This week, Netflix and Disney announced a US$300 million deal where Netflix will get exclusive streaming rights in the first TV viewing window. This means that once movies have been in movie theaters and on DVD (or available via Video-on-demand for a fee), Netflix will be the first to offer them, a spot that was traditionally reserved for premium cable TV channels like HBO and Showtime.

The deal is but the latest in a series of offering that are helping Netflix move beyond its original DVD-by-mail business and more heavily as the leading player in the online streaming world. But this transformation is coming at a heavy price.

Studio Deals

The Disney deal is but the latest in a series of deals Netflix has been working on. If we look only at the deals where the company has sought out exclusivity, we end up with the following.

Studio Date Cost Note Criterion February 2010 $15-20 million While the company had an early lead with this deal for 150 titles, it was dealt a blow when Hulu managed to wrestle the exclusive away from them in February 2011. The deal ended and Netflix no longer carries this catalog. Disney December 2012 $300 million over 3 years. Dreamworks September 2011 $30 million per movie Dreamworks release 3-4 movies a year so this deal may cost Netflix $90-120 per year. This represented a 50% premium over what HBO previously paid Dreamworks for the same rights. Nu Image/Millenium Films September 2010 $20 million per year over 5 years This was one of Netflix’s earliest multi-year agreement, with a smaller studio that release 5-10 movies per year. Open Roads Films June 2011 $25 million per year over 5 years While the studio is smaller, its roster of upcoming movies include one with Robert DeNiro and one based on a book by the author of the “Twilight” series, which could appeal to a younger audience. Relativity Media July 2010 $30 million per year over 5 years One of the early deal to put HBO and Showtime on notice as Netflix paid a premium to get access to the film catalog before they did.

As we can see from the chart, Netflix is not afraid to spend money for first-run content. While the Disney deal represents the first major studio deal the company has undertaken, it has also slowly built up a collection of independent studio first runs to add to its catalog. It is clear, however, that access to top line studios is going to come at a substantial premium. The Disney deal alone is higher than the cost of all the other deals the company has cut for movies in the TV-first-run window (if we total it up, those deals amount to about $100 million per year right now, while Disney’s deal is 3 times that).

In a way, Netflix is currently acting like a traditional TV programmer, building up exclusivity on a number of wanted properties and bidding at levels higher than the competition to get its seat at the table. This is good news for studios as they now have a partner who will allow them to drastically increase the amount of money they get for the content they have. With Netflix currently willing to pay a hefty premium to beat out HBO and Showtime for first-run movies, we will see a steady inflation in the price of such properties moving forward.

On a combined basis, Netflix has bet somewhere around $500 million per year to acquire this content. When you spread it across its user base of 20 million US customers (the rights are not covering other countries), that means it needs to recover roughly $25 per customer for the year just to cover those rights. At $7.99 per month, that means that the first quarter of the company’s yearly revenue is spent on these efforts.

The Disney deal is but the first shot in what is destined to be an epic auction game for movie rights. Whether this is sustainable financially, however, is unclear, as other studios (WB, Fox, Universal, Sony, Paramount) probably saw the Disney deal as an early indicator of the new price floor for movies.

Catch up TV

Netflix has also worked on getting exclusive rights to re-run some TV content.

TV Station Date Cost Note AMC April 2011 $750-900k per episode The deal gives Netflix exclusive streaming rights to all seasons of the popular “Mad Men” TV series. Estimates are that the company is paying close to $1 million per episode for that exclusivity. CW November 2011 $1 billion over 4 years Netflix cut a deal that gives it exclusive rights to all seasons for 9 TV series: Ringer, Hart of Dixie, The Secret Circle, The Vampire Diaries, Gossip Girl, 90210, Supernatural, Nikita, and One Tree Hill. If you average it out, it ends up being roughly $27 million per series per year, with Gossip Girl getting a premium compared to the other series. Epix August 2010 $1 billion over 5 years While the deal provided early exclusivity, Epix cut a similar deal with Amazon when that exclusivity expired, taking some steam out of the overall value that it provided. Netflix’s relationship with Epix has considerably cooled since the deal first started and Reed Hasting (Netflix’s CEO) even highlighted on an investor call in the summer of 2012 that viewership of Epix-related content on the service was not that high, opening the door for a sunsetting of the relationship when it comes to terms in 2015. WB TV June 2012 $500k per episode Netflix acquired the rights to all seasons of “Pretty Little Liars” and “The Lying Game”.

In order to blunt some of the competition coming in from Hulu and Amazon, Netflix has been developing a strategy where they offer a lot more television-related content than movie content on the service. Because a lot of the audience for streaming media tends to be younger, the company has been going after exclusivity on content that resonates with younger demographics and is not afraid of spending widely to get some exclusive.

While this fills up a gap in the company’s catalog, early indications (based on how they are treating the Epix deal) seem to point to the fact that they do not see this as a long term viable strategy. The focus here is to provide enough content so people stick around until Netflix can provide some of its own original content. Expect Amazon to take a more aggressive stance when it comes to this area as it is the only company outside of Netflix to offer a subscription based service for this type of content. It is also possible that the recent rumors regarding Apple’s upcoming expansion into the TV business would mean the entry of a new competitor for this type of content.

Original Shows

In its very early days, Netflix had ambitions of becoming a movie producer. Its Red Envelope Entertainment unit produced 12 movies. between 2006 and 2009. But the creation of a content acquisition arm initially hurt Netflix in its relationship with hollywood studios and the the company shuttered the unit after having initially leveraged it to acquire rights to individual movies.

But its ambitions of getting original content did not stop.

As it works a transition from a being a DVD-by-mail to an all-you-can eat streaming service and now to becoming a strong replacement for regular pay TV, Netflix has not only built up a catalog of first run movies and popular TV series but is also going heavily into developing its own content. Netflix has aggressively bid for new properties and for the rejuvenation of older ones. The most anticipated release is “House of Cards,” which is rumored to be costing Netflix upwards of $50 million for the first of two planned seasons.

Show Number of episodes Cost (per episode) Note Arrested Development Between 10 and 13 episodes Up to $3 million The show has a successful run for 3 TV seasons but was eventually cancelled due to lackluster ratings. A dedicated fan following has been trying to get someone to sponsor new episodes and Netflix stepped up, with an expected release later in 2013. Derek 6 $600k per episode (rumored) Netflix has gotten the exclusive US rights as a co-producer with the UK’s channel 4 for this Ricky Gervais’ produced show. Hemlock Grove 13 $4-5 million for the season Originally announced on March 2012, the series is slated for an early 2013 release. House of Cards 26 Up to $4 million The show is a remake of a British TV series, produced by David Fincher and Kevin Spacey. It is expected to be released in 2013. Lilyhammer 8 $100k While critics generally panned the quality of the show, Netflix signed it up for a second season in 2013. Orange is the new black 13 $700k This new series, by the creator of Weeds, is produced by Lionsgate and is slated for a first run in the second quarter of 2013.

Lilyhammer, the company’s first foray into initial episodic content, received a lot of press but failed to live up to the hype. The new roster, however, delivers talent with established track record and, in some case, a dedicated following. I would expect Arrested Development and House of Cards to have a substantial impact in the way people are looking at Netflix, much as the Sopranos did for HBO. These efforts, however, come at a fairly high price.

On a combined basis, it looks like Netflix will be spending between $225 and $250 million on the development of original content over the next year. This means that the company is spending roughly a month’s worth of subscribers revenue to get this content created.

The billion dollar question

In the past year, Netflix has made a bit over $3 billions in revenue but its aggressive push into securing content is coming at a high cost, adding $1 billion in extra yearly costs to the bottom line so they have to hope that this effort will bring a large amount of new customers if it wants to succeed in the long run. Considering that the single largest premium pay TV channel, Encore, has 33.2 million customers in the United States, it is possible that Netflix could add up to 10 million users. Doing so would probably cover these added costs.

In the long run, however, the company will need to expand aggressively on a global basis if it wants to recover its investments in content and sustain the margins it has had. Whether it can do that or not will be the key to understanding whether it is an exciting new offering or merely another premium TV channel.

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