This Shift Is Good for Netflix, but Also Bad for Netflix

By Markets Fool.com

Americans are watching much less traditional television, but that doesn't mean they're spending less time staring at screens. Live television viewing dropped 4% last quarter (down from 147 hours per month in Q3 of 2013 to 141 hours in Q3 of 2014), while online video streaming increased 60% year over year to 10 and three-quarters hours per month, according to a new report from Nielsen.

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The report corroborates what many suspected after Nielsen ratings declined for broadcast television across the board this summer: With a finite amount of time for entertainment, a larger chunk of that time is being spent on Netflix and other streaming services instead of live or recorded television.

This trend presents a big problem for broadcasters, especially those that rely heavily on advertisements for revenue, and leaves them in a predicament when it comes to licensing content to streaming services. As streaming services cut into viewer ratings -- and consequently ad revenues -- broadcasters will try to make up for losses by charging those streaming services higher licensing fees.

Making them pay
Netflix is no stranger to rising content costs. In the first nine months of 2014, the company's "cost of content," which primarily consists of licensing fees, rose 19%. Part of that rising content cost comes from the company's expansion internationally, which also helped lead to revenue growth of 26% in the first nine months of the year.

Over the last year, total streaming content obligations -- including current, medium-term, and long-term obligations -- climbed from $6.5 billion to $8.9 billion, as the company snatches up future rights and produces more original content.

To its credit, Netflix is prepared to continue spending more on content. The company plans to increase its contribution margin of domestic streaming from 28.6% last quarter to 30% in the first half of next year. It plans to reach 40% contribution margin within five years of reaching 30%. The increase in domestic streaming contribution margin will give it more room to increase spending on content.

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Netflix isn't worried, but should it be?
Netflix Chief Content Officer Ted Sarandos told The Wall Street Journal he doesn't think broadcasters will be able to push higher prices on the streaming service. "There's no market to support why you'd pay," he was quoted as saying. Netflix only has to offer "a dollar more than the next bidder."

The next bidder may offer more than Sarandos thinks, though. With streaming video sites gaining more viewers, it's not just Netflix adding subscribers and growing revenue. Over the last year or so, Amazon.com has added an estimated 30 million Prime subscribers while raising its rate to $99 per year from $79. The success has given Amazon room to add new benefits to Prime while increasing its streaming video content library.

Meanwhile, Hulu -- a joint venture from Disney, Fox, and NBCUniversal -- may look to bid more on content to help protect its parent companies' interests.

While Netflix only needs to outbid the competition, the competition also has a lot more money to spend than it did last year due to the increase in online video streaming. As the saying goes, a rising tide lifts all boats.

On the flip side, it will be difficult for media companies to forgo the guaranteed income of licensing their content. Especially with a weakening ad market and the streaming services' moves into original programming. Still, they seem to hold the upper hand as Netflix et al still largely rely on their content to attract subscribers.

Will subscriptions grow faster than cost of content?
For Netflix investors the equation for profit growth and stock appreciation is simple. Subscription revenue must outpace the growth in cost of content -- which includes licensing fees, content distribution costs, and now interconnect costs.

Netflix already has 36 million subscribers in the U.S., but the company believes it could eventually capture 60 million to 90 million domestic subscribers. It had more than 14 million international subscribers in Q3 and is expanding overseas. Growing subscriber counts can be a double-edged sword, however. While it brings in more revenue, it also detracts from the amount of time viewers will watch live broadcasts. In turn, they'll continually look to get more out of streaming services like Netflix, increasing the company's cost of content.

Eventually, subscriptions will saturate, but there's no guarantee that content costs will. Look to the cable industry for an example. The only way Netflix will be able to increase domestic profits at that point will be to increase its price -- and its track record with that is mixed at best.

The article This Shift Is Good for Netflix, but Also Bad for Netflix originally appeared on Fool.com.

Adam Levy owns shares of Amazon.com and Apple. The Motley Fool recommends Amazon.com, Apple, Google (A shares), Google (C shares), Netflix, and Walt Disney. The Motley Fool owns shares of Amazon.com, Apple, Google (A shares), Google (C shares), Netflix, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.