Netflix (NFLX 1.45%) hasn't been shy about attributing its recent blowout quarter to its increasingly addictive content.
The streaming giant recorded a record-breaking 8.3 million quarterly subscriber additions, blowing away its previous record of 7.05 million subscriber additions in the fourth quarter of 2016.
|Netflix total subscribers at year end
The company said the growth is "due primarily to stronger-than-expected acquisition fueled by our original content slate and the ongoing global adoption of internet entertainment," according to a letter sent out to investors on Jan. 22.
With Netflix announcing an increase in its content budget for 2018 to between $7.5 billion and $8 billion, up from $6 billion in 2016, we can expect continued subscriber growth in the U.S. and internationally.
Does Netflix really need to spend $8 billion?
Netflix has been steadily increasing its content budget by about $1 billion each year. That means it spent about $5 billion in 2016 and $6 billion in 2017, and it originally planned to spend between $7 billion and $8 billion in 2018.
However, because it has more money from gaining more subscribers than it expected last year, it revised its 2018 content budget to between $7.5 billion and $8 billion. Meanwhile, revenue grew about 30% year over year, from $8.83 billion in 2016 to $11.7 billion in 2017.
"Membership, revenue, and original content spend are booming," Netflix wrote in its letter to investors. "We're growing faster than we expected, which allows us to invest more in original content than we had planned."
Netflix argues that the increased spending on content will pay off in the long term because bigger and better movie and show titles attract more subscribers and improve hours of engagement among current subscribers.
When asked on the earnings call why Netflix chose $8 billion versus $7 billion or even $10 billion, Netflix CFO Ted Sarandos said the company has to do a balancing act: The more Netflix invests, the faster it will grow, but it doesn't want to get ahead of itself, either.
Will Netflix's content spend ever slow down?
Eventually, Netflix will have to reduce how much it's spending on content each year, Sarandos admitted. But that time is not now, when the company is seeing intense subscriber growth.
"We keep investing forward based on the confidence of how we're doing," he said. "And at some point if we're seeing -- if we're not growing viewing hours or not growing subs or not growing enjoyment, then you've hit a point of diminishing returns. We just haven't seen that yet."
And Netflix doesn't expect content spend to stagnate anytime soon. CEO Reed Hastings said he's expecting the content budget to continue to go up in both 2019 and 2020. "Don't think of $8 billion as some new plateau," he said. "Instead, it's just a point in time as we grow both the revenue and our content budget."
What did Netflix's $6 billion budget go to in 2017?
Looking at Netflix's content slate from the past year, it's hard to believe it's only been five years since the company launched its first original series.
Just in the fourth quarter of 2017, Netflix released follow-up seasons of three hit shows, including The Crown, Black Mirror, and Stranger Things. In addition, two new shows have already been renewed for second seasons: Marvel's The Punisher and director David Fincher's critically acclaimed show Mindhunter.
Netflix also spent a reported $90 million on sci-fi film Bright starring Will Smith. While Netflix didn't specify its price on the earnings call, it did admit the movie was "our largest investment in original films to date." Although critics slammed the film, Netflix defended it as "one of our most viewed original titles ever." A sequel is already in the works, and the project has encouraged Netflix to look at investing more in original films in the future.
Netflix also had a solid year with new seasons of Club de Cuervos and The Day I Met El Chapo in Mexico, Suburra in Italy, Jack Whitehall: Travels With My Father in the UK, and the debut of its first German original drama series, Dark.
Most importantly, Netflix realized that its hit international titles travel well and can be released in other countries. For example, Dark was a hit show in the U.S., Latin America, and Europe outside of Germany. Encouraged by this success, Netflix plans to release 30 international original series in 2018.
What does this mean for Netflix's free cash flow?
Netflix's free cash flow may be the one weak spot on its balance sheet.
The ambitious company has been investing a lot of money in its content, leading to a free cash flow of negative-$2 billion in 2017 -- though that was at least at the lower end of its projected range of a $2.0 billion to $2.5 billion deficit.
But next year isn't going to get any better. The company is expecting to report free cash flow of negative-$3 billion to negative-$4 billion in 2018.
Netflix thinks people shouldn't be worried because its cash spend for projects happens one to three years before a project gets released. In the future, according to the shareholder letter, the company says a combination of rising operating profits and slowing growth in original content spend will make it a free cash flow-positive business. For the full year of 2018, Netflix is projecting a target operating margin of 10%, up about 300 basis points year over year.
The good news is that the high content spend is paying off in subscriber numbers. Netflix expects to report 6.35 million global net adds in the 2018 first quarter, notably higher than the 5 million global net adds from the same quarter last year.
Netflix is clearly doing well. But it's important for investors to understand that its content spend, subscriber growth, and revenue growth are all interconnected. Investors worried about its increasing content spend need to know that if they want Netflix to continue this period of impressive subscriber growth, it's best to relax about the free cash flow situation for now.
Eventually, Netflix will start to ease up on its content budget, and the free cash flow will be positive. Until then, it's better to focus on the subscriber figures.