How Netflix, Inc. Plans to Balance Big Investments and Growing Profits

By Daniel Sparks Markets Fool.com

As Netflix (NASDAQ: NFLX) continues to scale its business, its profitability is finally turning upward. Not only did the company report better-than-expected earnings per share in every quarter of 2016, but the company's outlook for the trajectory of its profitability looks optimistic, too. However, near-term profitability is far from Netflix's primary focus. Indeed, the company is ready to spend big, even if it slows down profit growth.

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Image source: Netflix.

In Netflix's fourth-quarter update, management gave investors a window into this careful balance of growing profitability and aggressive spending.

Temporary international profits

To see Netflix's balancing act of profitability and spending, take a look at the company's international segment.

In a nice twist to Netflix's cash-burning international expansion, for the first time, Netflix provided guidance for a first-quarter contribution profit, or revenue less cost of revenue and marketing expenses incurred, in its international streaming segment. Management said it expected a first-quarter international contribution profit of $16 million, up from a contribution loss of $104 million in the year-ago quarter and a contribution loss of $67 million in Q4.

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A forecast for an international contribution profit wasn't entirely a surprise. The segment's contribution margin has been improving for some time as revenue grows rapidly in these markets, and as marketing expenses and cost of revenues decline as a percentage of revenue. Still, it was nice to see Netflix forecasting a meaningful contribution profit in the fast-growing segment for the first time.

But even with an international contribution margin in sight, management isn't ready to aggressively keep improving profitability abroad -- especially if this would mean the company would have to tone down the same big investments that have driven international growth in the first place. This is why management is forecasting a return to a contribution loss in the second quarter of 2017 and a contribution loss for the full year.

We plan on investing over the remaining quarters of 2017 internationally and, as a result, anticipate an international contribution loss in Q2. On a full year basis, we expect international contribution loss to improve substantially year on year.

A broader theme

There's no question that Netflix is on its way to profitability. A look at the company's overall contribution margin and management's guidance for its operating margin in 2017 particularly highlight this important trajectory. Netflix's fourth-quarter contribution margin for its streaming business was 20%, up from 16.2% in the year-ago quarter. This drove the company's contribution profit for its streaming business up 74%, to $470 million. And Netflix says it expects an operating margin of about 7% in 2017, up significantly from an operating margin around 4% in 2015 and 2016.

Image source: Netflix.

But despite these early enticing promises of a lucrative, scalable business model, the company won't focus on profits first. Management explained in Netflix's fourth-quarter shareholder letter:

From here, we will seek to steadily increase revenue and operating margin as we balance growth and profitability. We are in no rush to push margins up too quickly, as we want to ensure we are investing aggressively enough to continue to lead internet TV around the world.

In other words, while Netflix is keeping a vision for profitability in mind, it won't forego the big investments needed to maintain its leadership position in internet TV for the sake of boosting its bottom line.

In the near term, this mentality from Netflix could keep profits more suppressed than they would be if the company made growing its profits a bigger priority. But long-term investors should be encouraged by the company's commitment to balancing profitability with growth by ensuring it's investing aggressively enough to stay ahead.

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Daniel Sparks has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Netflix. The Motley Fool has a disclosure policy.