Netflix (NASDAQ:NFLX) burned a record amount of cash last year, with free cash flow hitting -$3.3 billion.

That's one of several reasons bears have been skeptical of the leading streamer, along with rising competition and a maturing U.S. market with rapidly slowing growth.

Despite the excessive cash burn, Netflix nonetheless executed on its goal of delivering an operating margin of 13% last year. The key drivers of that were its 27.8 million new subscribers and a price hike that helped revenue jump 28% to $20.2 billion. However, one overlooked aspect of Netflix's improving profitability is its operating leverage, especially in its marketing budget, and as the company aims to grow its operating margin to 16% in 2020, investors should keep an eye on that line item.

A receptionist sitting in Netflix HQ

Image source: Netflix.

A look at Netflix's operating leverage

Netflix's content spending in 2019 on a generally accepted accounting principles (GAAP) basis rose 25% to $12.4 billion, while on a cash basis, content spending was up 21% to $14.6 billion. On a GAAP basis, which is how Netflix is measuring operating margin, content costs grew almost as fast as revenue. While cash spending is important to monitor as negative free cash flow has led to the company's taking on billions of debt, investors should also keep in mind the company's GAAP profits, because they factor in amortization costs and better reflect the long-term value of the content library Netflix is creating.

What helped give Netflix's operating margin a boost last year was that marketing spending, its next biggest line item, only rose 12% to $2.65 billion. That's a sign that Netflix's marketing spending is getting more efficient, and as the brand matures, it should continue to gain leverage in its marketing budget.

CFO Spencer Neumann described Netflix's approach similarly, saying on the third-quarter earnings call:

We will market as we think appropriate and needed to grow our business. We had a very large increase in our marketing spend last year, so this year, you're seeing spending at similar levels to last year. And that's because we've learned a lot. We learned a lot along the way. We'll continue to test and learn, so we find new and different ways to reach our members every day. And so we'll continue to turn the knobs there.

Netflix's marketing needs have also changed over the years, shifting from brand-building in its more mature markets to creating demand for its original content. The streamer has also become established enough around much of the world that it can benefit from word-of-mouth advertising and has leveraged industry awards to expand its reach and improve its reputation for quality. That explains part of the reason why Netflix is so intent on capturing Oscars this year. Winning awards and nominations is a way of gaining essentially free publicity. Though the company may spend on campaigns along the way, the return on that investment is likely much greater than more traditional advertising.

The path to 16% operating margin

Netflix doesn't give full-year guidance, but analysts expect revenue to grow 20.9% this year to $24.4 billion as the company laps an aggressive U.S. price increase last year and faces increasing competition. However, content costs also seem likely to slow as Netflix sees free cash flow improving to -$2.5 billion for 2020, $800 million better than its 2019 result. If Netflix's GAAP content spending rose $2.5 billion in 2019, a fair guess for 2020 would seem to be a $2 billion increase, which would bring it to $14.4 billion. It's worth remembering that Netflix also derives operating leverage from its subscription model, since each new subscriber's payment effectively goes to the bottom line after minimal costs for streaming technology.. That gives Netflix more control of its profitability than most investors seem to think it has as it can fully control how much it is spending.

If marketing costs increase at similar rate as 2019, by 12%, they will reach $3 billion, and if Netflix's other operating costs increase in line with revenue, the company will end up with $4 billion in operating income for 2020, up from $2.6 billion in 2019. That gives the company an operating margin of 16.4%, hitting its target with a little room to spare.

For years, Netflix has outlined its approach to spending in its Long-Term View document, explaining:

Our operating margin structure is set mostly top down. For any given future period, we estimate revenue, and decide what we want to spend, and how much margin we want in that period. Competitive pressures in bidding for content would lead us to have slightly less content than we would otherwise, rather than overspending. The same is true for our marketing budget. The output variable is membership growth that those spending choices influence.

In other words, Netflix isn't going to destroy itself by overspending. It's shelling out for content strategically, and the company expects to steadily increase profit margin beyond 2020, meaning operating margin could top 20% in just a few years.

The streamer isn't without challenges. It's borrowed extensively to fund its content spending strategy, costing it $626 million in interest expense and eating into profits. It faces new competition, which threatens its pricing power, its ability to raise prices, and could raise content costs, and growth is slowing in its biggest market.

However, Netflix has plenty of strengths of its own, and the company has a well-established pattern of hitting its own forecasts, much like it did with 2019 operating margin. Though the company is often jeered for burning billions each year, Netflix looks like it's setting up to be a high-margin profit machine in just a few years. If the company can do that and keep delivering growth on the top line, the stock could still have a long way to run.