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Content Costs Aren't the Problem You Think They Are

By Jim Mueller, CFA - Updated Apr 6, 2017 at 10:13PM

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Netflix controls what it spends and won't let that spiral away.

This is the second of a series of articles this week outlining my long-term bullish perspective for video content provider Netflix (Nasdaq: NFLX) -- certainly longer than the three- to six-month "long term" mentioned by one analyst in a Netflix earnings preview. (Maybe that means, as one person said, that "short term" is between now and 4 p.m.?) Yesterday, I covered the information Netflix has on viewing habits and how that is a huge competitive advantage. Today, I'll discuss the power flexible spending gives Netflix.

I've owned Netflix shares for more than four years and covered the company for our Motley Fool Stock Advisor service for 11 straight quarters. Last night's earnings report was what I've come to expect from this company. It beat estimates on both earnings and revenue, as well as management's own guidance for the number of subscribers. However, management guided to lower-than-hoped-for earnings this quarter, which put a damper on the stock price after hours.

Sing the chorus with me
While that's a short-term response to one quarter's predictions, I'm a long-term investor. Let me lay out the second reason why I believe that Netflix still is a good long-term investment today. Don't worry, it won't hurt.

A common comment from many shorts is some version of, "Higher content acquisition costs will squeeze margins, making Netflix less profitable in the future." There are three misunderstandings of the dynamics of the company in that statement.

Virtuous cycles, mmm
First, Netflix is in the middle of a virtuous cycle: More subscribers leads to more revenue leads to more spending on content leads to better content leads to more subscribers. Management highlighted that in last night's release: "The virtuous cycle we've mentioned previously of increased investment in streaming content, strong word of mouth and an expanding device ecosystem truly worked for us in the quarter." A similar virtuous cycle has led (Nasdaq: AMZN) to become the retail powerhouse it is today.

Second, Netflix has relatively little in fixed costs. Salaries and overhead, research and development, interest and taxes, delivery costs, and a target for operating income. Once the other costs are met, management can adjust its marketing and content acquisition spending as needed to meet that target.

Last night, management reported a higher-than-expected level of marketing spending in the first quarter. That led to a higher subscriber acquisition cost that spooked some analysts. CFO David Wells said that the higher SAC was an artifact of the higher marketing thanks to the shifting balance between content acquisition and marketing.

Regarding content acquisition, as the company gets more subscribers, it can write bigger and bigger checks. That means Netflix becomes an ever-more-important source of revenue for content producers. And it's getting easier for Netflix to get content, not harder.

In the fourth-quarter 2010 conference call, there was a question: "Do you believe it will get harder to acquire incremental films and TV shows from major Hollywood studios?" Wells answered, "No, it's not gotten harder. It's gotten easier as we pay more. Three, four years ago, we couldn't pay much, it was very hard, and, now, because we've got significant dollars to spend, we've got people coming to us, and that makes perfect sense."

It spends what it needs to
Third, Netflix is not after every piece of content out there, especially the high-priced, new releases. Apple (Nasdaq: AAPL) and Amazon are more than welcome to have those available on pay-per-view. Netflix's strength lies elsewhere. Management said in last night's release, "Recently, the CEO of an MVPD [e.g., cable and satellite] characterized Netflix as 'rerun TV' ... [and] he is fundamentally correct. Our focus for TV shows is on prior season TV and completeness of series, because this class of content enables us to license content broadly and provide consumers a differentiated experience." And with its informational edge, it knows what to buy.

From a recent company presentation: "Netflix's goal is content so broad, engaging and affordable that everyone subscribes. Despite the fact that consumers also do pay-per-view for new releases, go to movie theatres, buy DVDs, and subscribe to cable/satellite/telco TV. New release movies are not available for subscription streaming to us (or others), and are reserved for higher-margin pay-per-view and DVD. We are more movie-catalog and prior-season TV-show focused." (emphasis in the original)

All in all, I was quite pleased with the earnings release. If you're interested in the company, I suggest that you read the letter from management available on the company's investor relations Web page. Netflix spent a fair amount of time describing the dynamics that are driving this company.

Come back tomorrow for the third part of this series, where I discuss more on Netflix's focus on content and the type it's after.

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.

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