The streaming wars are heating up, and a few services are emerging ahead of the pack. Netflix (NASDAQ: NFLX) has consistently remained the top dog in this race, and it is likely to maintain its position thanks to its pivot to original content. Netflix is beginning to reap the rewards of its early investments and long-term focus, which are finally showing up in its widening operating margin.

Individual holding TV remote pointed at TV

Image source: Getty Images.

Netflix's basic strategy

Netflix consistently tracks operating margin -- the percentage of its sales that it gets to keep as profit before it has to pay interest or taxes -- as a measure of how profitable its core business operations are. Higher operating margins could potentially lead to higher reinvestments in the business.

In order to expand operating margins, however, Netflix had to differentiate itself from other streaming services. Five years ago, the streaming company shifted its main focus from licensing content to creating original content to form a more sustainable moat. Original content, however, comes with massive initial costs. In 2020 alone, the streaming company spent $17.3 billion on content, up from the $2.4 billion it spent in 2013. Compare this to Amazon's (NASDAQ:AMZN) Prime Video content budget of $7 billion in 2020. Although Netflix's content budget is large, it has accounted for less of the company's total revenue over time; in 2017, content costs made up 76% of total revenue, whereas in 2020, it made up 69% of total revenue. The lower percentage of content spend relative to revenue is helping fuel Netflix's increasing profitability.

Better content, more subscribers

Netflix bet that investments in original content would lead to more subscribers, an expanding operating margin, and higher profits in the long run. So far, this strategy is proving out.

Initially, Netflix grew its content budget faster than it increased subscribers. That trend has reversed as noted in the table below. Over the past several years, subscribers increased at a faster rate than content spending did. As of 2020, subscribers grew about 22%, outpacing content spend by a wide margin. 

 
Metric 2018 2019 2020
Content Spend Increase (in percentage points) 35.29 27.01 13.07
Subscriber Base Increase (in percentage points) 26.5 27.07 22

Source: Company investor letters.

This subscriber growth continued even though Netflix increased its standard plan from $9.99 to $13.99 -- suggesting that Netflix customers are mostly sticking with the service. Once Netflix covers its initial investments in original content, it can keep all the money made after that as profit. That is why Netflix achieving a sticky customer base is so critical to expanding its operating margin -- its spending on original content will pay dividends for years to come.  

Netflix has done a tremendous job overall with its bets on original content. As of 2020, Netflix had 1,949 shows on its platform, 34.5% of which are originals. Its closest competitor, Prime Video, had 2,236 shows, but only 6% of those were original. Of the "high quality" content on Netflix (meaning the show/film earned 6.5 stars or above from viewers on the Internet Movie Database), 46% of those were Netflix originals. On Prime Video, high-quality originals only made up 15% of the high-quality content.

The success of originals on Netflix most likely has played a part in reducing the company's marketing spending. Marketing spend, as a percentage of revenue, decreased from 15% in 2018 to 9% at the end of 2020. These improvements in the financials all boost Netflix's operating margin and profitability.

Investments are paying off

For years, Netflix's operating margins were too thin for the company to come even close to generating positive cash flow. The shift to originals is fixing this. Its growth rate on licensed content spending, which requires continual payment from Netflix, has slowed from 41% in 2016 to 23% in 2017, 20% in 2018, and finally only 4% in 2019. In 2020, originals made up almost 35% of Netflix's library; again, that's much higher than Prime Video with only 6%. Unlike the more common content licensing strategy, Netflix only has to pay for the original content once up front -- not on an ongoing basis. After Netflix's revenue surpasses the initial investment made in the original series or film, each additional subscription after that turns into pure operating profit, improving operating margins over time.

These positive developments for Netflix took years of investments and growth to turn into increased profits, and the table below shows how they paid off:

 
Metric 2017 2018 2019 2020
Operating Margin 7.20% 10.00% 13.00% 18.00%
Year-over-year increase (in percentage points) 3.2 2.8 3 5

Source: Company investor letters.

Over the last four years, Netflix's operating margin has increased significantly, finally showcasing the strength of Netflix's long-term-focused business model. But this is just the beginning. Management expects to continue to become more profitable over time, targeting three-percentage-point annual increases on average for several more years. This target, of course, is excellent news for investors.

Because the streaming wars are only getting more competitive, Netflix will likely continue spending more on originals. However, Netflix is betting this could lead to more subscribers, as it has in the past. That, in turn, could lead to more profits -- assuming subscriber growth materializes.

If this unmistakable upward trend in Netflix's operating margin continues, its profits and cash flow could grow substantially more than what the market is reflecting in the coming years, potentially rewarding investors handsomely.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.