One of the common criticisms toward Netflix (NASDAQ:NFLX) is that while NFLX stock has a market cap of $160 million, Netflix itself is burning cash. To many investors, that alone suggests that Netflix stock is overvalued.

While I’ve argued NFLX indeed is priced too high (and been wrong so far, even with the stock dipping after Q2 results last week), that’s too simplistic a view. Netflix’s free cash flow is being pressured by a staggering amount of investment in content — some $8 billion this year alone.

Fundamentally, that spend is — if all goes to plan — an investment, not necessarily a sign that the business “can’t” generate positive free cash flow right now.

Spending $90 million on the Will Smith movie Bright hurts free cash flow in 2018. But it creates content that Netflix will monetize for decades to come — for free. Netflix could let studios make the movies and then pay them to license them. That model, however, means less control and less profits long term (again, assuming all goes to plan).

Qualitatively, that spend is designed to create a competitive “moat” around the Netflix business. If Netflix has more content than anyone else — and/or better content — then it becomes the primary destination for viewers.

It means Amazon.com (NASDAQ:AMZN), Hulu or the newest entrant, Walmart (NYSE:WMT), can’t become more than a secondary player. That in turn gives Netflix pricing power and future cash flows that more than justify the current spend on content.

That’s the plan, anyway. And that’s why I wrote back in March that the success of the content strategy is the most important factor affecting NFLX stock going forward. I still believe that’s the case, and I’m still not sold on it working long term.

The Quality Question

An excellent Vulture essay back in February highlighted the potential Achilles heel of Netflix’s content strategy. As author Kevin Lincoln pointed out, the six biggest U.S. studios released 94 movies in 2017. Netflix alone is releasing 80, and perhaps even more staggeringly 700 (seven hundred!) original TV shows.

From where are those 80 films coming? As Lincoln points out, that type of volume requires Netflix to find scripts that those studios have passed on.  And he argues that Netflix “ignores a crucial feature of the film industry: by and large, however perfectly or imperfectly, the good scripts tend to get made.”

It simply may be that there aren’t 174 good movies — or 124 good movies — out there to be made. Walt Disney (NYSE:DIS), Twenty-First Century Fox (NASDAQ:FOXA, NASDAQ:FOX) and Sony (NYSE:SNE) know what they’re doing, if it doesn’t always look like it.

And without theater distribution or big budgets (though Bright did cost a reported $90 million), Netflix would be left with essentially second-tier scripts and perhaps directors and actors as well.

The Quality Response

But a June feature on the same site takes a different viewpoint. “Inside the Binge Factory” details the inner working on Netflix’s content division, with some surprising revelations. (Among them: the company has an “extraordinarily decentralized production and development pipeline,” particularly in an industry known for consolidating power in top executives.)

That feature highlights what may be Netflix’s edge: data. As Josef Adalian writes:

“When Netflix adds content, it lures new subscribers and gets existing ones to watch more hours of Netflix. As they spend more time watching, the company can collect data on their viewing habits, allowing it to refine bets about future programming.”

“‘More shows, more watching; more watching, more subs; more subs, more revenue; more revenue, more content,’ explains Ted Sarandos, Netflix’s chief content officer.”

Netflix simply may be better than the studios. In fact, it benefits from some of the trends in the content space. Most notably, audiences continue to fragment. That’s bad news for traditional studios (in both movies and TV) looking for blockbusters. It’s easy pickings, however, for a company that can define viewer preferences and deliver content tailored to them.

NFLX Stock and Q2 Earnings

The debate over Netflix’s content strategy helps explain why NFLX stock seems detached from the fundamentals. It actually does trade on the fundamentals, but the most important fundamental is the subscriber count, not the near-term profitability.

For bulls, Sarandos’ explanation makes perfect sense. The more subscribers in Q2 or Q3 2018, the more cash flow in 2021, 2025 and 2035.

By that logic, spending on content now to get those subscribers is a high-return investment. In a Netflix largely driven by owned content, additional revenue generated by new subscribers, or existing subscribers that don’t defect to rivals, has enormous incremental margins.

The cost of serving an additional subscriber is minimal, but that subscriber pays the same rate as those currently supporting the platform.

Of course, that’s also why investors dumped NFLX stock after Q2 earnings. The earnings beat ($0.06 ahead of consensus) didn’t matter. The subscriber figure did. U.S. growth disappointed by the company’s own admission. And that disappointment came at the same time that Netflix is ramping its spend to extend its dominance in the domestic market.

And that’s a big problem for NFLX stock. Because the content strategy only works if the $8 billion of new content is attracting a heavy stream of new subscribers.

Netflix content has to get to the point where most consumers can’t live without it — and maybe can live with nothing else. If it costs $8 billion a year just to keep existing subscribers happy, then Netflix really is just burning cash. NFLX will not be valued at $160 billion, or close, for very long if that’s the case.

As of this writing, Vince Martin has no positions in any securities mentioned.