Is Netflix Widening Its Moat or Spending Like a Drunken Sailor?

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The above quote came from Netflix (NASDAQ: NFLX) CEO Reed Hastings during the company's recent third-quarter conference call, when he was asked about Netflix's projections for negative free cash flow this year and next. Netflix's stock is the subject of much debate. Bulls see it as a leader in streaming video with a widening moat, while bears see only $3 billion to $4 billion in negative cash flow, with guidance for a similar $3 billion to $4 billion negative cash flow in 2019.

In spite of increased losses and a seemingly expensive stock price, Netflix continues to fund its aggressive content and marketing spend with debt. Netflix's long-term debt load has ballooned to $8.3 billion, and will probably increase even further in the year ahead.

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Where is all this money going, and will it pay off?

Throwing Hail Marys

Legendary cable investor John Malone once described Netflix's business plan as "throwing Hail Marys and then growing into them," and that's an apt description of what Netflix is doing. By virtue of its first-mover advantage in global streaming and large reinvestment in content, Netflix's subscriber count has surged to 137 million (good for a 25.5% year-over-year increase), and the company expects to continue growing, guiding for 146.5 million global subscribers by the end of 2018.

That huge subscriber base is Netflix's biggest advantage, allowing the company to continue investing in more and better content, which in turn generates more subscribers in a virtuous circle.

Staying ahead of the pack

Netflix is fully aware that success shouldn't be taken for granted. Competition is coming down the pike from the likes of Amazon, Disney, and AT&T, with the latter recently unveiling its new three-tier streaming platform.

That's why, although Netflix claims it's profitable based on GAAP earnings (in which content spend is depreciated over time), the company continues to invest all of its profits -- and then some -- into original content.

Still, if the company is gaining so many subscribers year over year, and has also raised prices to boot, why aren't its free cash flow losses narrowing?

Building its own library

One of the primary differentiators between Netflix's current spending and its past is that the company is beginning to produce more and more of its own content. Previously, Netflix acquired the majority of its content through licensing deals. Even a "Netflix Original" like Orange Is the New Black is actually licensed from Lions Gate, though Netflix has exclusive rights to distribute new first-run episodes.

It's akin to the difference between renting and owning a house. Buying takes much more upfront cash, but it's ultimately more valuable to own the asset rather than making rental payments until the lease is up.

Management outlined this phenomenon in the company's recent letter to shareholders:

Netflix started investing in lots of cheaper non-scripted content such as Queer Eye, Fastest Car, and others, but is now really stepping up its content game, investing in an entire production hub in New Mexico.

It's also what led to the blockbuster deals for proven hit makers such as Shonda Rhimes ($100 million), who Netflix lured away from ABC, and Ryan Murphy ($300 million), who Netflix lured away from AMC Networks. Netflix is also luring premier filmmakers such as the Coen brothers, Martin Scorsese, and Paul Greengrass to premiere their films on Netflix as opposed to the traditional theatrical release. "What we're finding is that people want their films to find an audience, and that they're in a better position to do that with us than without us," said Ted Sarandos, Netflix's chief content officer.

Reasons to be bullish on Netflix's strategy

Unless you have the brand strength of Disney, streaming services need to attain a reputation for continual great content to attract and keep subscribers. With a bigger subscriber base, Netflix is giving itself more and more swings at the plate and paying up for the best talent. With its current lead, I think Netflix is going to be pretty hard to displace.

Don't be scared of the negative current cash flows -- Netflix's future looks bright.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Billy Duberstein owns shares of Amazon, AT&T, Netflix, and Walt Disney and has the following options: short January 2019 $125 calls on Walt Disney. His clients may own shares of some of the companies mentioned. The Motley Fool owns shares of and recommends Amazon, Lions Gate Entertainment Class A, Lions Gate Entertainment Class B, Netflix, and Walt Disney. The Motley Fool recommends AMC Networks. The Motley Fool has a disclosure policy.