Let's get this out of the way right up front: Netflix's (NFLX 7.65%) upcoming earnings report will be a blockbuster. If the streaming video giant just manages to meet its mid-January forecast, it will have gained 9 million new subscribers in the last few months to surpass its prior record set in the fiscal fourth quarter.
CEO Reed Hastings and his team are predicting weaker earnings for this announcement -- set for Tuesday, April 16 -- but that's nothing for shareholders to worry about since the drop is powered by the timing of content launches. Profit margins are rising right along with average monthly prices, after all.
The bigger investor concern is cash outflow, which is on pace to reach $3 billion in 2019 for the second straight year. Netflix is aiming for that number to begin improving in 2020, but there are big questions on the timing of that stabilization and the speed of its (eventual) rebound.
Mind the gap
There's a huge gap right now between Netflix's earnings and its cash flow because of the time delay between producing a movie like Bird Box or a show like Stranger Things and booking the profits associated with its release. Production costs are paid as many as three years before launch -- with cash -- at which point the company can reap the rewards in terms of higher membership growth and increased engagement.
Meanwhile, since Netflix is diving deeper into original, high production-value shows and movies, there's been an acceleration in cash outflow. The company's operational cash drain was $1.7 billion in 2016, $2 billion in 2017, and $3 billion last year.
Netflix outperformed management's free cash flow forecast last year, landing at the low end of its $3 billion to $4 billion outflow prediction. That result was in some ways a repeat of the prior year, when the outflow hit $2 billion compared to the predicted range of between $2 billion and $2.5 billion. However, back then executives said the cash performance was stronger than expected because some content spending got pushed into 2018. The fact that this past year's results also beat expectations is a good sign for shareholders, although it doesn't mean positive cash flow is likely anytime soon.
Why it will improve
The major factor determining when free cash flow starts improving is the timing of management's decision to start scaling back on original content spending. At some point the extra cash directed toward new movies and shows won't deliver enough user engagement to meet internal return targets. That moment would likely be preceded by a period of slowing membership growth. But so far there's no indication that this slowdown is approaching. After all, Netflix just closed out its fifth straight year of accelerating subscriber growth.
In the meantime, investors can follow operating margin for a good indication of how quickly the business might return to positive cash flow in the next few years. That metric has improved by about 3 percentage points in each of the last two years and management's goal is to keep that pace going so that profitability reaches 13% of sales in 2019 from the current 10% level. Higher monthly fees support this expansion, and those fees are in turn sustained by the rising user engagement brought on by all the new, quality content.
Hastings has been clear all along that Netflix's profitability level will ultimately depend in part on the quality of its streaming competition. Thus, it will be interesting to see whether the massive new launch of Disney+ by Disney in November knocks Netflix off of its 3-percentage-point per year margin expansion pace. With a 150 million-member head start, it will be hard for Disney to seriously challenge Netflix's streaming dominance immediately. But the streaming pioneer hasn't yet faced direct competition from a company with such valuable content assets.