Investors loved Netflix, Inc. (NASDAQ:NFLX)’s latest quarterly report. The numbers fell just where analysts wanted them to fall.
Netflix, Inc. (NASDAQ:NFLX) added more than 2 million new subscribers to its service in the United States and 1 million internationally.
It announced a new $11.99 monthly service that provides subscribers with the opportunity to pay more to stream more than two movies at one time.
The company launched a new series, House of Cards, which is its first true foray into creating its own content.
There is no doubt that the company is making headway toward becoming the “internet TV.” It’s adding subscribers, adding new content, and focusing on acquiring exclusive to Netflix content.
Show us the money
For all the promise of Netflix, Inc. (NASDAQ:NFLX)’s future, it still hasn’t figured out how to show it on the income statement. Certainly, Netflix’s goal is ambitious. It knows that scale is the most important factor to its eventual success. Thus, for right now, it’s all about the top line.
The question is when can investors expect that a $12 billion valuation will be justified by the cash flow that shareholders can call their own? As a reminder, Netflix reported $2.7 million in net income on $1.02 billion in revenue. It’s barely breaking even.
Low net margins aren’t unheard of in internet businesses – Amazon.com, Inc. (NASDAQ:AMZN) has gotten away with near zero margins for years – but eventually, Netflix will have to deliver fatter margins to justify its valuation.
Analysts have identified two sources for eventual profit margin:
1. Price increases for online streaming.
2. Slashed spending on content, specifically the “bulk deals” that executives discussed no longer having an interest in.
Netflix can increase the cost of its service. It can cut back on the content it provides for a flat monthly fee. The question is whether or not higher prices and lower spending will ultimately fall in Netflix, Inc. (NASDAQ:NFLX)’s income statement.
The biggest fallacy in business
Warren Buffett famously shuttered the mills at Berkshire Hathaway Inc. (NYSE:BRK.B)‘s textile business after realizing that each dollar of invested capital was a bigger benefit to his customers than himself. New mills may make it cheaper to make textiles, but ultimately, those savings had to be passed on to the customer to make a sale. The result? More capex for the same net income, and a lower return on capital.
Netflix, Inc. (NASDAQ:NFLX) is a middle-man that buys licenses to one group of people and resells that license in piecemeal to millions of people. It’s not the same as a textile mill, but it is a commodity business in much the same way. Its profit is the difference between what it pays for content and what it receives from customers.
It’s an incredibly transparent business model. Netflix’s income is money left on the table by people who make the content. Each dollar that Netflix earns is a dollar that content providers will want in the future.
To think Netflix, Inc. (NASDAQ:NFLX) can get away with simple increases in pricing without paying more for content is foolish. In the same way, to think Netflix can cut content spending and post billion-dollar profits without drawing attention from content producers who it keeps in its library is equally foolish. What’s to keep major players like Disney from asking for more and more money for its content each time Netflix ups its pricing?