Factoring Credit Risk Into The Netflix, Inc. Thesis

  • Netflix is planning to increase its debt from $2.37 billion. The debt is going to be used in creating and acquiring new content.
  • For this to succeed, Netflix's investment in original content needs to be able to create long-term shareholder value.
  • Long-term shareholder value relies on Netflix stock price appreciation. But this might not happen.

Netflix's Debt Conversation

In the Q4 2015 shareholder letter under the subheading "Free Cash Flow and Capital Structure", Netflix (NSDQ:NFLX) reminded investors of the capital intensive nature of its investments in original content. Netflix currently has more than enough cash to cover its interest payments. It currently has $2.37 billion in debt and $2.31 billion in cash, as of the most recent quarter.

But the company mentioned that given their expected cash needs relative to required investments, Netflix is "likely to raise additional debt in late 2016 or early 2017."

"Free cash flow amounted to ‐$276 million in Q4 and ‐$921 million for the full year 2015. As a reminder, our investment in originals, particularly owned content, requires more cash upfront relative to licensed content, which will continue to dampen free cash flow. We finished Q4 with debt of $2.4 billion, unchanged from the prior quarter, and with cash & equivalents and short‐term investments of $2.3 billion. Given our expected cash needs, we are likely to raise additional debt in late 2016 or early 2017. We are managing our balance sheet to lower our blended cost of capital over time, while maintaining financial flexibility. Despite being FCF negative as we grow our original content and invest in international, our bonds trade like a BB credit (vs. their single B rating) due, in part, to the long‐term growth of Internet TV globally and our low debt to market cap ratio, which provides bond investors with a very thick cushion of protection." - Netflix's Q4 2015 shareholder letter

Netflix will need external cash infusion to support its accelerated original programming. For instance, Netflix is planning to have 600 hours of original programming in 2016. Netflix's chief content officer was quoted saying, "We're going to spend in 2016 about $5 billion on content on a P&L basis, which means about $6 billion in cash."

"I mentioned a couple weeks ago, we’re going to launch 600 hours of new original programming this year alone. So it is a function of as our budget continues to grow, as our subscriber base grows, we are licensing programming and we are creating programming." - Netflix's Q4 2015 earnings call transcript.

"The increase in ARPU will allow us to invest more in content next year, and we are taking up our expected spend from about $5B in 2016 to over $6B on a P&L basis in 2017 (more on a cash basis)." - Netflix's Q1 2016 shareholder letter.

At the end of Q1 2016, Netflix reported having "cash and equivalents totaling $2.1 billion." implying that if Netflix is planning to spend around $6 billion to launch the "600 hours of new original programming this year (2016) alone," they will need north of ~$3.9 billion in cash (the $6 billion - $2.1 billion) to fund their plans. But because Netflix had $6.78 billion in trailing twelve months (TTM) revenues, any debt in the $3-$5 billion range would still not raise any red flags. This is because the company is capable of generating enough cash to cover interest payments.

The near-term additional debt is not very concerning, but what investors might want to pay attention to instead is how long it might take Netflix to recoup such high levels of cash infusion. If "about $5 billion on content on a P&L basis" means "about $6 billion in cash", then "over $6 billion on a P&L basis in 2017" implies more than $8 billion in cash.

The $6 billion in cash for 2016 and the $8 billion in cash for 2017, would mean that Netflix needs to continuously borrow money in the near-term since its total cash available of $2.1 billion is unlikely to increase by 186% in 2016 and 281% in 2017 to cover the $6 and $8 billion cash needs.

"With respect to un­grandfathering, currently, more than half of our US members pay only $7.99 or $8.99 for our $9.99 HD 2 ­screen plan. We will phase out this grandfathering gradually over the remainder of 2016, with our longest ­tenured members getting the longest benefit. To reinforce brand trust, we won’t change anyone’s price without their acknowledgement of the new price in their member experience, where they will see a dialogue box about their options. Members can choose our $7.99 SD 1­ screen plan, our $9.99 HD 2­ screen plan or our $11.99 UHD 4 ­screen plan. We are rolling this out slowly over the year, rather than mostly in May, so we can learn as we go. Most of our grandfathered members are in the US, but we’ll take the same approach internationally.

We expect only modestly increased churn from un­grandfathering, partially because these members have been with us for a reasonable period already, and because our content continues to improve. The increase in ARPU will allow us to invest more in content next year, and we are taking up our expected spend from about $5B in 2016 to over $6B on a P&L basis in 2017 (more on a cash basis)." - Netflix's Q4 2015 shareholder letter

But what happens beyond 2017 when subscriber growth starts to decline due to increased competition and declining international subscriber growth rates? Will Netflix continue to borrow more money for content creation and acquisition? What will be the effect on the company's stock price when it can no longer sustain the historical double-digit growth rates? If that happens, its credit risk might start to increase and its credit ratings might be downgraded. These risks might hinder Netflix's stock price appreciation in the long run.

Netflix's Big Bet

Netflix's aggressive investments in original content are based on the idea that more content will help them retain and attract users, and penetrate into new markets. And original content can do so much more. Original content enables Netflix to maintain dominance over online video streaming. It is also a great value proposition for consumers. This is because having more content makes Netflix appeal to anyone and everyone. It gives people variety and reasons to come back.

However, Netflix is not the only game in town. Its competitors such as Amazon, Hulu and HBO have enough capital to also aggressively create and acquire original content. This is problematic because Netflix's high valuation hinges on its ability to sustain its double-digit subscriber and revenue growth rates. This article has more information on whether Netflix can sustain its steep valuations amidst competition.

But if growth deteriorates, Netflix's capital intensive investments in original content might not generate good returns for shareholders.

Conclusion

One of the counter-arguments to this thesis is the fact that Netflix has managed to outperform street expectations for a very long time. For instance, Netflix's initial plan to takeover traditional TV was once considered unrealistic. There was no way a company like Netflix could disrupt an industry that has enjoyed growth for years. An industry with powerful players. But Netflix managed to achieve the impossible. Meaning it is possible that adding more debt will not affect Netflix's credit ratings. It is also possible that the new competitors will have less material impact on Netflix growth rates.

But Netflix is a company, nonetheless. More debt has been detrimental to companies like Valeant that were once considered cash machines with outstanding growth rates. In addition, competition is not something to take lightly. Giant's like Samsung lost market share to new competitors such as Xiaomi and Huawei. Consequently, bringing debt into the conversation should help long-term investors objectively evaluate the opportunity cost of being long Netflix amidst all the aforementioned uncertainties.

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Comments on this article and NFLX stock

user profile picture
usernamewhatx
neutral
Netflix has lost over 3.5 million users in the past week world wide due to their crack down on geo-blocking. It will be interesting to see exactly how much they lost next quarter. Pity the people whom own any share in netflix at the moment.
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user profile picture
PairWiseCapital
neutral
Hi usernamewhatx, thank you for sharing. That will not be good for shareholders considering the high growth subscriber expectations.
I have not found the exact number of users the company might lose. May you please share your source?
Do share this awesome post