7.605 % Yield to Worst Call at par in November, 2015
Netflix (NFLX) bonds are one of our favorite bonds, and we appreciate the opportunity to buy it while the stock is showing such glaring weakness. Although this Netflix bond is only rated Ba2 by Moody’s and BB- by Standard & Poor’s, its underlying fundamentals exceed the stringent criteria that we here at Durig Capital use to find better high yielding bonds. Furthermore, this bond provides an ideal example of why we think the official rating agencies may occasionally be mistaken in their assessment of a company’s credit worthiness.
Netflix has recently issued approximately in $200 million in stock and $200 million more in zero coupon convertible bonds. Prior to these actions, Netflix’s had a very conservative balance sheet and excellent liquidity. Including these two issues do not change the interest expense or current cost structure of the company, as the primary effect appears to be a dilution to shareholders.
What is surprising to us is the view that some people appear to have taken on Netflix debt. Netflix has to buy the content for their mailing and streaming clients. Historically, this cost of doing business has been in the 52-57% of their revenues range. Netflix currently has a $3.456 billion revenue run rate, and historically has spent above 50% of their revenues on content. Together these would put projected costs for film libraries next year at about 1.72 billion. While they have made forward contracts for library content that obligates them to $2.136 billion over the next three years, this is the product that they need to serve their clients. If next year’s library cost is in the $740 million range for 2012, which Netflix presented as an obligation in their last 10Q, which represents only about 24% of their anticipated revenues, which is significantly below their normal costs ratio. The simplest and most logical explanation appears to be that they have merely committed to buy (in the future) about one half of their projected library needs.
If this future purchase commitment is incorrectly categorized and painted as debt, as some writers evidently have, it quickly becomes a stumbling block for the average fixed incomer’s desire to own Netflix bonds. And while it’s true that building a large rental library of ongoing newly released films, older films, classic films, and popular old TV shows is very expensive for Netflix, one must also consider and remember that it also presents a formidable barrier for anyone looking to compete with Netflix.
Netflix believes and has stated many times that their client churn is being reduced, but we acknowledge that their image has been tarnished recently and more work is needed to restore the shine.
Looking at the basics - Interest Coverage Ratios
Netflix had $120 million in operations income last quarter, an unbelievable 22 times coverage of the roughly $5.3 million quarterly interest expense resulting from their debt. There has been no addition interest rate expenses with the new bonds. But with projected short term loses, coverage will possibly go negative the next few quarters. Knowing that the last quarter was influenced by many factors, we reviewed the previous calendar years numbers and found they had about 13 times coverage, which is well above most of the companies we review. In fact, this is a stronger number than several AA rated companies we follow.
Debt to cash ratio
Netflix reported long term debt at $200 million, and raised approximately $200 addition in zero interest convertibles bonds since the quarter, so we estimate total long term to be about $400 million. Cash and short term investments should be about $700 million, as they raised approximately 400 million in both stock and convertible debt offerings. Cash on hand would therefore exceed long term debt by about $ 300 million dollars, which is very rare for a billion dollar in revenues company. This is one of the best cash to debt ratios among the many companies we have reviewed.
Flexible balance sheets
The reason we like a flexible balance sheet is because when we last wrote about Netflix, it only had a 6% debt to equity ratio and subsequently had very little trouble raising an additional 400 million dollars, an amount that was double their entire $200 million debt at the time. Netflix currently has about a $3.5 billion dollar market capitalization, while long term debt is around $400 million. This debt to equity ratio of around 11% is still among the lowest we have reviewed, even after NFLX’s recent sharp stock price decline and new stock and debt issuance. In comparison, if a home were valued at $ 100,000, a relatively similar debt ratio would indicate an owner only owes about $ 11,000 to the banks. Even after the restructuring, Netflix retains one of the most flexible balance sheets we have analyzed, having plenty of flexibility remaining with which to pay off their earlier debenture.
This issue’s yield to worst call at par in November 15 of 2015, or about four years, is 7.605% if bought today at the premium price of 103.00. At this point it is unclear whether Netflix will exercise this option, as rates then may or may not allow them to refinance at a much lower rate and save substantially on interest expenses. If the bond is held to maturity in 2017, a time frame concurrent with our economic outlook, it would return a handsome 7.858% and represents a whopping 6.5% spread above the current rate for a longer 7 seven year U.S. Treasury bill. Here is a link to current junk grade bond offerings one can use as a benchmark against Netflix Inc.
Even though many companies have tried to emulate Neflix’s model, few have achieved the marketing and economics of scale that is essential in this specialized movie service. Netflix is still a rapidly evolving company in a segment of business that is renowned for having bankrupted both previous major players, Blockbuster and Hollywood Video.
The Technology and Rental industries are very volatile and market capitalization's can experience breath taking swings. However, the debt to equity ratio is so low for Netflix it remains in very low double digits. This extremely low ratio provides excellent balance sheet flexibility, even if the stock were to decline another 50%.
Netflix may not be profitable for several quarters or even a year as a result of their global launches, and this would reduce their interest rate coverage and possibly decrease their cash position. Since this is an annuity business, these short term expenses and build outs could be scaled back if needed, and the annuitized cash flow makes them a more stable business than most.
The 7.605 % yield to worst call scenario is extremely attractive for a diversified portfolio given the current market conditions. Although Netflix Inc. lacks an investment grade rating and some appear to have mistakenly claimed that their largest single cost of doing business is their debt, we perceive their stated obligation as a simple forward contact to purchase core products and are not dissuaded by the lower credit ratings assigned to them. If the last domestic company we reviewed, Century Aluminum (CENX), obligated itself to a forward purchase of raw material used in the production of its end products, perhaps it would be easier for most to understand this to be a purchase commitment of the company, and not debt. Given that Netflix’s largest cost is to provide film libraries for their clients, it is surprising to see people refer to this planned future cost as debt.
Netflix’s historically strong operating cash flow, its solid annuitized business model, and its current large cash position gives them what we believe is a very firm foundation. With one of the highest cash balances, previously very high interest rate coverage, and one the lowest debt to equity we have analyzed, we are recommending that our clients take advantage of this bond's high rate of return, possibly the result of a misinterpretation of Netflix’s forward contract obligations and a credit risk that we think is not properly understood.
- Coupon: 8.5 %
- Ratings: Ba2/BB-
- Maturity: 11/15/2017
- CUSIP: 64110LACO
- Price: 103
- Yield to Worst: 7.605 % 11/15/2015 call at par
- Yield to Maturity: 7.831 %
Disclaimer: Durig Capital and certain clients currently do have positions in Netflix bonds. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.