Netflix Will Be More Profitable Than You Think

Netflix Inc. (NASDAQ: NFLX) did it again. For the umpteenth time in recent memory, the streaming champ this week blew past earnings estimates, sending the stock soaring again. Shares are now up 131% over the past year, giving the company a market cap of $144 billion, which puts it within breathing distance of Walt Disney Co., the world's most valuable entertainment company.

The first-quarter report featured the usual blowout numbers as revenue surged 40.4% to $3.7 billion, its fastest quarterly sales growth since 2011 thanks to a recent price hike, and it added 7.4 million new subscribers, nearly matching its record of 8.3 million in the previous quarter. Two million of those new members were from the U.S., while 5.5 million sign-ups came from abroad. Once again, a heavy slate of new original content seemed to drive subscriber growth.

However, the most impressive part of Netflix's earnings report was its rapidly improving profit margin. Operating margin jumped to 12.1%, due in part to the timing of content spend, and management said full-year operating margin would be 10%-11%, its best ever. While Netflix's earnings multiple is still sky-high due to the stock's rapid growth, it's becoming clear that Netflix will be solidly profitable, with double-digit margin that should continue to get wider. Here are three reasons why.

1. The strength of the subscription model

A tried-and-true business strategy, the subscription model has been around for centuries. Rather than try to sell an individual product multiple times, the subscription provides a business with a steady cash flow that will support it, and helps locks consumers into the service.

More importantly, the subscription model in a business like media gives the company significant operating leverage. That's because the cost of the product is the same no matter the number of customers. Ttherefore, the revenue from each incremental customer essentially goes directly to the bottom line. With 125 million subscribers, Netflix exemplifies the model's success.

While analysts have made much ado about the company's rapidly growing content spending, subscriber numbers are climbing just as fast. Netflix plans to hike content spending from about $6 billion last year to $7.5 billion-$8 billion this year, or 25%-33% more, but subscribers have increased 26.6% in the last year and revenue jumped 40.3% in that time. Content spending will eventually plateau, and as it does, profitability will accelerate thanks to the power of the subscription model since Netflix won't have to spend any extra dollars to serve those new customers.

2. Customers don't leave

Netflix doesn't report churn, or the percentage of subscribers who leave the service each quarter, but we can guess that the figure is low -- for a number of reasons.

First, Netflix offers users tremendous value as they pay just $11 a month for access to thousands of shows or movies from the nearest smartphone, tablet, or TV. Subscribers watch about an hour on an average day, meaning they pay just $0.37 per hour for the service. Netflix has also increased its prices twice on domestic users in recent years, from $8 a month all the way to $11, but user growth barely flinched. In fact, Netflix has been steadily adding 5 million-6 million domestic accounts since it separated the streaming service from the DVD one in 2011, and it looks set to do so again this year.

That's evidence of the company's enviable pricing power. If customers were on the fence about the service, price hikes would cause them to cancel. Instead, it just allows Netflix to add new content attracting even more subscribers. The ability to raise prices will also help it grow profitability.

3. The opportunity is huge

Netflix's consistent growth in the U.S. also demonstrates something else: that the company is just beginning to tap into a huge opportunity in streaming. It's looking like the modern-day cable service, which once reached more than 100 million American households. Netflix said it expects to reach 60 million-90 million U.S. households, but it could exceed that goal, especially if it keeps spending on quality content.

We've already seen that competition is essentially moot as Netflix CEO Reed Hastings predicted. There's room in the market for plenty of services, and since each one of those services typically has exclusive content, consumers see all of them as complementary rather than mutually exclusive choices. Plenty of Americans, for instance, subscribe to a number of similar services including Netflix, HBO Now, Amazon Prime, and Hulu. While some analysts have made noise about the incoming threat from Disney, it's unlikely to draw subscribers away.

Internationally, where Netflix completed its global launch just two years, we're only starting to see the company's potential. It already has nearly 70 million subscribers abroad and profitability is just starting to ramp up. As the company expands into the massive video entertainment market, profits will surge along with it. Spending growth will eventually slow, but its subscriber base should continue to steadily expand.

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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. Jeremy Bowman owns shares of Netflix. The Motley Fool owns shares of and recommends Amazon, Netflix, and Walt Disney. The Motley Fool has a disclosure policy.