What Netflix, Inc. (NFLX) Investors Don’t Know Could Hurt Them

The $13 billion question
Netflix has been booking small accounting profits recently, but free cash flow has remained negative. To justify its current valuation around $13 billion, Netflix, Inc. (NASDAQ:NFLX) will have to turn its free cash flow around and boost its operating margin well beyond last quarter’s 3% level. In essence, the company needs to grow its streaming revenue faster than content expense increases.

This is why the stock’s recent run-up seems somewhat misguided. There’s no doubt that adding new series like the recently announced Dreamworks Animation Skg Inc (NASDAQ:DWA) children’s offerings will boost subscriber numbers (all things being equal). However, the cost side of the equation is still unknown. As I pointed out last week, Netflix’s signature original series — House of Cards — reportedly cost the company $4 million per hour. At that rate, the Dreamworks Animation Skg Inc (NASDAQ:DWA) deal would cost more than $1 billion!

The moment of truth
Ultimately, the moment of truth could still be years away. Netflix has been busy locking in long-term deals for high-quality content — especially originals — betting that they will produce the subscriber growth necessary to offset the high upfront costs. However, if Netflix’s addressable market is smaller than management expects (as analysts at Sanford Bernstein recently argued), Netflix could see subscriber growth tail off in a year or two while content costs continue to march higher.

This is a big underappreciated risk for Netflix investors. Recently, the company has managed to walk a tightrope by investing heavily in content but growing the subscriber base just as quickly. However, as the company locks itself into more and more long-term, expensive content deals, there is an increasing chance that a mismatch could develop between content costs and streaming revenue. If that problem ever materializes, Netflix, Inc. (NASDAQ:NFLX) investors will be in for some rough sledding.

The article What Netflix Investors Don’t Know Could Hurt Them originally appeared on Fool.com and is written by Adam Levine-Weinberg.

Fool contributor Adam Levine-Weinberg is short shares of Netflix and Amazon.com. The Motley Fool recommends Amazon.com, DreamWorks Animation, and Netflix and owns shares of Amazon.com and Netflix.

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