Does Netflix Have a Marketing Problem?

Netflix (NASDAQ: NFLX) surprised investors when it announced plans to increase its marketing spend from $1.3 billion in 2017 to $2 billion in 2018. The reason for the decision: "because our testing results indicate this is wise," management wrote in the company's fourth-quarter letter to shareholders.

In the earnings call after dropping that bombshell, CEO Reed Hastings said he expects marketing spend to decline as the service sells itself. But not everyone on Wall Street is sold on Hastings' vision.

Barclays analysts recently released a note contending Netflix will have to spend more on marketing than traditional media networks do. That's because Netflix's on-demand programming and lack of commercials mean it doesn't have a significant opportunity to promote its shows internally.

"What is different about Netflix is the fact that its non-linearity limits the ability to chain/cross market shows the same way that NBC was able to do with Seinfeld and Frasier by putting shows one after another," Barclays wrote.

What Barclays doesn't point out, however, is that not all of Netflix's marketing budget goes toward marketing its original content, and that it has advantages linear programmers do not.

Netflix still has marketing efficiencies

Netflix's decision to increase its marketing spend falls into two categories: marketing in established markets and marketing in growing international markets. Netflix reports both domestic and international marketing expenditures, which gives us a glimpse of the dramatic difference in marketing efficiency in more established markets versus its new markets.

Here's how the two markets compared for the full year of 2017.

Netflix's marketing spend in the United States isn't nearly as efficient as it is internationally. And it's a good bet that Netflix's marketing spend is even more efficient in newly established international markets compared with older markets such as Canada and Latin America.

At a recent investor conference, CFO David Wells explained that there's a significant difference between how Netflix markets itself in the U.S. and more established markets compared with its newer markets. In the U.S., Netflix highlights its original content; internationally, Netflix explains what exactly Netflix is and why you need it.

As Netflix establishes itself in newer markets, its international marketing will start to look more like that in the United States. Not only will it start promoting its originals in an effort to further penetrate the market, but the efficiency will also come down as it gets harder to find new subscribers.

As such, Netflix will probably see a greater shift in the ratio between its content spend and its marketing spend. As Wells and Chief Content Officer Ted Sarandos like to say, the best use of its next dollar may favor marketing its existing slate of originals, versus making a new series or film.

Can Netflix become a self-marketing machine?

Barclays' argument regarding Netflix's inability to promote its other shows internally underestimates the power of Netflix's platform. Netflix collects data on everything its users do within the app: not just what they watch, but also when they watch it, what device they watch on, how long they watch for, when they pause, what scenes they rewind, how often they watch a show, and even what shows and films they look at but decide not to watch and how long they look at those shows before deciding not to watch them. That's something traditional media networks can't do.

Netflix feeds all of its user data into a recommendation algorithm, which the company says saved it $1 billion in 2016. The recommendation algorithm reduces churn and also increases the efficiency of Netflix's content spend. With a substantial increase in subscribers since then, thanks to its international expansion, Netflix is probably saving even more per year.

Barclays analysts believe Netflix will have to spend more on marketing to get users to watch its new original shows. In the short term that might be true, especially as Netflix begins to saturate the international markets and its advertising starts to look more like it does in the United States. But even that will be offset somewhat by pulling back on simple brand marketing in those markets.

Long-term, however, Netflix could reach a point where its marketing efficiency reaches equilibrium because it has strong word of mouth, brand recognition, and incomparable user data. It could even see a drop in marketing spend at that point, as it's much easier to retain customers than attract new ones, especially with that billion-dollar algorithm at Netflix's disposal.

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Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Netflix. The Motley Fool has a disclosure policy.