The Secret to Netflix's Future

The rebirth of Netflix (NASDAQ: NFLX  ) has been one of this year's big stories on Wall Street. With Netflix spending so much time in the financial press, most aspects of the company have been covered extensively.

However, one secret statistic consistently slips under the radar yet is critical for understanding Netflix's long-term profitability prospects. This "secret" is Netflix's operating expenses. For the past few years, Netflix's operating expenses have been growing almost as fast as the company's revenue. If this continues to be the case, Netflix is unlikely to become as profitable as most analysts expect.

What we know
Bulls frequently highlight Netflix's rapid subscriber growth since the beginning of 2012, growth in the company's margins, and Netflix's international opportunities. Netflix's subscriber growth is certainly impressive; on a global basis, Netflix added 10 million streaming subscribers between June 2012 and June 2013, for a 36% growth rate!

On the other hand, bears frequently point to Netflix's rapidly rising content expenses and its dependence on other media companies for content as big red flags. They also note rising competition from companies such as Amazon.com, Outerwall, and a resurgent Hulu as a significant threat.

However, there are holes in both sides' cases. While Netflix's subscriber base has grown rapidly and margins have expanded, on a companywide basis, Netflix still has a razor-thin profit margin. Netflix is likely to post a pre-tax margin of just 4% this year, which is hardly impressive. Yet on the bear side, it's hard to argue that Netflix is on the verge of crisis when it has been reliably growing revenue and profit over the past year.

The big secret
In the midst of this debate between bulls and bears, Netflix's operating expenses are rarely mentioned. When I call "operating expenses" the big secret at Netflix, I'm referring to all the costs classified as "technology and development" expenses or "general and administrative" expenses. These are essentially overhead expenses that are necessary for the Netflix service to operate.

Bulls take it for granted that Netflix can grow its profit margin rapidly by leveraging expenses. Indeed, if Netflix had a fixed amount of overhead, then the marginal revenue from new subscribers (after advertising and acquisition costs) would drop straight to the bottom line. In fact, some bull analyses completely ignore Netflix's operating expenses!

Netflix bulls are expecting a lot of operating leverage. After all, based on Netflix's likely 2013 profit margin, the company would need as many as 400 million subscribers to achieve a P/E ratio in line with the broader market average. Even the most adamant Netflix bulls don't expect that the service will reach that size. Instead, they expect margin growth to do most of the "heavy lifting."

However, Netflix's operating expenses have been growing almost as quickly as revenue. In the first half of 2013, revenue grew 19% year over year. Meanwhile, technology and development expenses increased by 13%, and general and administrative expenses increased by 27%, primarily because of increased headcount to support growth. Combined, these operating expenses increased 17% year over year.

What it means
The key point here is that while it's possible Netflix could eventually leverage its operating expenses, it hasn't shown much ability to do so yet. In the first half of this year, operating expenses grew 17%, just a tad slower than Netflix's 19% revenue growth.

Netflix primarily relies on improvements to the service (including its user interface and recommendation algorithms) and the addition of new international markets to drive subscriber growth. Both of these initiatives will continue to drive operating expenses higher.

Based on the recent pace of cost increases, there may be less room for leveraging operating expense increases than the bulls believe. This would constrain profit growth over the next five to 10 years.

On the other hand, if Netflix could continue growing revenue while keeping operating expenses in check, that would provide a platform for significant margin expansion. Very few people are investigating which of these scenarios is more likely, yet the answer is critical for understanding Netflix's future.

Looking ahead
When Netflix reports its Q3 results on Monday afternoon, I'll certainly want to know how many subscribers the service added and whether EPS growth is living up to expectations. However, I will also be sure to look at the trajectory of Netflix's operating expenses.

If Netflix is able to keep operating expense growth well below revenue growth, that's a big positive sign for the company. If not, I'll continue to harbor serious doubts about Netflix's long-term profit potential.

The full Netflix story
The TV landscape is rapidly evolving, and Netflix sits in the center of this changing landscape.  If you want to understand how Netflix stacks up against the other players in the brave new world of TV, check out The Motley Fool's special report on the future of television: "Will Netflix Own the Future of Television?" The report not only outlines where the future of television is heading, but explains what it means for investors like you. To get your free report, just click here!


Read/Post Comments (6) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 20, 2013, at 12:58 PM, duuude1 wrote:

    Hi Adam,

    If you were running a company and you hit a tough spot and needed to reduce OpEx - what would you do? Would you throw up your hands and say "ahhhh, there's no way, lower the life rafts..."? Or would you look at a Pareto chart and look at the biggest expenses, and then start cutting the fattest items on that chart?

    And if you were running Netflix, what would the biggest fattest expenses be? And easiest to cut?

    Advertising.

    No problems, duuude! OpEx back in line.

    The fact that NFLX is spending a crap-load on advertising to keep growing is a good thing. I recall some Fool looking at NFLX's growth rates per ad dollars and found fewer $$'s needed per unit growth.

    Hang tough duuudes, we still have a growth monster on our hands.

    Duuude1

  • Report this Comment On October 20, 2013, at 2:06 PM, TMFGemHunter wrote:

    HI Duuude1: I'm not including advertising in operating expenses. (That's because Netflix allocates it to the different business segments.) In fact, advertising is one of the few areas where Netflix has seen cost efficiencies. As the service grows, there's more "free advertising" in the form of word-of-mouth recommendations, and this has allowed Netflix to more or less hold the line on advertising costs over the past year or so.

    When I'm talking about growth in operating expenses, it's really the technology for distributing content, making recommendations, etc. and then general overhead (management costs, legal costs, accounting, etc.).

    Adam

  • Report this Comment On October 20, 2013, at 2:49 PM, duuude1 wrote:

    Thanks Adam. Google's finance site lays out the numbers nicely so I reference NFLX's income statement here:

    https://www.google.com/finance?q=NASDAQ%3ANFLX&fstype=ii...

    So the "Selling/General/Admin. Expenses, Total" that I was referring to (where you would find ad expenses) is the biggest OpEx item - and that item runs 2x more than the R&D item which it sounds like you are referring to.

    But I think we're starting to argue how many angels dance on the head of a pin - the important question is: what do we want from NFLX?

    Do we want immediate gratification and profits? Or do we want NFLX to grow like gangbusters so it has the scale and reach to become a stable and therefore highly profitable company?

    NFLX is NOT at the stage where it can relax and focus on profits. It is still a very small player and needs to grow considerably so it is safe from the many environmental risks like huge competitors (AAPL, GOOG, AMZN, WMT, CMCSA, etc...), nervous suppliers (TWC, CMCSA, DIS, ADR, etc), fickle viewers, etc...

    So I WANT to see NFLX spend like crazy on technology, content, advertising, etc to ensure that it continues growing.

    Bottom line is that I think your focus on OpEx is misplaced - unless you have evidence that the specific things they are paying for are not leading to growth.

    For that we'll see on Monday (and the year after that, and the decade after that...).

    Best,

    Duuude1

  • Report this Comment On October 21, 2013, at 8:10 AM, TMFGemHunter wrote:

    I don't think that Netflix is necessarily spending too much on OpEx. The question is just how much OpEx spending is needed to run Netflix, and what does that say about future profitability.

    If I actually thought that Netflix was going to grow "like gangbusters" I might agree with the rest of your argument. 20% revenue growth is certainly better than the vast majority of U.S. companies. However, it's not so fast that I would assume profitability will naturally follow from continued growth. (There's also a big question about how much longer Netflix can grow like this before hitting saturation in the U.S. and even some of the int'l markets.)

    Adam

  • Report this Comment On October 21, 2013, at 2:50 PM, TMFFischer wrote:

    Good analysis, Adam. (And it's always good to hear critical thoughts on popular stocks.) Fool on!

  • Report this Comment On October 22, 2013, at 5:26 AM, CoreAndExplore wrote:

    Great article. I made pretty much the same argument about LNKD as it's OpEx is growing at practically the same rate as revenues and there is no indication of sustained margin expansion. Grow revenue all you want, but unless it has legitimate prospects of hitting the bottom line at an attractive clip, I'm going to have to take my investing dollars elsewhere. Growth for growth's sake, without any regard for profitability, is a dangerous game for investors to take part in.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2690910, ~/Articles/ArticleHandler.aspx, 10/23/2014 12:33:55 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement