By most accounts, it was a stellar fourth quarter for Netflix (NASDAQ:NFLX). The streaming leader brought another 8.5 million paying customers into the fold, easily surpassing Wall Street's estimates. It also more than doubled its operating income year over year, underscoring its membership growth triumph.

Be wary of assuming Netflix's Q4 profit margin explosion represents the new norm though. The streaming giant culled spending in one area where it can't afford to skimp for long. In fact, we're already seeing subtle evidence of the adverse impact of this cost-cutting.

Woman using a calculator at a desk.

Image source: Getty Images.

Curious cost-cutting

Last quarter's revenue of $6.64 billion was a 21.5% year-over-year improvement. Netflix's cost of revenue -- its outlays on procuring or producing video content -- grew too, but not quite as much. The company spent $4.16 billion on content, up 20.2% from the $3.46 billion it shelled out during the final quarter of 2019. Technology spending grew nearly 9% year over year, while administrative expenses were up 8.2%. Bear in mind that administrative spending is the smallest piece of this company's operating costs, so its slowing growth yielded the least fiscal benefit.

There's a curious disparity within Netflix's fourth-quarter income statements though. Rather than rising in step with other expenses, marketing spending fell 13.2% year over year, from $878.9 million to $762.5 million. That difference of $116.4 million accounts for roughly one-fourth of the additional $496 million the organization reported as operating income during Q4. And, presuming marketing spending would have otherwise grown similarly to other expenses in a non-pandemic environment, one could argue that the dip in marketing outlays led to nearly half of Netflix's profit growth.

Metric Q4 2019 Q4 2020 Change % Change
Revenue $5.467 billion $6.644 billion $1.177 billion 21.5%
Cost of revenue $3.466 billion $4.165 billion $699 million 20.2%
Marketing $879 million $763 million ($116 million) (13.2%)
Technology and development $409 million $487 million $78 million 18.9%
General and administrative $255 million $276 million $21 million 8.2%
Operating income $458 million $954 million $496 million 108.1%

Data source: Netflix.

Perhaps it doesn't matter. As was noted, Netflix still picked up 8.5 million subscribers last quarter, bringing its full-year gain to 36.6 million. The company is also already the market leader, and could simply be facing saturation headwinds.

However, Netflix does appear to have paid something of a price for not promoting its product as aggressively as it has in the past, and despite the clear increase in promotional spending from the subdued levels of Q2 and Q3.

Cause and effect

Market research company Kantar explained earlier this month AT&T's HBO Max was Q4's big winner in terms of new streaming media signups in the U.S. All told, HBO Max won 19.2% of the quarter's total domestic subscription-video-on-demand enrollments. The next-best platform was Amazon's Prime, boasting 18.2% of new SVOD subscribers. Walt Disney's Hulu and Disney+ came in third and fourth place, respectively, with 13.7% and 13%. Netflix's fifth-place showing was a distantly disappointing 7.4%. In this vein, only 860,000 of the 8.5 million members Netflix signed up in the fourth quarter live in the United States or Canada.

There's nothing inherently wrong with this. Netflix's streaming service has been available in the U.S. for over a decade, and there's a real possibility that it is close to market saturation here. That's why its international business has been a big priority for some time now.

Still, Netflix only has 73.9 million Canadian and U.S. subscriptions, versus the 135 million households found within the two countries. That's 61 million prospective households Netflix could yet bring on board. 

Here's another way of looking at it: How come Netflix's membership growth was so much weaker than rivals' subscriber growth during Q4 despite Netflix's big sequential increase in marketing outlays?

Netflix has been spending noticeably less on marketing of late, and may be paying a price for it.

Data source: Netflix. Chart by author. Dollar figures are in thousands.

Investors should be wondering if these results are connected to promotional spending cuts that began in 2019. If North America's growth slowdown is a harbinger of similar issues looming on the international front, perhaps backing off on marketing spending right now isn't the ideal move.

Worth watching

Netflix isn't doomed. The king of streaming is still profitable, and it's growing its margins in ways other than via its unsustainable spending cuts. Revenue grew by nearly $1.2 billion year over year during Q4, for example, while its cost of revenue only expanded by $700 million. The company's fourth-quarter letter to shareholders even noted its march toward sustained positive free cash flow, adding "we believe we no longer have a need to raise external financing for our day-to-day operations." That implies the company should soon be able to add revenue without spending just as much or more on programming.

We can't presume the part of Netflix's margin growth rooted in lowered marketing spending is sustainable though. Many people are still largely self-quarantining, and looking for ways to ease their boredom. But, with coronavirus vaccines now being distributed, it's going to become more challenging to garner their attention. The advent of HBO Max into a competitive market that already includes Disney+ means Netflix may need to spend even more on marketing -- not less -- than it did in the past.

That's certainly something for current and prospective Netflix shareholders to keep an eye on.