- Huge expansion in upfront spending in international markets means that Netflix will continue to register negative free cash flow.
- The management may seek to raise additional money from debt markets to cover for the cash flow deficit.
- Wall Street still values Netflix shares based on subscriber growth, but the company needs to address free cash flows.
Netflix (NSDQ:NFLX) started out as a small DVD by mail service in the United States in 1997. Since then, the company has expanded big time into a streaming media provider in both the United States and abroad.
Netflix eventually embarked on international market expansion in 2010, offering subscriptions in Canada and has accelerated its exposure to more than 190 countries now. The strategy seems plausible noting that the growth lies in non-US subscribers over the coming years. In fact, IHS Markit expects the international subscriber count to exceed Netflix's US subscriber base by 2018 when Netflix will have 75 million international subscribers. As of Q2 2016, the company finished the quarter with over 83 million total subscribers.
Fast forward to 2020, the report mentioned overall revenues are expected to reach $13 billion where $7 billion will come from the international segment, and the remaining $6 billion from the US.
In tandem with this expansion plan, the company has gradually invested in its content library. The company has recorded substantial losses in the last few years, and part of the reason is that they have invested in content, a huge upfront investment.
Further, it still needs to aggressively invest in marketing costs outside the United States. After all, most international markets do not follow the “if you build it, they will come” mantra. Additionally, it also needs to invest in local content in a particular country to solidify Netflix’s appeal in a local market.
As shown in the below table, international markets showed accumulated losses of $350 million for the last 4 quarters. Consequently, free cash flows have also been negative racking up a deficit of $1 billion. This is expected to continue, considering that Netflix is reportedly expected to spend $6 billion on content in 2016 and $1 billion on marketing. Despite this, investors need to take a longer view considering that these costs are somewhat upfront in nature, and the benefits are spread out over a longer period. Also, as soon as Netflix’s international business reaches economies of scale, revenues could eventually end up exceeding these costs.
One should also note that the company faces various additional challenges in certain geographies which it will also need to address. It's likely that Netflix will need to make additional investment into those international markets to overcome challenges like language barriers and underdeveloped payment processing infrastructure.
Growth Isn’t Free, Netflix Needs to Raise Money
Netflix's management has reiterated that it will continue to invest in content and exclusive rights. Since free cash flow has continued to be in the negative territory, it needs to source the cash flow deficit from debt markets in 4Q 2016 or early 2017 as disclosed by the company.
It is important to highlight that the company exhibits financial flexibility with net debt to equity ratio of 0.41 as of the end of 2Q 2016. This means that there is a strong possibility that they could cheaply source funding through debt markets rather than equity, thus minimizing the risk of equity dilution to existing shareholders. Incremental debt of $1 billion (i.e., equivalent to free cash flow deficit) would keep the net debt to equity ratio acceptable at around 0.82.
Markets Fixated on Subscriber Growth But…
Subscriber count has increased from 27 million in Q1 2012 to 83 million in Q2 2016 driven by the expansions into international markets. Its share price has also risen in a similar fashion from $12 in January 2016 to the current levels of around $97, suggesting that the key driver for Netflix stock is the company’s continued growth in subscriber count.
Over time, the company needs to address the cash flow deficit issues sooner or later as it enters into a maturity phase. Otherwise, the market will need to re-evaluate its lofty current valuations of more than 300 times earnings.