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1 Big Reason Not to Worry About Netflix's Profitability

By Jeremy Bowman - Updated Jul 25, 2017 at 3:33PM

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Critics have long questioned Netflix's business model, but the company's own management has a perfect explanation of its strategy.

Netflix, Inc. (NFLX 5.84%) stock received another standing ovation from Wall Street this past week. Shares of the home-entertainment specialist jumped 13% after a blowout earnings report, and they have continued to climb since then, tacking on another 3%.

Subscriber growth surged past expectations as the leading video streamer added 5.2 million new members globally, much better than its own forecast of 3.2 million, and its best performance ever in the second quarter, generally a seasonally slow period.

The reception at Netflix HQ

Image source: Netflix.

Given the jump in new subscribers, thanks to its biggest ever slate of new content, the subsequent surge in the stock price was not surprising. Some observers continue to express doubts about Netflix's ability to generate long-term profits. Others, like my colleague Evan Niu, have called into question Netflix's growing reliance on debt, as the company is on track for negative free cash flow of more than $2 billion this year as it spends heavily on content. 

Doubts about its capability of turning a profit have long dogged Netflix as the company has operated around breakeven for essentially its entire history. However, there's one big reason investors should feel confident in management's current strategy of plowing billions into content in order to grow its subscriber base. In fact, the company spells it out on the Long-Term View statement on its website.

In the driver's seat

Management explains in the strategic statement that it sets its "contribution margin structure" from the top down, with contribution margin defined as revenue minus spending on content and marketing. 

It goes on to say, "For any given future period, we estimate revenue, and decide what we want to spend, and how much margin we want in that period." In other words, revenue is driving spending, not the other way around, as the company determines what it spends based on expected revenue.

Netflix isn't spending $6 billion on content this year to maximize profit, but to grow its subscriber base. If it wanted higher profits, it could just cut back on content spending.

Critics have also claimed that Netflix would eventually flop because of increased competition in streaming, which would spark a bidding war for content. However, the company has an answer for that charge as well, saying, "Competitive pressures in bidding for content would lead us to have slightly less content than we would otherwise, rather than overspending." Netflix also says, "The same is true for our marketing budget. The output variable is membership growth that those spending choices influence."

In other words, Netflix has much more control over its profit levels than the numbers might otherwise indicate. The company has long targeted a 40% contribution margin in the U.S. by 2020, and it has already topped that mark in some quarters, with a 41.2% contribution margin in the domestic market in the first quarter, for example. 

That it's already hitting a long-term goal for three years from now should be reassuring sign for investors. Additionally, Netflix's subscription model offers some stickiness and a cushion from any fluctuations in content spending. While popular new content will entice more subscribers to sign up for the service, long-term subscribers would be unlikely to leave if Netflix were to have slightly less content, as it explains.

The power of long-term thinking

Netflix's focus on the long term is reminiscent of the strategy of another Wall Street darling, (AMZN 3.58%). Amazon has operated at breakeven for nearly all of its history as well, as the company puts whatever profits would have existed back into expansion and entering new markets. That strategy has clearly paid off for Amazon, as it's now one of the most valuable companies in the world with a number of enviable competitive advantages. 

Like Amazon, Netflix reports slim profits not because of necessity but by choice as it prefers to invest in content. After the surge in subscriber growth last quarter, it's clear management is making the right decision. As Netflix scales up, profits should materialize as the company has long predicted. It's foolish to think Netflix's lack of profitability is a sign of weakness. As it spends record sums on content, its market power only gets stronger each quarter.

Jeremy Bowman owns shares of Netflix. The Motley Fool owns shares of and recommends Amazon and Netflix. The Motley Fool has a disclosure policy.

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