When Will Netflix, Inc. Finally Start Making Money?

By Markets Fool.com

Image source: Netflix.

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Netflix (NASDAQ: NFLX) isn't exactly a money-printing machine these days. Over the last four quarters, the digital video veteran has generated just $141 million of adjusted earnings on $7.6 billion in top-line revenues. The adjusted net margin there is a razor-thin 1.8%. Meanwhile, the company also reported negative free cash flows of $966 million.

The skimpy earnings led to a trailing P/E ratio north of 300. Many investors simply won't touch a company that's burning cash.

Will Netflix ever make money -- and how long will investors have to wait?

The timeline

Netflix's management has held its profit targets steady for quite a while. In January 2015, the company said it would complete its global expansion within two years, followed by "material global profits from 2017 onwards."

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The worldwide expansion was abruptly completed one year later (with the notable exception of China). Otherwise, nothing much has changed. Here's a snippet from the recent second-quarter 2016 report:

We continue to expect to run around breakeven on a net income basis in 2016 and to generate material profits in 2017 and beyond. We will drive operating profit growth in 2017 by reducing our international losses and continuing to grow US profit.

How much?

CEO Reed Hastings and CFO David Wells are still keeping their cards close to the vest. They remain committed to delivering "material profits" on the bottom line next year, but have declined to supply a firm number.

As for cash flows, Wells has said that the current cash-burn trend will continue until the net profit focus starts to kick in.

"Free cash flow will improve when we drive more profit, and start organically funding more of our content investment," Wells said in the second-quarter earnings call. Again, there were no solid numbers attached to this ambition.

Thinking about the mechanics involved, Netflix is currently pumping all available operating funds into two targets: Improving the technical infrastructure behind its global media networks and marketing its services around the world.

Netflix's technology budget is currently racing ahead of the marketing costs. In the second quarter, global revenue jumped 28% higher year over year, driven by a 9.6% increase in marketing expenses and 33.7% higher technology costs. Completing the worldwide video distribution framework should allow Netflix to hold its operating costs stable while revenues continue to rise.

Spitballing the available data, Netflix could double its bottom-line profits by simply completing the technology rollouts and reining in the galloping expenses in that department. But that's not all. In the long run, Netflix is aiming for so-called contribution margins near 40% in the domestic market, with international territories catching up to the same level several years later. This metric includes marketing and content costs, but not technology expenses, and currently stands at 17.3% for the global streaming operations.

This margin goal will not be reached in 2017, but long-term profits should roughly triple again as this trend plays out.

A long profit story

Doubling the earnings line in 2017 at current share prices would still leave the stock at a nosebleed-inducing P/E ratio of at least 150. A long-term triple would only bring the P/E ratio down to 50 or so. In short, Netflix would remain a pricey stock even after a six-fold earnings boost.

From another perspective, Netflix might want to reach net margins comparable to other entertainment giants. Taking a look around the industry, net margins commonly sit between 10% and 20%. Netflix would still be generously valued if net margins jumped to that range right now.

Yes, Netflix is set to start reporting solid profits as early as 2017. It's unclear how large the bottom-line haul might be, or how the market will react when Hastings and Wells finally set a firm profit target.

This is enough to keep risk-averse investors far away from Netflix shares, but does not change my view that the company (and stock) has barely begun telling a very long and profitable story. It is the largest holding in my investment portfolio, and will probably stay that way for years to come.

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Anders Bylund owns shares of Netflix. The Motley Fool owns shares of and recommends Netflix. Try any of our Foolish newsletter services free for 30 days.

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