Jan 24, 2018 ยท 5 minutes

As investors ride into the first wave of tech earnings reports in 2018, there is a weird mix of optimism and unease.

From a financial perspective, the prospects for big tech look as bright as ever. And yet, there is this nagging undercurrent that something, sometime has got to give.

While there may be some smaller tech companies that are struggling, to be big in tech these days is to be fat with profits and stock gains. The Nasdaq is up 39% in the past year with the big four – Facebook, Apple, Alphabet and Amazon – all outperforming the index with gains between 48% and 82%. At the same time, there is a growing sense that a stock market that sets record after record can't keep it up forever. Just as there is a disconnect between the financial success and the moral backlash tech is facing, which also can't last long.

This is why Netflix is such an interesting case study. The stock's 102% rise in the past year is better than that of any of the Big Four. Netflix has typically been the first notable tech name to report earnings each quarter. It performs well even, as in the previous quarter, when it fell short of earnings estimates. When it exceeds growth expectations, as it did in the most recent quarter, it shoots higher. Netflix rose 10% Tuesday by doing just that and is up another 3% today.

Reading through Netflix's letter to shareholder and listening to its executives chat in the earnings call, there's a lot for investors to celebrate. Netflix raised its monthly subscription rate last quarter – by $1 to $10.99 for its most popular plan – and yet the number of net new subscribers in the US and abroad exceeded Netflix's and Wall Street's estimates.

Netflix saw 8.3 million new subscriptions, above the expected figure of 6.3 million. Average hours streamed per account rose 9% last year. With that kind of growth, along with the higher fees, revenue grew by 33% to $3.29 billion in the quarter. Operating profit rose even more, by 59 percent to $245 million.

This is encouraging because, longer term, Netflix is going to need to finance its hefty investments in home-grown content by its own profits. Right now, Netflix is relying mostly on long-term debt, which will become more costly to maintain if interest rates continue to head higher.

The thing is, to get more people to pay more to watch more Netflix, the company needs to keep spending more money – currently around $8 billion a year – on content. And that is causing it to burn through enough cash at an Uber-like pace. Netflix's free cash flow was negative $2 billion last year, and will come in between negative $3 billion and negative $4 billion this year.

Netflix is increasing spending on new content at a rate faster than it's signing up new subscribers. And that, despite the celebration this week about Netflix earnings, leaves you wondering how long this can last. Something's got to give, the question is when.

There are a few reasons why bulls are rushing to Netflix's defense. One is that during the company's 20-year history, it's often proven naysayers wrong by shrewdly anticipating long-term changes in its market. Some questioned the wisdom of shifting from DVDs to streaming, but Netflix saw a huge market shift coming before anyone else. Others worried about its push to creating its own shows, or its expensive expansion into Latin America and Asia. Both of those risky moves are also looking uncannily prescient.

There have been concerns for years of market saturation as well. But as CEO Reed Hastings said on the earnings call, Netflix predicted five years ago that the US market would top out between 60 million and 90 million subscribers. Despite the strong growth in US subscribers, Netflix is still at only 55 million accounts. “So we've got a ways to go just to cross into the bottom of our expectation range,” he said.

The key to sustaining new signups is big titles, like Stranger Things and The Crown and even the critically panned Bright, which Netflix insists was a popular success in all of its regions. “That’s what pulls in people who haven’t yet joined as all their friends are talking about the shows,” Hastings said. “That’s the dominant accelerator.”

Analysts bullish on Netflix call this its virtuous circle. And it's why they were more than pleasantly surprised that higher prices didn't slow down subscriber growth. “Our responsibility is then to take that increased revenue and turn that into even better content. That’s the fundamental deal,” Hastings said. “And consumers are tolerant as long as something’s improving.”

The thing about an accelerator is that it drinks up a lot of gas. The harder you press it, the more gasoline you need. Netflix's fuel has been a low cost one: long-term debt. As long as interest rates remain low, that's not much of a problem. Netflix's long-term debt nearly doubled last year alone to $6.5 billion. Moody's said last fall that that's not a big concern as long as Netflix's operating profits grow enough to pay off the debt.

But if interest rates rise high enough, Netflix may find it harder and more expensive to take out new debt to keep the virtual circle going. Again, if profits grow fast enough, that may not matter. If they don't, Netflix will need to either raise subscription fees or dial back on content spending, if not both. Either approach could add to cancellations, throwing the virtual circle out of whack.

Asked about this, chief content officer Ted Sarandos said, “We keep investing forward based on the confidence of how we’re doing. And at some point if we’re not growing viewing hours or not growing subs or not growing enjoyment, then you’ve hit a point of diminishing returns. We just haven’t seen that yet.”

So Netflix keeps investing heavily. After all, it's a leader in a market that's growing around the world, thanks to its bold investments early on. Now it's investing even more aggressively to strengthen its position. Amazon, Google and Disney are also making big moves in the streaming-video market Netflix pioneered, so right now is the company's best chance to build its lead. It all depends on a lot of moving pieces moving just the right way for the next few years.

All that explains why investors think the company is worth $108 billion, but there remains this underlying question of: How long can things work this well? In different ways, that is the question that is going to be asked throughout this earnings season. It's starting off with investors in a cheery enough mood. But high valuations and the length of this tech rally mean if things do turn, they will turn quickly.