Video-streaming veteran Netflix (NFLX +3.23%) has come a long way from its beginnings in the DVD rental space, but the company still has a lot to prove. The stock is valued like a high-growth investment, changing hands for 90 times trailing earnings and 364 times free cash flows. These lofty ratios can't last forever. Shares are trading at these nosebleed-inducing prices after a 64% gain in 2020, and investors are asking for proof that Netflix can live up to its enormous promises.
Well, Netflix really did give investors some of that long-awaited evidence this year. Let me show you what I mean.
Image source: Netflix.
1. There's plenty of growth on the table
Many critics argue that Netflix has gathered all of the low-hanging fruit in the media-streaming market, which would make it difficult to add more subscribers and raise subscription fees in the future.
I'll admit that 2020 was an unusual year. It started with a big jump as consumers under lockdown flocked to Netflix and other streaming services, then slowed down dramatically over the summer. All told, Netflix hasn't added this many subscribers in any of the last five years. The international customer count rose 34% year-over-year in the third quarter. Even the much more mature North American market saw a paid subscriber jump of 9%.
Subscriber additions drive Netflix's business model. The idea is to maximize customer growth while the video-streaming market is going through its formative years, and then ease off on marketing and other growth-oriented tactics to generate profits from a huge customer base.
Image source: Netflix.
2. Netflix can collect cash profits
A new wrinkle in that strategy appeared in 2020. Netflix is building an incredibly diverse portfolio of original shows and movies in order to boost subscriber growth and keep existing customers loyal.
It's expensive to create original content, and the costs are generally paid in cash when the cameras are rolling. As such, the content expenses turn up as cash costs on Netflix's cash flow statement and are brought over to the income statement in the form of amortizations over an estimated lifetime of 10 years. Netflix uses an accelerated amortization schedule, where 90% of each content asset's production costs are accounted for within the first four years of availability to viewers.
What this means is that Netflix's content creation results in massive cash costs right away, while taxable operating profits and bottom-line earnings benefit from a slower accounting treatment. That's how Netflix has been reporting positive earnings for years, while the free cash flows were printed in red ink. Cash flows were always expected to turn positive somewhere down the line when sharp subscriber growth had created a revenue stream large enough to support the new content production costs and other business activities.
Image source: Getty Images.
That timeline was accelerated in 2020. Coronavirus lockdown closed up Netflix's production studios around the world for several months. Strict virus-fighting protocols have slowed filming schedules. As a result, Netflix has generated $2.2 billion of free cash flow in the first three quarters of 2020.
This collection of substantial cash profits was neither planned nor voluntary. Netflix expects to get back to negative cash flows again in 2021. Still, the company has now proven that it can generate cash profits just by slowing down its production efforts for a while. That's an important morsel for traditional investors, who like to base their buys on financial data. Netflix won't be a cash-burning enterprise forever.
