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2 Huge Details You Probably Didn't Notice in Netflix's Q3 Report

Kudos to Netflix (NASDAQ: NFLX). Not only did the king of streaming pump up its per-share profits from $1.74 a year ago to $3.19 in the third quarter -- topping estimates of $2.56 in the process -- the company also added (net) nearly 4.4 million subscribers during the three-month stretch. Analysts were only expecting around 3.8 million new customers.

Sure, shares initially fell in response to disappointing guidance for the current quarter; returning to its pre-pandemic cadence of content creation means spending is up. The official corporate communication on the matter explains, "With production volume ramping successfully and a lower operating margin in Q4, we anticipate Q4 '21 FCF [free cash flow] to be negative." The shareholder letter goes on to say, though, "We continue to expect full year 2021 FCF to be approximately breakeven." Even so, that assuring message is undermined by Netflix's cautious qualification that this year's projected FCF breakeven is actually an ambiguous "plus or minus several hundred million dollars depending on the timing of production starts and related cash spending on content."

It's a lot for shareholders to digest, but with so much focus being placed on the current quarter's prospective spending, investors may be overlooking other more important nuggets of information. Here's a closer look at some of them.

The business can scale up, profitably

Six months ago (in response to its first-quarter update) I expressed concern that Netflix's profit surge wasn't sustainable. The bulk of its profit growth stemmed from a significant decline in marketing spending, but promoting a streaming service is relatively easy in the midst of pandemic lockdowns when bored consumers are largely stuck at home looking for new entertainment.

In retrospect, my concern was overblown. Not that the addition of 4.4 million subscribers is heroic, but last quarter's revenue growth of 16.3% was more or less matched by the 20.5% year-over-year uptick in marketing spending. Cost of revenue (original content as well as licensed programming) only increased 8.8%. Operating income improved to the tune of 33.4%, as relative/per-user costs declined.

Data source: Netflix. Chart by author. Dollar values in millions.

The disparate increases point to better fiscal efficiency. Margins are improving as the company's operation scales up with Netflix able to sell its video entertainment procured at a fixed cost to more and more paying subscribers. That hasn't always been the case for this company.

Netflix's strong engagement is about to be highlighted

Going forward, Netflix will no longer report the number of paying customers who watched a particular title. The company will instead switch to look at the total number of aggregate hours spent viewing each of its top shows or movies.

It's seemingly irrelevant on the surface. Regardless of how much or how little programming they may consume, Netflix's customers still pay the same rate for their respective packages. Besides, the hours-viewed data doesn't exactly indicate how competitive the streaming giant is compared to rivals like AT&T's HBO Max or Walt Disney's Disney+.

However, the move aligns with the metric increasingly being monitored as a measure of streaming services' success. And on this front, Netflix is crushing it.

Using Comscore data, market research outfit Lightshed reported that in June, Netflix's programming accounted for 26% of U.S. consumers' total streaming time. The next biggest streaming platform was Alphabet's YouTube with a time-spent share of 21%. Walt Disney's Hulu was a distant third with 13%, while Amazon's 9% topped Disney+ and HBO (including HBO Max) with shares of 4% and 3% -- respectively -- of total hours streamed during the month. Presumably, overseas markets are shaping up in a similar fashion with Netflix being the go-to service most of the time for many audiences.

Image source: Getty Images.

As was noted, Netflix's new hours-viewed disclosure won't necessarily tell investors something they couldn't have already guessed anyway. One could also expect Netflix to be the most popular service, since it also serves the largest customer base.

That's not quite the point, though.

See, this is a business that relies heavily on splashy titles like Netflix hit Squid Game and Disney's The Mandalorian. Streaming companies must have these powerhouse releases to draw a crowd, and Netflix has a bunch of them. For perspective, financial technology company Self says Netflix boasts about four times the amount of available programming as Prime or HBO Max do, with most of its content quality rated as "good" or "excellent." This is certainly evident in Lightshed's hours-viewed numbers.

This new metric will help investors better pinpoint exactly which of its originals are attracting and keeping paying customers.

The path forward

If you're a current or prospective Netflix shareholder, there's not as much to "do" with this information just yet as there is to "know." Know that Netflix's expectation for positive cash flow next year is credible in that it doesn't need to keep spending a fortune on marketing, nor a relative fortune on new programming. Also know total hours viewed is an increasingly important and tracked measure of a streaming service's success -- perhaps as much as subscriber counts -- since it points to a service's stickiness and perceived value. Just be prepared for the brewing rhetoric shift, which actually favors Netflix due to its broad selection of high-quality content.

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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. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. James Brumley owns shares of AT&T and Alphabet (A shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Netflix, and Walt Disney. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy.


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