Netflix Has a New Operating Metric It Wants You to Watch

By Adam Levy Markets Fool.com

Netflix (NASDAQ: NFLX) has long put subscriber and revenue growth well above profits in its list of priorities. For the past few years, management asked investors to judge the company's progress through its revenue growth and U.S. contribution margin. The idea is that the U.S. is indicative of what its younger international markets will look like as they reach scale.

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With its first-quarter report, Netflix agreed it's time to look at the big picture.

"Starting this year, we can be primarily measured by revenue growth and [global] operating margins as our primary metrics," management wrote in its letter to shareholders. With the global expansion now a full year behind it, Netflix is starting to turn profitable.

Image source: Netflix

Moving past last year's 130-country expansion

Netflix reached its global expansion goal nearly 12 months early, when it quickly filled in the rest of the map in January last year. The expansion fueled international subscriber growth, which climbed from 30 million at the end of 2015 to almost 48 million by the end of last quarter.

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Netflix also had to invest a lot to get those 130-plus countries off the ground. Not only did it need content-delivery technology in place, but it also had to forge new content agreements for many regions. Many of Netflix's long-term contracts are region-specific, including some of its older original productions.

Even still, Netflix's international contribution margin continued to improve throughout the year as it brought in significantly more subscriber revenue and spread the cost of its global rights licenses across more regions and subscribers. By the first quarter this year, Netflix international streaming produced a positive contribution margin for the first time ever. It's expected to dip back into negative territory in the second quarter because of the timing of original-series releases, but the upward trend is encouraging.

With the expansion completely behind it, Netflix can focus on managing steady operating margin expansion while still pushing subscriber growth in each region through marketing and continued content investments. The hard work is over. Now it just repeats the same playbook that's driven its success in the U.S., where it boasts a 41.2% contribution margin, and its older successful international markets.

But it's still burning cash

Even though Netflix is starting to produce meaningful operating profits, it's still burning through cash every quarter. Netflix's free cash flow (FCF) was negative $423 million in the first quarter. It's burning more cash than it burned in the first quarter last year -- $261 million. Zooming out, Netflix expects its annual cash burn to increase $300 million to $2 billion.

Back in October, Netflix CFO David Wells said the company needs $1 billion to $1.2 billion each year in cash burn to fund its expanding catalog of originals and licensed series. "I don't see that changing," he noted, indicating thatNetflix will continue burning cash for the foreseeable future.

The tune hasn't changed. "We have a large market opportunity ahead of us, and we're optimizing long-term FCF by growing our original content aggressively," management wrote in its letter to shareholders. "Since we want our operating margins to grow slowly so we can spend enough to quickly grow revenue and original content, we anticipate negative FCF to accompany our rapid growth for many years."

Increasing operating margins is the first step to turning cash flow-positive. Generating massive amounts of revenue at an operating margin anywhere near its U.S. margin should produce huge amounts of cash when Netflix starts ramping down its growing investments in original content. As long as operating margin keeps expanding, Netflix has the ability to start generating meaningful cash whenever it determines it can't effectively drive subscriber growth by spending more on content.

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