In an industry first, the Netflix-only series “House of Cards” scored nine nominations — and three wins (for directing, casting and cinematography) — at the recent prime time Emmy awards. Netflix also scored nominations for a Netflix-only season of the sitcom “Arrested Development,” which previously aired on the Fox network.

While “House of Cards” was shut out of the acting categories it was nominated in, the Netflix original series is prominent in the company’s strategy to transition from purely a distribution engine for movies, television and other content to a creator of its own programming. And Netflix has plenty of company — fellow distributors Hulu, and YouTube are also developing their own slate of programs. According to Wharton experts, the Internet and the power of data analytics are creating new opportunities for companies to define their audience and target programming to viewers’ likes and dislikes more closely than ever before.

The success of “House of Cards,” a political drama based on the British miniseries of the same name, was followed by an equally strong debut for “Orange is the New Black,” based on author Piper Kerman’s memoir about her time in prison. During a recent earnings call, Netflix executives noted that each of its new shows has improved upon the first week ratings of the previously debuted program.

“Winning an Emmy draws attention to Netflix from people who didn’t have the service and wouldn’t have signed up [otherwise],” says Wharton management professor Daniel Raff. “[Casting] Kevin Spacey [in the lead role] certainly got our attention. ‘House of Cards’ probably drew in more incremental customers.”

And according to Wharton legal studies and business ethics professor Kevin Werbach, the fact that the company outbid HBO for “House of Cards” “shows that Netflix is now in the same league as a more traditional distribution channel for high-end TV shows.”

Many of Netflix’s competitors are in a similar position. Last February, Hulu, a joint venture of NBC, Fox and ABC, launched its first original scripted series, “Battleground,” which followed political campaign staffers trying to elect a candidate to represent Wisconsin in the U.S. Senate.

Meanwhile, Amazon last April released the pilot episodes for 14 new shows and asked for feedback from viewers to decide which would be given full series orders. Critical reaction to the pilots was mixed, but Amazon green-lit “Alpha House,” a political buddy comedy starring John Goodman; “Betas,” a show set at a Silicon Valley start-up; and three children’s programs. Like its submission process for the Kindle, Amazon accepts scripts from anyone, and then pays writers $10,000 if a project is chosen. If a developed script becomes a full-fledged series, the creator gets $55,000 and up to 5% of Amazon’s net receipts from licensing, royalties and bonuses.

“The economics are such today, given the proliferation of free content, that there is not a lot of economic incentive for firms to construct high-quality content unless it is truly differentiating.” –Eric Bradlow

According to Wharton emeritus management professor Lawrence Hrebiniak, content and distribution go together like love and marriage. “You can’t have one without the other,” notes Hrebiniak, citing Disney’s 1996 purchase of the ABC Television Group and Comcast’s more recent acquisition of NBCUniversal. Hrebiniak says that companies can come from either the distribution or content production side and diversify by leveraging their strengths. For instance, Netflix and Amazon have built-in distribution much like cable providers and can easily push original content through those networks. Creating their own content means the companies become less dependent on other content producers, who can command lucrative licensing agreements because distributors know that audiences are attracted by proven hits.

In theory, if the online channels can use original content to attract new groups of viewers who wouldn’t otherwise subscribe, they can invest the extra money in producing more in-house series and features and recoup those costs over time. In contrast, the traditional content licensing model requires Netflix and others to constantly go back to the bargaining table with content owners and renegotiate when licensing contracts expire.

As of June 30, Netflix had $1.32 billion in current content liabilities — funds that have to be paid to content owners such as Disney, CBS, NBC and others. For 2013, Netflix said in regulatory filings that it expects spending on original content to be less than 10% of what it pays for streaming content overall. About 5% of Netflix’s $3 billion content library is original content, the filings show.

The ROI of Original Content

For Netflix CEO Reed Hastings, the bet on original content has gone about as well as it could, Raff states. Netflix hasn’t disclosed what it paid for Spacey and the other production costs for its original content, but did report in Securities and Exchange Commission filings that the company will be able to amortize original content quickly and count it as assets. In a licensing model, both Amazon and Netflix face higher costs to distribute content from traditional producers because they pay more for exclusivity and often bid against each other, Hrebiniak notes.

Wharton marketing professor Eric Bradlow says that Netflix’s biggest return on its original shows will be in differentiating the service from its rivals. “The economics are such today, given the proliferation of free content, that there is not a lot of economic incentive for firms to construct high-quality content unless it is truly differentiating,” notes Bradlow. “So the content [distributors] have maybe more incentive than the content developers.”

Hastings, along with CFO David Wells, outlined the case for original content in a second quarter investor letter in July. “Hulu and Amazon Prime Instant Video continue to license some exclusive content and develop their own originals. We have ‘House of Cards’ and many others; Hulu has ‘Battleground,’ and Amazon Prime Instant Video will have ‘Alpha House’. All are quite good and quite different. All three services are becoming more distinct from one another, like HBO, Showtime and Starz are distinct from one another,” Hastings and Wells wrote.

Later on a second quarter conference call, Hastings elaborated and said the goal was to create ongoing brands for Netflix. “If we do it right, these will turn into real franchises — that is, ‘House of Cards’ Season 2 … Season 3, Season 4 will be just tremendous assets for the company.”

“Netflix or Amazon knows much more about what kinds of content its customers want than a cable company, and they have leading-edge expertise in big data analytics to make use of that knowledge.” –Kevin Werbach

Raff agrees with Netflix’s strategy. “This is a matter of having privileged access to customers and exploiting a fixed cost to do as much business as you can,” Raff notes. “‘House of Cards’ was a shrewd investment.”

Hastings cautioned that it’s still early in Netflix’s original content experiment, but there are promising signs of an early payoff. Due to the launch of “Arrested Development” and the fan base that followed, Netflix reported that it added 630,000 net subscribers in the U.S. during the second quarter of 2013, compared to 530,000 in the same quarter a year ago. As of June 30, Netflix had 38 million streaming customers in 40 countries.

Although Hastings said the real impact of the company’s original content plans will play out in the years to come, experts at Wharton say Netflix appears to be off to a strong start. They noted, however, that what constitutes a hit or a flop is different for online programming than it is for traditional channels. If an online show attracts a niche audience to subscribe to a particular service and those viewers become long-running customers, it can pay off even if the overall viewership numbers are lower than those for a typical program airing on a broadcast or cable network.

The Data Advantage

Netflix, Amazon and Hulu enter the content sphere with a key advantage, according to Werbach: data. The subscription nature of their businesses and the data collection mechanisms built into their systems means the companies are all in a position to know hourly what customers are watching, how they interact with content and what their preferences are. Using that information, the firms can also develop original content based on specific demographic or preference information, further cutting dependence on Hollywood.

“The really interesting question is whether these new online distributors can use their vast stores of customer data to integrate with content more effectively than traditional media providers,” Werbach notes. “Netflix or Amazon knows much more about what kinds of content its customers want than a cable company, and they have leading-edge expertise in big data analytics to make use of that knowledge.

“Netflix can make decisions about what content to acquire based on more intelligent metrics than the usual audience demographics or betting on certain stars. And it can leverage their recommendation engines to push customers to content, which they have been doing all along. Only now some of the content is their own,” Werbach adds.

Netflix, Amazon and Hulu tend to have a closer relationship with their subscriber bases than a traditional television network, Raff points out. “These digital companies are all developing a clientele that’s … comfortable and happy to be doing business with them,” he says.

As more and more consumers opt to view content via the Internet, the playing field may eventually level, although Netflix and Amazon have a significant head start, Raff adds. For example, HBO could garner similar analytics through its HBO Go app.

What’s unclear at the moment is whether new outlets for original programming will dilute the market for high-end productions. “Obviously, there isn’t room for infinite content, but there is definitely room for multiple providers,” says Bradlow, noting that customers have multiple tastes and the mass market has fragmented.

Raff expects marquee actors to benefit from bidding wars. “Once one service starts [a show like] ‘House of Cards,’ others will try to find an actor with a marquee name,” says Raff. “People on the level below Spacey are likely to be telling their agents to make sure they also look at [projects from] Netflix and others.”