TVs sold worldwide. Let’s say the Netflix button is on 75% of them - that’s a complete guess! But that would mean Netflix pays out $150m every year just to have their Netflix button on remote controls. Incredible!

Okay, so that’s the consumer electronics companies. What about the internet services providers (ISPs). Why do Netflix need to pay them anything? Well, we won’t get too technical here. But basically, 6 companies take up ~57% of global internet traffic. Just 6! You can see their usage in the table below.

But as more people use these services - Google Search, YouTube, Netflix, Facebook, Instagram, etc - it puts a strain on the internet. Telecom companies like BT in the UK, and Comcast in the US have to invest in upgrading their infrastructure to handle the increased traffic. These investments include upgrading data centres and fibre optic cables. This article from Vodafone is a nice, simple guide into the kinds of investment ISPs need to carry out.

So how does this all relate to Netflix again? Well, it’s because ISPs believe that they shouldn’t have to foot the bill for all this investment. They think Netflix should be paying them for all these upgrades. And in the US, that’s exactly what happens! It’s up for debate what exactly happened between Comcast and Netflix. But many observers believed that Comcast was intentionally slowing down Netflix speeds on their network. But long story short, in 2014 Netflix ended up having to pay Comcast and other US ISPs a fee. So that these networks would prioritise Netflix’s traffic.

And now, we’re seeing ISPs all around the globe wanting to do the same. In South Korea, Netflix were taken to court by SK Broadband. The company claimed that the popularity of Netflix’s show Squid Game put a huge strain on their resources. And that Netflix should have to contribute to the costs required to upgrade their services. In the UK, BT and Vodafone are also looking for payments from streaming players! However, in Europe the net neutrality law makes these agreements a little harder…

Open Invitation For Open Connect!

Okay, so as we’ve seen. For a company like Netflix, content delivery is crucial. Streaming services put a real strain on internet bandwidth. And it can rub companies like BT and Comcast the wrong way! However, Netflix had realised this a few years ago…

… and the company has actually developed their own technology to help in the distribution of their services. Open Connect is Netflix’s own content delivery network (CDN). And as we mentioned yesterday, this video gives a brilliant explanation of what a CDN actually does.

In the interest of time we’ll be super brief! But Open Connect basically just helps ISPs relay Netflix content to their users easily and for free. Netflix transfers all their content to specific data centers, avoiding all the general internet traffic. ISPs can then access those data centers, protect their bandwidth and provide their customers a great Netflix experience! Netflix has spent roughly ~$1 billion to building out the infrastructure and lot of Netflix’s ‘technology and development costs’ are due to Open Connect. For a much more in-depth read, give this article a go!

Profitability? You Bet!

So, on Tuesday we looked at how Netflix makes money. Today, we’ve looked at the costs involved in the business model. Now, let’s wrap up by putting it all together. And we’ll see that Netflix really wasn’t your average startup, aimlessly losing money for years before turning a profit. The guys and girls at Netflix are pretty incredible!

The chart below shows us how EBIT margins, whilst very negative, were always improving from the company’s founding in 1998. There seemed to be a path to profitability.

And the chart below shows us that Netflix reached profitability in 2003 - just 5 years after being founded! Given the number of tech companies in Silicon Valley that are worth billions, but don’t make any profits. This is incredibly refreshing to see… and a little surprising!

Since becoming profitable in 2003, Netflix has continued to improve their profitability with EBIT margin hitting a high of 21% in 2021.

And we said earlier that there was something very helpful for Netflix which allows them to keep costs under control. And hence grow margins. And that special sauce is their subscription model. And it’s something unique to what we’ve seen from the previous businesses we’ve analysed. None of them really had a subscription model.

Now why is a subscription model so helpful when it comes to managing margins? Well, let’s actually look at what Netflix say themselves on their website!

Look at the first part of that sentence - ‘for any given period, we estimate revenue’. The reason the subscription model is so beneficial for Netflix when it comes to margins is because it’s very easy to estimate revenue. And then Netflix can manage their costs based on that. Let’s do a quick hypothetical example…

Let’s say that in 2022, there were 10m Netflix subscribers in the UK. And the average monthly subscription price was £10. That means each subscriber pays £120 in a year. And annual revenue in the UK would be £1.2bn (£120 x 10m). Now, let’s assume that prices are kept the same, and 2% of subscribers cancel their subscription. Netflix can easily estimate their 2023 revenues (£120 x 9.8m). And the company can then control their spending on content, remotes and Open Connect to make sure their profitability is strong. So it’s this incredible visibility of revenues that allows Netflix to decide how much margin they want!

12th Apr 2023

Nigel Jacob CFA