Netflix (NFLX +0.96%) is modestly profitable today but should be extremely profitable in the future. The company has increased its operating margin -- operating income as a percentage of revenue -- by about 3 percentage points each year since 2016, and management expects it to reach 16% next year.
When revenue is growing quickly and margins are rising, profits tend to grow very quickly. I believe the current trend should continue over the long term despite the recent increase in streaming video competition.
Data source: Netflix. Chart by author. E = company estimate.
Why Netflix's operating margins have been expanding
The company's operating margin has been expanding primarily because Netflix pays for its single largest expense -- content -- on a fixed-cost basis. That means every piece of content that Netflix either licenses or self-produces costs the company a fixed dollar amount regardless of how many people watch it or how many subscribers the company has. As a result, each additional subscriber comes with very little extra cost and is therefore extremely profitable. Netflix has been able to grow subscribers at a rapid rate over the years.
Data source: Netflix. Chart by author. E = company estimate.
That growth has given Netflix a huge amount of additional revenue every year. To date, it has chosen to reinvest most of it in even more content and marketing. Despite this significant spending, the company has still been able to book a growing amount of profit and higher margins.
Where margins are heading
Netflix's margins are likely headed higher over time primarily due to its fixed-cost content deals and the benefits of scale afforded by its 158 million subscribers. Greater scale is a big advantage for Netflix as it allows the company to spend an expected $15 billion on content this year -- vastly more than its streaming competitors. For example, Hulu has about 29 million subscribers and is thought to be spending about $2.5 billion.
A good example is Netflix's production of Oscar-hopeful The Irishman -- a Martin Scorcese film starring Robert DeNiro, Al Pacino, and Joe Pesci that hits the service on Nov. 27. It has been reported that Netflix paid an eye-popping $160 million to produce the film, but that is only about $1 on a per-subscriber basis. Contrast that with the $134 that the average Netflix subscriber currently pays the company per year and it's clear that producing The Irishman was a rounding error for Netflix.
But it would have been an extremely risky project for anyone else, which is perhaps why every other studio reportedly passed on making it. Certainly, people need to continue watching Netflix's content, because subscriber engagement is the primary driver of retention. If no one watches The Irishman, it won't benefit the company's subscriber numbers. But that 's unlikely and, to date, management has executed its content strategy very well.
You can see the implications of this in the chart below. Netflix raises prices over time, which is justified by all the content it is adding, while its content costs per user remain relatively flat. I expect the gap between content costs and revenue per user to continue to widen over time, which should drive the company's operating margins much higher.
Data source: Netflix. Average revenue per user and content cost per user calculations by author. Chart by author. E = author's estimate.
Investors might be concerned that new streaming services from Apple, Disney, and others may throw a monkey wrench into Netflix's growth algorithm. Time will tell, but I think exclusive content means many households will subscribe to multiple streaming services. And Netflix is spending multiples more on content this year than every streaming competitor, so it is hard to imagine a competitor dislodging Netflix from the pole position.
HBO's margins suggest Netflix should have robust margins over time
In a quarterly conference call in early 2012, Netflix founder and CEO Reed Hastings commented on what he thought the company's U.S. streaming profit margin could be.https://www.capitaliq.com/CIQDotNet/Transcripts/Detail.aspx?keyDevId=145601149&companyId=32012
We hope that we can have a much larger subscriber base than [HBO]. And that will allow us to spend even more on content and have an even better service. Then you've got, obviously, the on-demand aspect of Netflix and all the work that we do to make it personalized and even more useful. So we should be able to, in the long term, have an even better margin position than HBO, but it really depends on a relative scale. So if we're twice as large as the nearest competitor, it would tend to lead to large margins. If it's neck-and-neck of us and HBO in terms of subscriber size, then there would be tighter margins for both of us.
HBO has had operating margins in the low 30% range, including at the time Hastings made those comments. And Netflix now has 61 million U.S. streaming subscribers versus HBO's 34 million. That bodes well for Netflix's margins over the long term.
