Last Wednesday, Netflix (NFLX +3.23%) crushed investors' expectations by reporting a huge increase in its subscriber count in the fourth quarter. The company added more than 7 million streaming subscribers during the quarter. Netflix also comfortably beat its earnings guidance.
Following the earnings report, Netflix held its usual earnings interview between management and two Wall Street analysts. During the interview, Netflix executives highlighted these five key points.
Internet TV is taking off
So we are seeing some lumpiness in the quarters, depending on when we launch certain content, but the big picture is remarkably steady ... so think of it, really, as this big adoption of internet TV.
-- Netflix CEO Reed Hastings
Not surprisingly, the analysts quickly asked Netflix's management to explain why subscriber growth accelerated so dramatically last quarter. However, CEO Reed Hastings explained that he takes a longer-term view.
Internet TV is gaining traction across the world. Image source: The Motley Fool.
The timing of new content releases and pricing changes (if any) can have a big impact on growth in any given quarter. This is really just noise. Netflix has shown repeatedly that the "good" quarters and "bad" quarters average out over time. The bigger picture is that consumers across the world are rapidly adopting internet TV as a key part of their content consumption.
On a path of long-term profit growth
[Netflix is] now targeting a 7% operating margin for this year and steady growth afterward. ... So we will grow operating profit by continuing to grow U.S. margin, and also reduce international losses ... but we have not provided a specific target.
-- Netflix CFO David Wells
Thanks to its rapid subscriber growth, Netflix is finally starting to gain enough scale to leverage its substantial fixed costs. As a result, the company expects to post an operating margin of about 7% this year, up from 4% in 2016.
There will still be significant margin volatility from quarter to quarter for the foreseeable future. Nevertheless, on an annual basis, Netflix should be able to expand its profit margin for quite a while. Netflix's management isn't willing to set out a formal margin target. Yet its long-term margin potential will be the most important determinant of how high Netflix stock can rise.
Persistence is the key to international success
No, there is no specific like pricing, marketing tactic [driving growth in France and Germany]. It is the cumulative effect of show after show being in market, just the steady work that we have done. And this is what we also saw in Latin America...
-- Hastings
During the earnings interview, Hastings noted that Netflix is really starting to gain momentum in Europe. He couldn't trace that momentum to any particular catalyst, though.
Instead, Hastings and the rest of the management team see international growth as a long-term process. People rarely join Netflix for a single show. But after they hear about show after show on Netflix, any given piece of new content can become the "tipping point" that convinces them to subscribe. Thus, as Netflix expands and improves its content library in key markets like France and Germany, subscriber growth should eventually follow.
Last year's new markets have a long way to go
We have really liked what we saw once we localized in Poland and Turkey in terms of increased viewing, increased membership growth. So we will just keep on that pattern. So think of it, from a near-term subscriber standpoint, it is a background influence, compared to the big established markets in Europe, LatAm, and North America. And then of course, over time, they should be quite substantial.
-- Hastings
A little over a year ago, Netflix went live in 130 new countries, essentially completing its global rollout -- with the notable exception of China. However, this was a soft launch, in that Netflix hadn't yet put much effort into creating or licensing local content. In many cases, even the menus and interface were not available in the local language.
Netflix needs to localize its content and interface in many of its new markets. Image source: The Motley Fool.
In September, Netflix started the process of localization in Poland and Turkey. This is already starting to pay off in the form of faster growth. Going forward, localization will be a growth driver in many other countries. That said, Netflix still has a small presence in these new markets relative to its more mature markets, so the impact may not be noticeable right away.
The shift to owned original content will continue
... [W]hile it is a bit more cash consumptive, owning our own content and including our original productions has a lot of big scale advantages to the business. Probably the most meaningful one is removing the studio markup and overhead on those productions...
-- Netflix Chief Content Officer Ted Sarandos
One area where Netflix is still struggling is free cash flow production. During 2016, it burned nearly $1.7 billion of cash, up from less than $1 billion a year earlier. In 2017, that figure could rise to $2 billion, despite the company's improving profitability. Netflix will need to issue more debt this year to plug its cash flow deficit.
Up until about a year ago, Netflix's negative free cash flow was driven primarily by the timing of payments for new original series that the company was licensing from content producers.
Today, Netflix is increasingly producing original shows in-house. This requires even more upfront investment, weighing on free cash flow. However, Netflix executives see a big potential payoff from this strategic shift. Owning original content outright will reduce Netflix's costs in the long run while increasing its control over how that content is distributed.
