After Disaster, Netflix Is Back From the Brink

The streaming company is now roaring thanks to smart investments in original content

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In Wall Street’s on-again, off-again love affair with Netflix, passions are currently running hot. The streaming video service’s stock, which was trading at less than $60 per share just a year ago, is now closing in on $400–a 566% change–thanks to the company’s quickly increasing subscriber base and its growing stable of hit original shows.

In its quarterly earnings report, Netflix quadrupled its earnings year-over-year, generating almost $32 million in profit during the quarter, or 52 cents a share. The company also revealed that it now boasts more than 40 million subscribers worldwide. The company added 1.3 million U.S. subscribers and 1.4 million international subscribers between July and September, hitting the top end of its quarterly forecast. With 29.9 million paying streaming subscribers in the U.S., Netflix now has more American customers than HBO, according to estimates from SNL Kagan.

That figure is of particular symbolic importance because of the transition Netflix is undergoing and what it means for the rest of the television industry. Once wholly dependent on agreements with traditional content creators to populate its service, the Los Gatos, Calif-based company has begun financing its own original programming. Netflix is not alone: Amazon, Google‘s YouTube, and Hulu are trying to do the same. Now this new crop of Internet broadcasters is waiting to see how such moves impact their bottom lines, not unlike cable operators in the early days of that medium.

Indeed, Netflix is attributing much of its current success to its big investment in original programming and the highly positive response to the first batch of shows. House of Cards became the first online program to win a Primetime Emmy when David Fincher claimed the Best Director prize in September. Arrested Development’s much-hyped revival kept Netflix in headlines for weeks leading up to its May debut. And sleeper hit Orange is the New Black is on track to be Netflix’s most-watched original show by the end of the year, CEO Reed Hastings said in a letter to shareholders.

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Because Netflix keeps its viewership data private, it’s not clear how the actual popularity of these much-talked-about shows compares to shows on traditional TV networks and how much they drive subscriber growth. “It definitely helped,” Hastings said about Orange Is the New Black in an interview with analysts Monday. “But we don’t need to know if it’s 2% or 5% or 10% of our [subscriber growth].”

So far, the main function of the original shows has been in rebranding Netflix as a direct competitor to prestige cable networks like HBO and Showtime, instead of just a digital repository for old movies and TV shows.  “The main value of their original content at the moment is promotional,” says Dan Cryan, the research director for digital media at IHS Screen Digest. “It’s undoubtedly helped them grow mind share in terms of the establishment of the product as a home of decent content you can’t get elsewhere.”

Wall Street seems to be an even bigger fan of Netflix’s original shows than subscribers. Following its solid earnings report, the company’s stock shot to nearly $390 in after-hours trading, an all-time high. Netflix has performed better than every other stock in the S&P 500 this year except Best Buy, according to Bloomberg.

But sky-high valuations are nothing new for the streaming service. The company’s shares were flying high at $300 in July 2011 when it tried to spin-off its original DVD-by-mail service into a separate business called Qwikster. The move angered customers and sent Netflix’s stock tumbling down to less than $65 by the end of the year. That might be why CEO Hastings has been careful to not get caught up in the current hysteria over the stock price. “We do our best to ignore the volatility in our stock,” he wrote to shareholders, calling the company’s current valuation “momentum-investor-fueled euphoria.”

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Some analysts agree with the assessment. Michael Pachter, an analyst at Wedbush Securities, says Netflix’s negative cash flow ($58 million in 2012 and $22 million so far in 2013) underscores a growing problem with trying to bankroll original content and pay expensive licensing fees for old programming while keeping the subscription price at $7.99 per month. “As this negative cash flow flows through the income statement and you start seeing Netflix not making as much money, they have to raise the price,” Pachter argues. “If they charge $9 a month instead of $8, one would think that will place downward pressure on subscriber growth. It’s a balancing act, and it’s expecting a lot from Netflix that they’re going to get it perfect.”

Netflix has not altered its pricing structure since the Qwikster debacle, and Hastings told investors the $7.99 price point is “working great” for the moment. For now, the company’s main focus is cooking up more hit shows. Netflix is planning to double its investment in original content in 2014 and has already confirmed second seasons for House of Cards, Orange is the New Black and Hemlock Grove. Another high-profile drama from the creators of the FX legal drama Damages will also debut next year. Meanwhile the company is launching a stand-up comedy special by Aziz Ansari in November and is planning to air original documentaries in 2014. Chief Content Officer Ted Sarandos said Netflix might even consider producing content in-house (as HBO does) in addition to licensing shows from third-party production companies.

A  potential alliance with cable companies also might help the company grow. Netflix is in talks with Comcast and other pay-TV providers to make the streaming service available to cable subscribers via their set-top boxes. “I don’t think at this point it would be a problem to be on a Comcast box,” Hastings told investors. “We have to figure out deal terms that make sense for both parties.” Still, that would represent a fairly dramatic reversal for a company that was once seen as a direct, sometimes antagonistic competitor to cable.

More originals could give Netflix an advantage in such discussions. A company that started with a super-simple service (DVDs by mail) is quickly gaining clout as a big-time content distributor with the same ambitions as a major cable network. “The advantage of moving into original content is that it gives Netflix the ability to create must-see TV,” Cryan says. “And must-see TV means a Netflix subscription can sit very happily alongside an HBO subscription.”

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