Depending on how you look at it, Netflix (NASDAQ:NFLX) is either profitable or losing a lot of money. The company produced $1.9 billion in net income in 2019, up from $1.2 billion in 2018. But its free cash flow came in at negative $3.3 billion, widening from negative $3 billion the year prior.

The difference is primarily due to Netflix's spending on content. On a cash basis, it spent around $14.6 billion on content last year. But just $9.2 billion of that hit its income statement. That's because Netflix amortizes its content spending over the useful life of the film, series, or special. The gap between cash spending and amortized expenses has grown considerably since 2014, when Netflix amortized all but $520 million of content spending.



Data source: Netflix letters to shareholders. Chart by author.

But 2020 promises to be the start of a reversal in those trends. And while the continued growth of the company's top line and improved profit margins should contribute to the positive trend in free cash flow, closing the gap between cash spend and amortized content expenses should have the most significant impact.

Moving up the business-model curve

At a recent investors conference, Netflix CFO Spence Neumann laid out how he's seen the company's business model evolve over the last few years.

When Netflix started streaming content, it licensed second-run series and films from other studios. There's basically no gap between when Netflix spent the cash on that content and when it showed up on its income statement. But that type of content is becoming a smaller and smaller portion of Netflix's library. Major media companies are pulling back their content at the same time Netflix is increasing its spending on originals.

Netflix's earliest originals still came from third-party studios. So, there was an up-front cash expense for the company when the series was delivered to Netflix, and a licensing fee for the next few years as well. That big up-front cash payment needs to be amortized over the useful life of the series even though it came out of Netflix's pocket around when it debuted.

Four boys on bicycles staring at an ominous sunset.

Title art for self-produced original Stranger Things. Image source: Netflix.

Netflix's latest focus is on self-produced originals. In the case of self-production, Netflix spends cash well ahead of the debut of a series or film on its service. A series might start production a year ahead of its debut and a feature-length animated film could take as long as four years. Neumann said the shift to self-production resulted in "a pretty meaningful pull forward of cash spend for similar content on the service."

More than 50% of Netflix's content spending goes toward originals at this point, and increasingly self-produced originals, Neumann explained. It's over the hump on the transition to originals, and as such cash content spending growth ought to continue slowing down as it starts to benefit from previous up-front investments. Growth in cash content spending slowed from 35% in 2018 to 21% in 2019. At the same time, as more of those self-produced films and series hit the service, amortization expense growth should remain fairly stable. Amortized content expenses grew by about 22% in both 2018 and 2019.

The overarching philosophy on content spending

Neumann thinks there's still a lot of room to grow its content budget, and the model for determining how much Netflix will spend on content is fairly straightforward. Since Netflix derives nearly all of its revenue from monthly subscriptions, its top line is fairly predictable. Technology and general and administrative expenses are equally predictable. At the start of the year, management guides for a certain operating margin -- 16% this year -- so whatever's leftover can be funneled to content and marketing spend.

Over the last few years, Netflix has found in-house productions to be the most efficient use of its content budget. More and more of those productions are starting to reach viewers, which requires the company to start amortizing the cash it spent years ago. And with the uptick in operating margin outlook, the amount left over to invest in incremental content isn't as big as it used to be on a percentage basis. So, if Neumann wants to stick with his outlook, the acceleration in content spending will slow.

That doesn't mean Netflix won't be opportunistic and grab a good deal on licensed content from other media companies when it's available. But its slow-and-steady approach to improving profits and cash flow somewhat dictate how much it's willing to spend, and it'll forego other, less efficient content opportunities when it needs to.