Netflix (NASDAQ:NFLX) turned in another blockbuster quarter this week. Posting a new record in quarterly subscriber additions, the company saw revenue and profits surge, pushing the stock up double digits as the streamer's market value passed the $100 billion mark.
While bulls were celebrating, though, the usual group of party-poopers emerged from behind the popcorn bowl to hit the pause button. "Free cash flow, free cash flow!" they screamed, perplexed that Netflix stock could be soaring when the company's losing billions of dollars on a cash basis each year.
#Netflix said they will burn $4 billion in free cash flow next year. This is the ultimate bubble stock that one day will trade under $100— Will Meade (@realwillmeade) January 22, 2018
Netflix is forecasting free cash flow of negative $3 billion-$4 billion in 2018. And the stock still soared? WTF?!?!?!— Suresh Singh (@Sureshsinghn) January 22, 2018
Is this sane? Netflix has a $100 billion market cap but isn't generating free cash flow...— Steve Matthews (@SteveMatthews12) January 23, 2018
Indeed, Netflix is projecting another year of heavy investment into its business. After posting free cash flow of negative $2 billion in 2017, management now expects its free cash flow shortfall to increase to $3 to $4 billion this year, meaning the amount it spends on content, marketing, research and development, and other cash expenses in 2019 will be at least $3 billion more than what it generates in revenue from subscribers. Netflix will take out more debt to fund that spending.
In its letter to shareholders, management offered an excellent justification for this strategy. It explained that operating margin and income are rising and that producing movies like "Bright" can take as long as three years before it becomes available to subscribers. In other words, there's a long investment period ahead of reaping the benefit of streaming a new show or movie, and since Netflix is self-producing more of its own original content, those costs are rising.
Netflix expects free cash flow to eventually turn positive as operating profits grow and content spend slows down, but it also says membership and revenue are booming, and the business is growing faster than expected. Therefore, it sees an opportunity to drive further growth by increasing its content budget as it's found that content investments drive growth.
A quick accounting lesson
If the hive minds on Wall Street are still balking at this explanation, it's because they've been taught to value free cash flow above all else when evaluating companies as the discounted cash flow model, which is based on free cash flow, is essentially the gold standard on Wall Street and business schools for valuing companies.
While FCF-valuations are a useful tool for investors, there are limits to their usefulness since it only tracks cash, not accounting profits.
Take this hypothetical example: Say I open a hotel chain called Bowman Hotels. In Year 1, I have no properties, so I spend $20 million to build my first hotel, giving me negative $20 million in FCF. In year 2, the hotel is successful, clearing me a cash profit of $5 million, so I decide to build five more the following year. Based on this pattern, in Year 3, I'll have negative $95 million in free cash flow. That may look like a terrible decision, but considering the profit from the first hotel, I should expect to generate free cash flow of $30 million by Year 4 when I have six hotels running (assuming no growth in profitability from scaling up the business).
Netflix is in this "Year 3" phase of its growth, and it's not nearly as scary as it may seem. Free cash flow fluctuates among business all the time according to investment cycles. Toy-maker Mattel, for instance, posts negative free cash flow three out of four quarters a year, as it invests for the holiday season when toy sales jump.
Who could fault the company for that strategy as it's a safe bet that toy sales will spike come Christmas? Netflix, by comparison, is simply in a more drawn-out version of this investment cycle.
Netflix bears seem to think this strategy is way too risky, but really, it's no riskier than Mattel betting on a jump in toy sales for Christmas. In fact, for a company competing in video entertainment, what Netflix is doing is less risky than how Hollywood studios normally do business. Major studios like Walt Disney make big bets almost every time they release a movie. A few years ago, Disney said it expected to take a $190 million loss on The Lone Ranger, following a $200 million loss on John Carter the year before. Sony took a goodwill impairment charge of $962 million a year ago as it cut future profitability projections for its movie business.
The hits for Hollywood studios tend to outweigh the flops, but box office receipts are anything but predictable. With its built-in subscriber base of nearly 120 million giving it a steady revenue stream, Netflix doesn't have to worry about a single movie like "Bright" being a hit. If its members don't like it, they'll find something else on the platform to watch. They're subscribers because of Netflix's massive library, great value, and the convenience it offers. Compared to getting a Netflix membership for $11 per month, paying $14 for a seat at the local multiplex is a much riskier decision.
Furthermore, accelerating its content spend gives Netflix even more of a cushion from new entrants like Apple and Disney, and helps solidify its competitive advantages. Even Apple, with annual profits around $50 billion, isn't about to dump $8 billion in content onto an unproven platform. Instead, the iPhone-maker pledged a more modest $1 billion in original programming this year. Disney, meanwhile, has an impressive library but still has to convince subscribers to pay for its upcoming streaming service.
You can call Netflix's strategy cash burn if you want, but this is no money pit. The streaming champ is making a smart investment in its future. I wish I could say the same for Bowman Hotels.
Jeremy Bowman owns shares of Apple and Netflix. The Motley Fool owns shares of and recommends Apple, Netflix, and Walt Disney. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.