Netflix (NFLX +0.34%) has been borrowing billions of dollars to fund its growing library of original content. While the company makes a profit on paper, it spends billions more in cash in up-front payments to produce original films, series, and specials.
Last year, the company spent $3 billion more in cash than it generated from its operations. Management initially expected to see a similar level of cash burn in 2019, but it updated its guidance to negative $3.5 billion in free cash flow for this year. CFO Spencer Neumann reiterated expectations that free cash flow would improve starting in 2020.
Investors are fine with Netflix's strategy of borrowing cash to produce originals. Mainly because it works: Netflix's subscriber count has tripled over the last five years. But any sign of slower subscriber growth -- like the company warned about in its outlook for the second quarter -- erodes investors' confidence that Netflix can keep borrowing money to fund its original content strategy.
Promotional art from Netflix original series Stranger Things. Image source: Netflix.
Diving into Netflix's disappointing outlook
Netflix expects to add 5 million subscribers to its service this quarter, a decline from 5.45 million last year. Analysts were expecting 6 million net additions.
Management pointed to the recent price increases in the U.S., Brazil, Mexico, and parts of Europe for the reason net additions will be lower this quarter. Some subscribers canceled their service when Netflix raised its pricing, but the company says gross additions were unaffected.
As long as gross additions remain strong, Netflix should see subscriber growth return back to expected levels after working through the price increases in those markets.
If you ask management what's driving gross additions, it's original content. The company decided to substantially increase its marketing budget in 2018 with a focus on its original content, and it resulted in over 7 million more global net additions to paid subscribers compared to 2017.
It's unclear, however, if that strategy will continue going forward, as Netflix faces new competition from several companies with sizable budgets for content and marketing later this year. Management brushed off the idea that new competitors will have any meaningful impact on its results. "There's already so many competitors for entertainment time," CEO Reed Hastings said during the company's first-quarter earnings call.
Making the most of its content investment
As Netflix's debt balance balloons, there's increased pressure on the company to maximize subscriber revenue. It's managed strong growth by rolling out price increases over the last few years, but it's considering another approach.
Management confirmed that it's testing plans like a low-priced mobile-only option in India. That would have a negative impact on Netflix's average revenue per user, but the marginal revenue from the new target market it addresses could be a substantial gain for the company.
New competitors are entering the market with lower price points compared to Netflix, and the company must consider the potential that it could miss out on a valuable market if it doesn't offer a low-priced option. That's not something Netflix can afford with its huge investments in content and a growing pile of debt. Netflix must maximize its revenue to justify its debt.
This is why investors got a bit scared after Netflix provided a disappointing outlook for its second-quarter subscriber growth. And it's why investors need to pay attention to the metric, as well as how competitors price and market their services -- and how Netflix responds.
