Netflix (NASDAQ:NFLX) stock has been on an absolute tear in 2018, more than doubling since the beginning of the year. This has increased Netflix's market cap to roughly $180 billion, making it the most valuable media company in the world.
Indeed, Netflix stock now trades at a lofty valuation of more than 140 times its projected 2018 earnings and 70 times the most bullish analyst's 2019 earnings estimate. Clearly, investors expect the company to achieve extremely high profit margins in the future, in addition to growing revenue at a rapid pace.
However, Netflix is discovering that it's important to spend heavily on marketing to drive "buzz" about its original content, so that it can keep existing subscribers on board and attract new ones. In the long run, marketing spending could rise just as much as revenue, preventing Netflix from achieving the level of margin expansion that bulls expect.
Stepping up the marketing investment
From 2013 to 2016, Netflix increased its marketing spending at a 28% compound annual growth rate, with the vast majority of the growth driven by its international expansion. The increase in marketing modestly outpaced Netflix's 26% compound annual revenue growth rate over that period.
By the beginning of 2017, Netflix had completed its international expansion. Nevertheless, it increased its marketing spending by 29% last year to $1.28 billion, compared to less than $1 billion in 2016.
This time, most of the increase in marketing came on the domestic side of the business. The marketing investments seemed to work well, as Netflix grew revenue at an impressive 32% clip. As a result, marketing spending ticked down from 11.2% of revenue to 10.9% of revenue.
Seeing the success of its 2017 marketing initiatives, Netflix decided to invest even more in marketing during 2018. In the first quarter, Netflix spent $479 million on marketing, up 77% year over year. For the full year, it plans to spend about $2 billion on marketing, which would be a 56% year-over-year increase.
Between the subscriber gains from its increased marketing investments and a price increase implemented last fall, Netflix's revenue growth has accelerated recently. Nevertheless, analysts expect revenue growth of "only" 35% to 40% in 2018. That means Netflix will spend more than 12% of its revenue on marketing this year.
Will marketing ever be unnecessary?
In January, during Netflix's fourth-quarter earnings call, founder and CEO Reed Hastings mused that one day, Netflix might be able to promote content so effectively on its own platform that it wouldn't need to spend money on marketing.
If that ever happened, it would obviously be a huge boon for Netflix's profitability. However, this seems like a pipe dream. Movie studios typically spend $150 million to $300 million to promote their big-budget films, according to Variety, even though many of these are sequels with wide name recognition.
Given that studios still need to spend hundreds of millions of dollars to promote franchises like Star Wars and Batman, marketing is likely to remain important for Netflix, no matter how big and successful it becomes. As a result, marketing costs will continue to escalate rapidly as the company expands its original content slate. Of course, Netflix could choose to pull back on marketing -- but that would lead to slower growth.
The ceiling is extremely high
In the past year or so, Netflix has been able to reverse a slowdown in its domestic subscriber growth by significantly increasing its marketing budget. Management is confident that the incremental subscriber growth more than makes up for the margin hit from higher marketing expenses.
There's really no reason to expect this calculus to change in the future. Given Netflix's plans to pivot most of its content spending to originals -- for which paid advertising is a key tool for building audience awareness -- and its global growth ambitions, annual marketing spending could plausibly reach $10 billion (or more) in the long run.
Even with this level of marketing spending, Netflix will still be able to achieve substantial margin expansion in the coming years by growing its revenue faster than content spending. It just may not be able to reach the margin levels that the most bullish investors expect.