At the beginning of the year, Netflix (NASDAQ:NFLX) surprised investors when it said the $2 billion in negative free cash flow it posted in 2017 was nothing; expect as much as $4 billion in cash burn in 2018.
Management said the drain on cash will come in at the low end of expectations, closer to $3 billion than $4 billion, in its third-quarter letter to shareholders. And investors can expect a similar level of negative free cash flow in 2019.
Through the first three quarters of 2018, Netflix's free cash flow comes to negative $1.7 billion. But there's a lot of spending planned for the fourth quarter, so it could easily reach the $3 billion total. Still, the guidance is encouraging.
Here's how Netflix managed to keep its cash burn under control this year.
It starts with top-line growth
Netflix is producing strong top-line growth thanks to better-than-expected subscriber growth. It added 2 million more subscribers than anticipated in the third quarter after missing by 1 million subscribers the quarter before and exceeding by 1 million in the first quarter. Combined with a price increase at the end of last year, Netflix has grown revenue 38% through the first nine months of the year.
Netflix is showing leverage in its business model as it scales. Operating margin expanded 500 basis points in the third quarter to 12%, above the company's 10.5% forecast. The company's operating margin is also 12% (and up 500 basis points) through the first three quarters. That said, management warned the fourth quarter margin won't be as strong due to the timing of content and associated marketing spend.
Note that Netflix doesn't start amortizing its content costs until a series or film is available for streaming on its service. That's the case even if the company spent millions in cash to produce the content months ago. So an expansion in operating margin isn't the greatest indicator of improving cash flow, but it's a signal to dig deeper.
Cash outlays for content spending aren't growing as much as anticipated
Last year, Netflix's income statement said it spent about $6.2 billion on content. But if you look at the cash flow statement, the company actually put down $8.9 billion in cash for its streaming content. As Netflix's library continues to grow and it continues to move more original productions in-house, investors should expect cash outlays for content to exceed the amortized cost of content for at least a few more years.
The cash spent on content so far this year is $8.5 billion, $2 billion more than at this time last year, indicating a massive pipeline of content coming out in the fourth quarter and early next year. But while investors should expect a bump in content amortization expenses hitting the income statement in the fourth quarter, they shouldn't expect a massive increase in cash spent on content. Netflix is steadily producing content throughout the year, and it releases it when it believes each piece of content has the best chance of finding the biggest audience possible.
So while operating margin might come down in the fourth quarter due to increased content amortization, cash flow ought to be relatively steady.
The biggest impact will come from increased marketing spend to promote the new original content releases and push for film awards in the fourth quarter. But with just $1.7 billion in negative free cash flow through the first three quarters, Netflix has a lot of room in the marketing budget to still hit the $3 billion cash burn mark.
Peak cash burn?
As I mentioned above, Netflix's letter to shareholders said it expects to use up another $3 billion of cash in 2019. But on the company's earnings call, CFO David Wells said he expects cash flow to improve in 2020 and beyond.
The company is starting to balance the growth of its content spending with the growth of its subscriber base. Content spending continues to fuel subscriber growth, but it's getting to the point where subscriber and operating income growth is keeping pace with the increased cash spent on content. As top-line growth overtakes growth in cash outlays for content, cash flow will start improving. Last quarter, the two were nearly even, so we may have reached the peak on Netflix's cash burn.