When it comes to Netflix and its stratospheric (forward) valuation, the thesis is simple: the company is (so far) the undisputed leader in the arena of internet streaming. As the LA Times summarizes, the global streaming giant today boasts impressive stats: 104 million subscribers worldwide, up 25% from last year and almost quadruple from five years ago. Its series and movies account for more than a third of all prime-time download Internet traffic in North America. Its more than 50 original shows garnered 91 Emmy Award nominations this year, second only to premium cable service HBO.
However, as Howard Marks observed skeptically in his latest memo, this explosive growth has had to be funded, and in the case of Netflix, it has been through debt. In the last year, the long-term debt level has more than doubled to $4.84 billion. Four years ago, the level was at just half a billion dollars. It is here that flashing red flags have started to emerge for Netflix, which has accumulated a whopping $20.54 billion in long-term debt and obligations in its effort to produce more original content.
This is what Marks said last week:
In early May, Netflix issued €1.3 billion of Eurobonds, the lowest-cost debt it ever issued. The interest rate was 3.625%, the covenants were few, and the rating was single-B. Netflix’s GAAP earnings run about $200 million per quarter, but according to Grant’s Interest Rate Observer, in the year that ended March 31, Netflix burned through $1.8 billion of free cash flow. It’s an exciting company, but as Grant’s reminded its readers, bondholders can’t participate in gains, just losses. Given this asymmetrical proposition, any bond issue should be characterized by solidity and a meaningful promised return, not the sex appeal of its issuer.
Is it prudent to lend money to a company that goes through it at such a prodigious rate? Will Amazon or Google be able to loosen Netflix’s hold on its customers? Is it wise to buy bonds based on a technology position that could be overtaken? Positive investor sentiment has taken the company’s equity value to $70 billion; what would happen to the bond price if worries about rising competition took a bite out of that one day? Should you take these risks to make less than 4% per year? In Oaktree’s view, this isn’t a solid debt investment; it’s an equity-linked digital content investment totally lacking in upside potential, and it’s not for us. The fact that deals like this can get done easily should tell you something about today’s market climate.
It's not just bond investors who may rue they day they allowed NFLX to borrow money at less than 4%: there is a major risk for equity investors too. As David Ng writes, Netflix is burning through cash at a growing clip. The company is pouring money into expensive prestige projects. Its net cash outflow this year is forecast to grow to as much as $2.5 billion, up from $1.7 billion last year. Reflecting its growth, Netflix recently moved its Southern California headquarters into a 14-story building in Hollywood.
Just how much has Netflix spent to dominate the world of online streaming, and how much is this in the context of its biggest peers? The answer is shown in the chart below from UBS which estimates that to continue its growth, the cash flow negative company will have to spend some $8.7 billion in cash on new content, nearly $2 billion more than it did in 2016, and more than double what its nearest, and cash flow positive competitor, Amazon, is spending on new content.
Additionally, more than half of the $15.7 billion in Netflix’s streaming content obligations - including commitments to license content - isn’t reflected on it balance sheet. In its most recent quarterly filing, the company said it has $8.2 billion in off-balance-sheet obligations. The practice a well-known way for companies to paint a rosier financial picture than is the case.
For now, Netflix - having literally thrown billions of dollars at the problem - has managed to drown any skeptics. But some industry experts are warning of a Netflix bubble that may burst if the company fails to produce enough hit series to keep attracting new subscribers. “Nobody is ever the dominant player forever,” said Mike Vorhaus, president of Magid Advisors, a media and digital video consultancy quoted by the LA Times. “I think they're going to need some luck in not drowning in debt in the ultimate slowdown of growth.”
That won't happen for a while: Netflix’s strategy is to invest more and more on self-produced original series such as the ’80s-themed “Stranger Things” and the kid-centric “A Series of Unfortunate Events.” The goal, executives say, is to increase the portion of self-produced originals to 50% of its slate in an effort to own more of the shows on its platform.
Which means Netflix will spend even more on future content: "That's a lot of capital up front, and then you get a payout over many years,” Chief Executive Reed Hastings said in a recent investor call. “The irony is the faster that we grow and the faster we grow the owned originals, the more drawn on free cash flow that we'll be.”
And the greater the reliance on debt, and the bigger the leverage.
Some additional details on the biggest use of cash by the online video streaming company:
A big chunk of Netflix’s expenses goes to licensing TV series and movies. Many of Netflix’s most popular and acclaimed shows are licensed from other studios despite being marketed as “Netflix Originals.”
In fact, some of the best-known shows on Netflix aren’t made by Netflix. “Orange Is the New Black” is produced by Lionsgate, and “House of Cards” comes from Media Rights Capital, an independent film and TV studio. “The Crown” is a Sony Pictures Television production, while “Iron Fist” is a Marvel creation.
Netflix pays undisclosed licensing fees for the exclusive rights to stream these shows. And many of those fees are expected to rise over time as TV networks — which have grown increasingly wary of Netflix — look to protect their business from further erosion. A growing number of consumers are bypassing linear TV in favor of streaming services like Netflix.
Netflix is investing more money into self-produced originals in hopes of becoming less dependent on outside studios.
But bearish experts say building a catalog of must-see titles can take years, even decades, and requires an enormous cash outlay. HBO has created numerous hit shows, including “Game of Thrones,” but more than half of the content consumed by the cable giant’s subscribers is still licensed from its content partners.
Netflix' biggest skeptic, Wedbush Morgan analyst Michael Pachter, believes that it is only a matter of time before the house of cards comes crashing down:
“I don’t believe Netflix is going to get this right at a better rate than anyone else,” said Michael Pachter, a Wedbush analyst who has long been pessimistic about the company. He said his “underperform” rating on Netflix shares has been wrong in the past but believes the company’s lavish spending will eventually catch up to it. “I think it is kicking the can down the road and a looming write-down is coming,” he said.
Meanwhile another major problem looms: saturation.
Wall Street treats Netflix’s subscriber growth as the key indicator of future health, and as the U.S. market gets closer to saturation, executives will be under greater pressure to seek new viewers elsewhere. But foreign subscribers are more expensive to acquire than domestic ones. Much more expensive.
Still, for the first time, Netflix counts more overseas subscribers than domestic ones, with 52 million subscribers outside the U.S. Titles such as the movie “Okja” from South Korea and the series “3%” from Brazil are designed to appeal to both local audiences and viewers worldwide. Netflix is excluded from China because of regulatory challenges, so it is looking to other Asian countries.
“With Asia, we've got a lot more to learn. We're really expanding a lot in India, Japan. We're figuring it out market by market,” Hastings told investors.
Meanwhile, Netflix is spending big bucks on courting A-list Hollywood talent, including new projects with Martin Scorsese, Sandra Bullock and Will Smith. “The Irishman,” which Scorsese will direct, comes with an estimated price tag of $100 million. The science fiction movie “Bright,” starring Smith as a cop in a dystopian Los Angeles, reportedly costs at least $90 million. Translation: add even more billions to the cash burn.
Netflix executives have downplayed the reliance on debt, saying that Netflix’s ratio of debt to total stockholder value is lower compared to peers, a concept so ridiculous it has been widely panned by investing analysts virtually everywhere.
But some believe that making blockbuster action movies on a scale of Disney’s Marvel would be the smartest use of money.
“One of the best examples of global content are big budget feature films,” said Michael Nathanson, senior research analyst at MoffettNathanson, where he covers the media industry. “I wonder if Netflix realizes that the best bang for its buck is to emulate what Disney and DC Comics are doing. Prestige films are not the best use of capital if you’re trying to build a global brand.”
But ultimately the key to Netflix' success - and failure - will be its access to cheap, easy capital. And it is here that the debt, which the company believes has a lower cost than equity, is once again in the spotlight.
For now, Netflix believes that favorable interest rates make debt an attractive option and it is looking increasingly to foreign capital markets to fund its growth. However, interest rates are slowly rising as the Fed is expected to hike rates as much as 4 times next year. And with Netflix expected to execute flawlessly for the foreseeable future with no chance of generating cash flow (as the alternative is sacrificing growth), could "growth stock" NFLX, and its largely unspoken debt infatuation, emerge as the best hedge to higher rates?