Sunday, September 2, 2018

Netflix: Managing a Mighty Debt Load

Netflix's stock values have surged, but debt investors assess its growing debt burden
In debt and equity markets, there's a love-hate relationship going on with Netflix, the Internet-streaming content provider. 

Equity investors, depending on snippets of information they find about Netflix content plans or Netflix's competitors, love the stock. Occasionally they dump the stock, then buy it, reminded that Netflix is at the pivotal center for how entertainment programming will be created and channeled to consumers for the long haul.

Equity investors, enticed by the company’s strategy, revenue growth, and market leadership, have pushed the company’s market value to over $150 billion (vs. $3.5 billion book value). Business journalists include the company in their special "FAANG" category--the technology movers and shakers that include Facebook, Apple, Amazon and Google. 

Debt investors get uncomfortable now and then, as they are also reminded of ominous non-investment-grade ratings from ratings agencies. The agencies provide alerts that Netflix faces daunting competition from the HBOs, Disneys, and Hulus and reports cash-flow deficits while confronting a big debt burden. (Moody's rates Netflix as non-investment grade, B1.)

It's a debt burden that will continue to rise--a chicken-and-egg conundrum. The company's revenues are indeed growing rapidly. To ensure they grow at that pace, the company promises new, more alluring content.  To develop that content, it chooses to fund it from new debt.  New debt requires even more cash-flow pressures to meet principal and interest payments.  The business model has evolved toward continuing promises of more content, the development of which requires mounting amounts of long-term debt.

Growing revenues have been accompanied by debt levels that now top $9 billion. The company has avoided tapping equity markets to fund these fixed assets.

Netflix, as many know, was originally founded as a service to deliver DVD content (movies, documentaries, etc.) via postal service. DVDs in red envelopes were literally mailed to subscribers, who watched the movies and returned them in pre-sent packages. Many are not aware this continues to be a small part of its business, but the core business now generates revenues from the tens of millions of subscribers who pay monthly fees to access entertainment content on Netflix’s Internet portal. 

In recent years, the Netflix strategy can be summarized:

(a) Grow revenues by expanding into various regions around the world (and introduce content appealing to those from different cultures) and

(b) Evolve gradually from licensing (or “renting”) content from other content providers toward developing new content because contents Netflix creates will likely be more attractive and of higher quality than content it finds elsewhere.

Give Reed Hastings, its CEO, and the company credit.  If it had stubbornly stuck to a DVDs-in-the-mail business, the company would have disappeared or been bought out a long time ago.
Revenues have grown at a compounded-annual growth rate of 28% the past five years and now exceed $11 billion annually; the company is profitable, although income has fluctuated. In 2018, it is on a pace to reach $13 billion in revenues. Equity investors trade the stock as if it will top $20 billion over the next five years.

The company generates positive cash flow from ordinary business operations, but must rely on new debt to fund the significant investments in new content, over $8 billion in new assets the past five years. Hence, until now, if the company didn't bother with creating content and relied only on its Phase 2 strategy of licensing or renting content from content providers (the movie studios, e.g.), it might continue to show positive operating cash flow.

But the same cash flows and revenues might dwindle over time, as subscribers would become turned off by old, familiar, unappealing content on the portal. Once-eager subscribers would cancel accounts and move on to other steamers with more interesting offerings.

Hastings and team are right that they had to figure out what subscribers want to see and what will appeal to a broad number of viewers from around the world.  And they couldn't rely on outside sources to provide it.  They had to arrange to develop it themselves.  Development, of course, means funding.  Long-term debt would be its strategy.

In the world of debt analysis--a world including lending banks, insurance companies, institutional investors and other asset managers--cash flow counts.  Can the company sustain ongoing operations to be able to meet cash interest payments regularly?

Can the company also make principal payments on the debt regularly and, as necessary,  encourage investors to refinance debt when it matures.  The company wouldn't necessarily have to pay down what's due; it would refinance it.

In the realm of debt analysis, the word "risk" arises often. Cash flows that should be available to pay principal and interest on debt are vulnerable to bundles of risks, and cash flow existing in early years can disappear in later periods, threatened by expected or unforeseen risks. What risks does Netflix encounter?
Increasing competition from other streaming services and from other companies launching their own services (Hulu, HBO, Disney, Amazon, etc.): A number of players, agreeing that cable TV cord-cutting will continue briskly, have joined Netflix in streaming. Some already have financial and business advantages. Some entered the streaming business out of desperation. Together, the competition will influence Netflix pricing and expansion strategies.

High costs and time commitment involved in developing own content: There is risks of escalating costs and risks of quality of new content after investing substantial amounts. 

Content piracy and illegal streaming: Regardless of developing or licensing content, Netflix encounters this regularly.  Some potential subscribers will privately vow not to become customers when they can get access to content without paying--legally or illegally.

Pricing strategy (variable monthly fees, depending on markets and geographies):  Netflix subscribers, especially with new competitors launching their own strategies, will likely be sensitive to Netflix plans to increase monthly subscription fees. But the company will consider fee increases if it is strapped for cash or if it wants to minimize cash-flow deficits.

Decreasing growth rate of new subscribers. There is risk its greatest growth rates in subscribers occurred in the past.  Growth rates can fall or flatten, because of competition and because subscribers' sensitivity to price increases and because subscribers indeed share accounts with others.

Global strategy for different cultures. As the company expands across the world, the company may not be attuned to different viewing tastes and cultural patterns in other countries. Netflix may guess and plan and be wrong. As it expands across borders, country, political, currency and legal risks exist.

Technology risks. Netflix is an entertainment company, but it is also a technology company, relying heavily on subscribers' access to Internet services. In the U.S., issues related to diminished "net neutrality" could pose a risk. (Subscribers don't have equal, uninhibited access to the site.)

Management risks: CEO succession. Longtime CEO Hastings presents himself as spokesman, heartbeat and pulse of the company. He, for the most part, devised, promoted and pushed the strategy to evolve from DVDs and develop content. But has he prepared for the next generation of leadership and strategy execution? Is there bench strength?

In most cases above, the impact of the risk is a threat to revenues. In some cases, the impact of the risk is a possible rise in costs or potential liability (litigation, e.g.). The risk review, in total, helps market and debt analysts project the performance of the company.

So what's Netflix's track record and true financial condition to date, and what do we expect going forward? Why have equity investors had such a favorable outlook on the company?


The company is consistently profitable, although profit margins and returns on capital are not high and not improving steadily. Revenues continue to grow significantly, while costs are growing just as quickly. The company, however, has shown it can keep most operating costs (administrative and overhead costs, e.g.) under control. As the company continues to grow and expand, some costs will be necessary to support growth.

Asset quality and productivity

The company doesn’t rely on substantial amounts of fixed assets to generate revenue, but it does rely on content (licensed content and owned content, both of which appear as assets on the balance sheet). High-quality content assets are important to attract and keep subscribers. However, to grow revenues, the company is aware it must add to existing content (and, therefore, must finance new content). It acknowledges it cannot increase revenues with old content or "borrowed" content.

Asset efficiency

The business model permits the company to match subscriber fees received to amounts paid to content providers, from which it licenses the right to use and stream. The business model also doesn’t require accounts receivables or efforts to collect monthly fees. (Subscribers pay immediately via credit-card charges.)

The model, therefore, doesn’t require funding for working capital purposes. As the company develops more content it owns, subscriber fees will be used more to service long-term debt, less to pay down payables to other content providers.


Ratios show the company has sound levels of cash or access to cash for short-term purposes. It can pay down short-term obligations with little difficulty. Some of the $2 billion-plus in cash reserves results from recent debt proceeds and may be earmarked for future content development.

Liquidity could be affected as current portion of long-term debt comes due and if the company is not in a position to refinance maturing debt.

Leverage and capital structure

The company today is committed to a strategy of debt financing.  It has vowed to continue to do so, even as interest rates might increase and balance-sheet leverage continues to increase. An already highly leveraged balance sheet will likely become more highly leveraged.

The debt levels are rising faster than capital on the balance sheet. The company does not pay dividends, which permits it to retain earnings, but earnings alone cannot finance the aggressive goals of new content.

Capital adequacy

The book-value capital base is growing moderately, but is offset by larger increases in long-term debt. Capital will likely continue to grow, as it maintains profitability and resists paying dividends and buying back stock.

Equity market values fluctuate occasionally, but the overall trend is pushing upward, as investors value the long-term revenue growth. High market values of equity suggest the company could issue new equity if necessary—an unlikely step in the short term.

Cash flow

Cash flow from business operations has been positive the past five years (between $200-500 mil/year), fluctuating from year to year. The company benefitted from tax credits in 2018, which bolstered cash flow (It didn't have to pay out taxes). The tax credits were a one-time event (and the company will have tax payments going forward).

The levels of cash flow, although increasing at modest amounts, however, are not sufficient to finance the combination of capital expenditures and new content, the latter of which approximated $3 billion-plus in each of the last two years and is likely to continue at that pace or above in years to come.

Cash flow after operations and after capital expenditures and investments in new content, therefore, is negative—and requires debt funding.

For now, it has avoided paying dividends to shareholders, who buy the stock based on long-term growth expectations and price appreciation. Despite non-investment-grade credit ratings, it feels confident it can continue to access debt markets, when it chooses.

Projecting Performance and Cash Flow

Projections of future Netflix performance and cash flows should be based on and consistent with the financial analysis and business-risk analysis above. As a matter of practice, projections in debt and credit analysis should be realistic and conservative.

Debt analysts project a base-case, no-growth case and peek at worst-case scenarios, although equity investors and management boast about the expected growth to come.

The challenge in projecting cash flows for the company is projecting annual expenditures for new-content development. New-content development in 2017 exceeded $3 billion in cash outflow, reaffirming this will be the company’s ongoing operating model in the future.

But new content expenditures could decline if operating cash flows decrease and if the company can no longer borrow new funds. Note the tie-in.  The company wants to grow via new content, but it can only do so--at least now--if it can access new debt.  If it can't access new debt (because of the declines in credit ratings and because debt investors are concerned), then new content won't happen and growth expectations from equity investors will dim.

While equity investors are eyeing revenues leaping from $14-20 billion over the next five years, ratings agencies and concerned debt investors might expect a short-term jump in revenues to about $15-16 billion, but much uncertainty looms in the long term.

A plausible future case of operating cash flows of about $650-700 million of year, while seemingly strong numbers, will still be insufficient to handle debt loads of $10 billion or more. But how else does it plan to finance new-content levels of $3 billion/year--except for even more debt?

Maximum debt capacity (assuming all debt is serviced from cash flows and not refinanced), based on a 10-year realistic-case horizon, at best is about $4 billion. Issuing new equity to meet funding requirements is an option, but one the company is resisting.  For now, the company’s current financing strategy presumes that as long as it can meet interest payments (which it can), then it will successfully refinance debt obligations when due.

Netflix’s financial condition will likely remain stable over the next 2-3 years. There is uncertainty in the long term, and there is no assurance the company can continue to tap debt markets to support new content—although new content is critical to maintain revenues at epected growth rates.

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