Netflix (NFLX +0.65%) just added more subscribers in the fourth quarter than any other quarter in its history -- 8.3 million. Management points to its growing slate of original content as the reason it outperformed subscriber growth expectations both in the United States and around the world. But all of those new originals come with a cost.
Netflix's free cash flow for 2017 was negative $2 billion. As management put it in its letter to shareholders, "The faster we grow our originals budget (particularly for self-produced content), the more cash we consume." Netflix spent about $8.9 billion in cash on content last year.
Management expects the cash burn to get worse this year, stepping up from $2 billion in negative free cash flow to between $3 billion and $4 billion. The company will once again tap the debt market as it expands its original content budget in an effort to keep growing subscribers.
Image source: Netflix.
An $8 billion content budget
Management revised its guidance for content spending on a profit-and-loss basis to $7.5 billion to $8 billion, up from $7 billion to $8 billion. A growing percentage of that content spend will go toward originals. Netflix CFO David Wells said Netflix ultimately wants originals to make up 50% of its content library. Netflix's spending on originals reached 25% of P&L content expenses last year, so there's plenty of room for that number to grow in 2018.
Ted Sarandos, the head of content at Netflix, says it plans to release 80 original films in 2018. That's more than double the company's film production rate back in the third quarter.
And Netflix isn't taking its foot off the gas with its original series, either. It's signed big deals with television producers and creators including Shonda Rhimes, David Fincher, Jenji Kohan, and Shawn Levy.
The ballooning content spend, particularly for self-produced originals, requires a huge amount of upfront cash. Unlike licensed content, where Netflix can pay over time, originals require cash upfront to start production.
The expenses for original content won't hit Netflix's income statement until the content shows up on Netflix, which could be as long as three years after productions starts. Even then, Netflix amortizes the cost of the original over its useful life, so the expenses usually don't all hit its cost of goods at once. That accounting (which, let me be clear, is totally valid) results in lower content spending on a P&L basis than a cash flow basis, and allows Netflix to show a better operating margin.
A big ramp-up in marketing for all those originals
Another major contributor to the big increase in cash burn this year is Netflix's decision to increase its marketing spending. Management says it increased its marketing budget to $2 billion this year, up from $1.28 billion in 2017, because "our testing results indicate this is wise." That 55% increase in marketing budget is a steep acceleration from the 29% growth in marketing last year.
Netflix's marketing spend is the hidden cost of its originals. "We want great content, and we want the budget to make the hits we have really big, to drive our membership growth," management wrote in its fourth-quarter letter to shareholders.
So, as Netflix ramps up its original content, it's also forced to ramp up the marketing expenses to let everyone know about all of its great shows. That's going to result in an additional $700 million or so in spending next year. Management expects it to pay off in better subscriber growth, but it's still going to hurt cash flow in the near term.
Netflix's ramp-up in cash burn for 2018 is a calculated risk from management. The company has had a lot of success spending more cash than it takes in for several years now, but investors need to consider the risk when they consider purchasing the stock. That level of cash burn comes with a lot of debt and no guarantees.
