For years, Netflix (NFLX -1.03%) has burned billions in cash to fund its giant appetite for new content. And for just as long, bears have pointed to that business model as fundamentally flawed, arguing that the strategy would one day lead to the company's unraveling. Below are some quotes from Netflix bears.
- "They're in a vicious spiral to the bottom in content spend." -Michael Pachter, Wedbush, July 2018
- "They expect to burn another $3 billion this year. While the company is talking about an inflection in 2020, we've heard similar stories in the past about changes in behavior." -Neil Macker, Morningstar, March 2019
- "[Netflix] will probably grow total paid subs 15% in 2020, vs. 20% in 2019. FCF [free cash flow] will still be negative $2.5B in 2020. I think the scenario of 5% sub growth with no FCF may be coming into focus soon." -Jim Chanos, January 2020
Indeed, Netflix has burned billions in cash on its warpath through the entertainment industry. The company now has more than $14 billion in debt, and finished 2019 with -$3.3 billion in free cash flow, which management believed would be the peak in its cash burn. Prior to the pandemic, it had expected to burn $2.5 billion this year, though it now believes free cash flow will be -$1 billion or better in 2020 due to delays in production.
COVID-19 and the resulting stay-at-home orders have been an unquestionable tailwind for Netflix, resulting in record subscriber additions of 15.8 million in the first quarter. At the same time, the crisis has kneecapped competitors like Disney, traditional media companies, and the movie studio/theater ecosystem. Based on the effect of the pandemic, Netflix's own impressive growth, and other recent events, the debate over the streamer's cash burn has essentially become irrelevant. Here's why.
GAAP profits matter
The bears roaring about cash burn conveniently ignore the fact that Netflix has been profitable for several years on a generally accepted accounting principles (GAAP) basis, and its operating margin has expanded significantly during that time.
Like every other company, Netflix accounts for depreciation and amortization using GAAP standards, but unlike most, the difference between its cash profits and accrual accounting profits is substantial. That's not a weakness; it's the nature of the business. Netflix is pouring billions of dollars into content each year, much of which won't be available to subscribers for years. Producing hundreds of television shows and movies annually requires huge upfront spending, and Netflix only recoups those costs over time through its subscriptions.
Bears also protest that much of the value of Netflix's content comes in the initial months that it hits the platform. But there's no doubt that one of Netflix's biggest strengths has become its massive library of original content, which would not exist without that aggressive spending approach. For television especially, that library can keep users entertained for days as they binge on multiple seasons of the same show.
How is Netflix doing on a GAAP basis? In the first quarter, it finished with $958 million in operating income and $709 million in net income. Based on revenue of $5.8 billion, it had an operating margin of 16.6%, much better than the average company in the S&P 500. Indeed, its subscription business model is building operating leverage as it's supposed to. Last year, it finished with a 13% operating margin, and Netflix is targeting 16% for 2020.
Streaming is officially king
The pandemic has made one thing clear. Streaming isn't just the future. It's the present. Ad revenue at traditional media companies, which has tumbled because of the crisis, likely peaked in 2019. Meanwhile, with the launch of Disney+, AT&T's HBO Max, and Comcast's Peacock, essentially every major media company has a streaming arm now. Reports show that streaming services have received the bulk of additional television viewing during the pandemic, and the transition toward streaming is accelerating during the crisis, as sign-ups are booming.
Netflix will be the biggest winner of that global movement. It now has close to 200 million paying subscribers. That offers creators by far the biggest audience and also gives Netflix the biggest subscriber base to leverage, a true business advantage. By comparison, Disney+, despite its strong start, doesn't expect to turn a profit until 2024 and the service is losing billions of dollars annually on a GAAP basis.
Launching and building a streaming business is expensive and challenging. That's why traditional media companies resisted it for so long. Now, they have no choice.
Netflix doesn't seem worried about cash
Management has always clearly articulated the strategy around originals and the cash burn necessary to achieve it. Some investors may not like that approach, but they can't say it was a mystery. The company has stuck to the strategy despite quarterly fluctuations in subscriber growth, and a recent move made it clear that the company has no concerns about cash or user churn.
In a blog post, Netflix said that it would ask subscribers who hadn't used the service in over a year to confirm that they still want to pay for it. If they don't confirm, Netflix will cancel their membership. The company said that such users account for less than 0.5% of its total subscriber base, and Netflix has already factored their inactivity into its guidance. The move may seem puzzling, but it will build goodwill with those subscribers and its broader audience. It may even encourage lapsed users to see what's new on the service.
Such a move is extraordinarily rare from a subscription-based company. Businesses like gyms are notorious for relying on paying customers who never show up, and subscription businesses often count on users being too lazy to cancel their memberships. Netflix doesn't need any freebies. It's doing just fine with committed users.
The company's status as a battleground stock is likely to remain, as it still trades at a high valuation and is a unique company continuing to penetrate a new industry. But the debate over Netflix's cash burn has been settled. The strategy worked. Netflix is making billions in annual profits. It has nearly 200 million satisfied customers around the world, and nearly all of the disruptions caused by the coronavirus pandemic work to its competitive advantage.