Why Netflix Investors Have Nothing to Worry About

Netflix (NASDAQ: NFLX) delighted investors with better-than-expected subscriber growth in the second quarter. The streaming-video service continues to attract new subscribers both domestically and abroad even as it's raised its pricing. Netflix points to its original content as a key driver of that subscriber growth, and it's investing heavily to create new originals every month.

But all those originals come at a cost. Not only do they factor into Netflix's monstrous $6 billion annual content budget, but Netflix has to pay out of pocket for all that content, leading to significant cash burn. Netflix management expects negative cash flow between $2 billion and $2.5 billion for 2017, and it expects negative free cash flow for "many years" to come.

That may concern some, but Netflix investors have nothing to worry about.

Balancing costs and subscriber growth

The important thing for Netflix investors to remember is that the push into original content is made to drive subscriber growth. The company could slow the growth in its number of productions, but it's seeing a strong enough return right now to justify investing more cash upfront. The biggest difference between producing originals and licensing content from other media companies is that Netflix is able to exercise even greater control over its content budget.

When Netflix agrees to license a series or all of Disney's (NYSE: DIS) films, for example, there's a certain level of uncertainty that Netflix simply can't account for. It doesn't know how many films Disney will release next year and it doesn't know how long a certain series will run, but it's agreed to license every film and episode. Netflix says this uncertainty adds another $3 billion to $5 billion in content costs over the next three years that don't appear anywhere on its balance sheet or even its off-balance-sheet content commitments.

With originals, Netflix has a lot more control over the costs, but it has to pay those costs now. Still, those costs end up being more efficient in the long run as Netflix is able to leverage its successes by renewing popular series, and it can quickly cut its losses with series that don't work out. It also retains the global streaming rights to most of its productions indefinitely, and it controls the intellectual property of those it produces in-house. Netflix doesn't have those luxuries with long-term licensing deals.

Netflix will continue to step up originals

Disney recently announced plans to stop licensing some of its films to Netflix beginning in 2019. While that presents a major blow to Netflix, the company has some time to find content that appeals to the same audiences as Disney does. The streaming video leader will likely look to original productions to fill the gap (although it's already approached Disney for Marvel and Star Wars films).

That means a bigger investment in original productions every year so long as the subscriber base continues to grow to support it. Netflix will continue to burn cash for the foreseeable future, but the growth of its content expense ought to slow as it moves to more efficient original content spending.

The debt concern

The one concern left is that Netflix is using debt to fund its push into original content. Management writes off the concern by noting its debt-to-market-cap ratio is well below other media companies'. And while that's true, it's somewhat misguided considering Netflix's stock isn't valued the same way most media companies are valued. Netflix is valued like the growth stock that it is.

As Netflix takes on more debt to fund new originals, it's also taking on more risk. So far that risk has paid off in better subscriber growth than anyone likely imagined four or five years ago when Netflix was just getting started in originals. But as long as investors understand the risks in an investment like Netflix, there's not really much to worry about with the increasing debt load.

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