Netflix Prefers to Overspend on Content

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In case you missed it, Saturday Night Live recently mocked Netflix‘s (NASDAQ:NFLX) spendthrift manner, joking that the company is “making every show in the world.”

Chief Content Officer Ted Sarandos took the jokes in stride at a recent investor conference, pointing out that Netflix is buying so much content because it’s not restricted by the same constraints of a traditional television network. In fact, Sarandos indicated next year’s content budget will continue to climb so long as it’s seeing positive return on investment from that content spend.

Importantly, Sarandos is willing to go too far with the content spend. “The marginal cost of being wrong about it, by the way, meaning overinvesting in it, is not that high,” he said. In other words, he’d rather err on the side of too much content versus too little.

Exterior of Netflix headquarters in LA.

Image source: Netflix.

How Netflix’s content creates value

There are three ways content can create value for Netflix.

The first way is if Netflix produces or obtains exclusive rights to a show that’s so good consumers subscribe to Netflix just for that show. These kind of series may or may not have broad appeal, but the audiences they do attract are extremely loyal and invested. When calculating the overall efficiency of spending on that kind of content when it comes to overall viewership, Sarandos says it sort of “gets a thumb on the scale” when it’s a show that gets new users to sign up.

The next way content creates value is if it keeps users from canceling. These are typically shows people discover based on Netflix’s recommendations. Many of the company’s newer originals, like its unscripted series, fit into this category of value creation, and they play an important part in retaining subscribers long term.

Finally, there’s content Netflix creates that may not attract strong viewership at first, but brings critical acclaim. These may win awards like Emmys or Oscars, and bring greater attention to Netflix’s entire content library. Additionally, award-winning content can also attract better talent to create new content for Netflix, which may have a broader appeal. For example, the company is set to release films from Martin Scorcese and Michael Bay next year and signed Shonda Rhimes and Ryan Murphy to extended contracts thanks, in part, to its growing presence at award ceremonies.

That last category of value creation is the most abstract, but it’s been big focus for Netflix over the last couple years. Not only is the company spending on the content itself, it’s spending heavily on marketing the content to get it in front of critics. Sarandos said there may be an opportunity to improve its marketing spend on the first type of content — the kind that compels new users to sign up — as well. That’s why Netflix expanded its marketing budget by more than 50% this year.

Finding the point of diminishing returns

Sarandos believes there’s still a lot more growth to extract from increasing Netflix’s content spending. “We’re also getting more users and more hours of usage from our existing users,” he said.

Sarandos stated:

We look at the incremental investment in content. And we look at it and say, ‘Look, at some point, you’re going to hit a point of diminishing returns on the investment,’ … I think until we see that, I think that we’re enthused to push forward.

That gives Netflix investors something to watch: subscriber growth and hours watched. Although management doesn’t report viewer hours specifically, it generally comments on the direction it’s moving. Third parties regularly publish estimates of how many hours the average Netflix subscriber watches, and while they may not be 100% accurate, they can provide an overall look at whether engagement is increasing or not.

As long as new subscribers continue joining the service, existing subscribers are watching more, and Netflix is winning more awards, there’s still a lot of growth left in the company’s content budget. And Netflix is going to spend right up to the edge where it no longer sees a positive return on investment — maybe even go over it — before it takes a step back on content spending.

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.

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