Let's start with the bad news first: Streaming pioneer Netflix, Inc. (NASDAQ: NFLX) continues to burn copious amounts of cash. For 2017, the company had negative free cash flow (FCF) of over $2 billion, at the lower end of its forecast in a range of negative $2 billion to $2.5 billion -- and the company says it's only going to get worse.
In its fourth-quarter 2017 shareholder letter, Netflix pointed out that this was largely due to timing and moving some payments to this year. The company is doubling down and expects to go even deeper in the red this year, expecting FCF in a range of negative $3 billion to $4 billion for 2018.
This strategy isn't new. Netflix has previously stated that it expects to remain FCF negative "for many years." But that's only part of the story.
It gets worse before it gets better
In order to fund its growing content library, Netflix continues to tap the high-yield debt market . The following table details the obligations the company has incurred related to content:
Balance Sheet Accounts -- as of Dec. 31, 2017
Current content liabilities
Non-current content liabilities
Total content-related liabilities
Data from SEC filings. Chart by author.
It's important for investors to understand the logic behind the company's strategy. Netflix's content falls into three broad categories. The first includes shows and movies that are licensed from their owners, like How to Get Away with Murder and Captain America: Civil War . Then there are Netflix Originals that are licensed, like House of Cards and Marvel's Jessica Jones . (When the company first began producing original content, it licensed the material rather than owning it.) The third category is Netflix Originals that the company owns and will benefit from for years to come, like Stranger Things , The OA , and Bright .
Netflix has explained that, for its original programs, it begins laying out cash when it greenlights a project, between one and three years before customers ever see the program -- investing now for a future benefit.
The good news
Then there's the good news. Netflix has stated that by 2020, its goal is to have half its content as owned original productions, while the other half will be licensed TV shows and movies. This means spending more upfront, but will result in greater financial benefits down the road.
In the company's October 2016 shareholder letter , Netflix explained why it believes this is the most logical path forward:
Over the long run, we believe self-producing is less expensive...than licensing a series or film, as we work directly with the creative community and eliminate additional overhead and fees. In addition, we own the underlying intellectual property, providing us with global rights and more business and creative control. Combined with the success of our portfolio of originals and the positive impact on our member and revenue growth, we believe this is a wise investment that creates long-term value.
Owned content is more cost effective on a per-subscriber basis, as Netflix can use those programs around the world for its growing ranks of international customers.
In its 2017 fourth quarter, Netflix revealed that popular programs like Stranger Things and Bright had global appeal, and called out Dark , a German sci-fi series that the company said had been "viewed by millions of members in the U.S. and has outsized watching throughout Europe and Latin America." Netflix now owns content valued at $2.9 billion as of the end of 2017.
It's all going according to plan
I've argued before that, while investors should certainly watch Netflix's growing level of negative free cash flow, that metric shouldn't be viewed in a vacuum. In its 2017 fourth quarter , Netflix added 8.3 million subscribers -- the highest quarter gains in the company's history and up 25% year over year. Netflix's revenue grew by 33% over the prior-year quarter, and diluted earnings per share skyrocketed 173% year over year.
Taken as a whole, these metrics show that Netflix's strategy is working. While investors will rightly continue to watch the cash burn, Netflix said, "We are increasing operating margins and expect that in the future, a combination of rising operating profits and slowing growth in original content spend will turn our business FCF positive."
From what I've seen, I think they'll succeed.
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