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What Is Netflix, Inc.'s Competitive Advantage?

Netflix (NASDAQ: NFLX) investors have been on a thrill ride for years. Even after a 10% correction when the streaming-video veteran fell short of its subscriber guidance last week, the stock still has doubled over the last 52 weeks.

The stock is trading at 218 times trailing earnings and 13 times sales right now, putting Netflix firmly in the category of premium-priced market darlings. The gains and the extreme valuation ratios are based on rampant business growth. The company more than quintupled its second-quarter earnings compared to the year-ago period, and revenues are rising at a 40% annual pace.

So how is Netflix making all of this work in an entertainment market full of hopeful challengers and fading has-beens? Let's have a look at three key components of the company's recipe for success.

Image source: Getty Images.

You have to spend money to make money

Some critics worry about Netflix's cash-burning habit. Free cash flows clocked in at negative $1.78 billion over the last year, forcing the company to take on $3.5 billion of new debt. The main driver of these huge cash costs is found in Netflix's growing content-production efforts.

Netflix is investing a larger and larger portion of its total content budget into original shows and movies, moving away from the earlier strategy of licensing content under ownership by other studios. The idea is to build a content portfolio of lasting value, which comes with large upfront cash costs but should keep subscribers coming for many years ahead.

There will be an inflection point a few years down the road when this strategy starts to pay figurative dividends, driving enough member growth and loyalty to outweigh the new content costs. Tax-saving accounting tricks, like depreciation and amortization, don't figure into this entirely cash-driven tactic.

This is not a new idea, just a slightly unusual application of a well-known growth strategy. Startups collect venture capital and big debts in their early years to build a platform for rapid growth, followed by profits later on. Netflix is a bit old for the start-up tag, but this is the same basic idea. It's just happening at a greater scale, since Netflix is attempting to boost itself from a platform that has already achieved $13.9 billion in annual sales.

Content is king

The company isn't throwing together some cut-rate videos and hoping for the best. Those billions of annual content-production dollars are bringing in top-shelf writers, directors, and actors with free reins to do their best work. The result is an award-winning content portfolio, including a leading haul of 112 nominations for the 2018 Emmy Awards.

For the first time in 18 years, the studio with the most nominations wasn't named HBO. It was Netflix.

Netflix is seen as a high-quality entertainment platform today, similar to how HBO built its top-shelf reputation in the golden age of premium cable networks. Consumers know exactly where to find favorites like 13 Reasons Why, Stranger Things, and The Crown. These are Netflix's answer to HBO classics such as The Sopranos and Game of Thrones. New subscribers on the hunt for Netflix's best eyeball magnets are likely to find more exclusive content that keeps them coming back for more.

Hence, the big production budgets. Netflix wants its original shows to pay big dividends over time and that takes quality -- expensive quality.

Image source: Netflix.

Simplicity for the win

None of the cash and content positioning matters if nobody wants to use the Netflix platform. This is perhaps the most subtle and underrated aspect of what makes Netflix special -- perfecting the user experience is priority No. 1.

Whether you're accessing Netflix from a smartphone, tablet, laptop, or big-screen TV, you'll find a strikingly simple interface. Poster thumbnails will help you navigate through a sorted and categorized catalog where the presentation is driven by your viewing habits. If you like action thrillers starring The Rock, you'll see more shows of a similar style in your Netflix panels. Prefer Norwegian zombie comedies or reality TV cook-offs? Netflix will drive you toward more stuff in those categories instead.

And at the heart of that effort stands simplicity. Hulu blends advertising into its content streams, hoping to collect additional revenue that way. By the same token, Amazon.com (NASDAQ: AMZN) Prime Video can be frustrating as the e-tailer often tries to steer the viewer toward buying Blu-rays or downloads for content that isn't included in the Prime subscription service. You won't find Netflix doing any of that.

The company removed online ads from its website many years ago because the additional revenue pennies weren't worth the resulting viewer distraction. The red DVD mailers used to carry third-party advertising on the inside flap, but even that disappeared over the years.

I kind of miss the "advanced search" function that Netflix previously provided, but most subscribers never used it -- so it's long gone now. And that's the way it goes. Anything that doesn't help subscribers focus on the actual content won't stick around for long.

That's a winning strategy. The competition might want to try it out eventually, but they're not ready to abandon their add-on revenue streams quite yet. Until they do, Netflix stands alone as a paragon of dead-simple entertainment.

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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. Anders Bylund owns shares of Amazon and Netflix. The Motley Fool owns shares of and recommends Amazon and Netflix. The Motley Fool has a disclosure policy.

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