Is Netflix Growing Too Fast?

| About: Netflix, Inc. (NFLX)


Netflix has relied heavily on the issuance of Senior Notes.

In order to achieve analysts' 148% rise in earnings forecast, Netflix will require external financing.

Netflix's cash coverage ratio is at 2.5x which doesn't leave much room for borrowing capacity.

Is there such thing as a company that grows too fast? Unfortunately there is. Most high-growth companies require capital to fund growth and if companies borrow too much, they risk defaulting on their loans. Netflix (NASDAQ:NFLX) is the prototypical definition of a high-growth stock. Revenues have been on the rise at a fairly consistent rate and they recently announced a positive fourth quarter which has propelled the stock to new heights. As a result of their high growth, Netflix has relied heavily on leverage and given their anticipated growth rate in 2017, I expect them to have to reach out again, either through the debt markets and/or by issuing equity in order to meet expectations.

Historically, Netflix has required debt issuance

One major question that companies that are in high growth mode need to answer is how best to fund their growth. In Netflix's case, they have done so over the past few years through the issuance of debt. Almost like clockwork, year-over-year Netflix has issued Senior Notes of varying amounts:

October 24, 2016: Netflix Prices $1 Billion Offering of Senior Notes

February 2, 2015: Netflix Prices $1.5 Billion Offering of Senior Notes

February 4, 2014: Netflix Prices $400 Million Offering of 5.750% Senior Notes

January 29, 2013: Netflix Prices $500 Million Offering of 5.375% Senior Notes

The reason they have needed external financing is because their assets are currently not generating enough return in order to fund their expected growth. At the moment, Netflix has an internal growth rate of 1.4%, which simply means that at a maximum, they can grow earnings by 1.4% without external financing.

Likewise, their sustainable growth rate, which measures their ability to grow by maintaining the same debt to equity ratio, is 7.2%. This means that Netflix can grow earnings by 7.2% if they were to maintain the same financial position. Once again, this is far short of analysts' expectations for a 148% YOY gain.

What will Netflix require to achieve such a high growth rate?

Assuming Netflix can achieve a 148% gain YOY on earnings, how much external financing will Netflix require? For starters, I will present four projected scenarios based on their ability to achieve varying operating margins based on their five-year historical revenue growth of 23%.

As you can see, based on revenue growth of 23% and using their 28% tax rate from 2016, Netflix will have to achieve a 5.75% operating margin in order to achieve their target growth rate. This appears reasonable based on their five-year historical average. In fact, 5.75% may be conservative based on the following company commentary: "We've been around a 4% annual operating margin for the past two years, and we are targeting about 7% for the full year 2017 based on current F/X rates" (Source: Q4 Report to Shareholders). Based on this information, and looking at the 7% operating margin, Netflix could outperform investors' expectations.

Now that I have the retained earnings number, which is equal to net income given that no dividends are paid, I can now estimate how much capital Netflix will be required to raise. Using the assets as a percentage of sales approach, pro forma assets would rise to approximately $16.711 billion (up from $13.586 billion) and pro forma liabilities, which excludes debt and equity, are equal to $14.855 billion.

Given these number we can now determine the external finance required:

Fundamentally, assets must equal lLiabilities + owners equity and as such, we come to the above financing requirements. Regardless of the scenario, in order to continue to achieve either of the aforementioned growth rates, I anticipate Netflix will have to raise in excess of $1.3 billion at some point in 2017.

Why should investors' concern themselves?

Netflix has been on a torrid pace and shareholders have been well rewarded. As with any high-growth stock, financial leverage is to be expected, but companies can't raise debt forever and at some point they will have to start paying down debt. The good news for Netflix is that of their current senior notes, none are payable until 2021.

(Source: Company 10K)

This provides Netflix with precious time by which to improve their profitability and subsequently their ability to pay off said debt. Also of importance, as of end of Q4, their cash coverage ratio was 2.5x which is an improvement over 2015 (2.4x), but well behind 2014 when their cash coverage ratio was 8.0x. This means that interest expense on their debt may soon become a problem. At a 2.5x cash coverage ratio, Netflix may be approaching their borrowing capacity and may need to turn to an equity raise. Although I believe Netflix can reach its anticipated earnings growth targets, how they get there, either by additional debt or equity raise, may provide a better entry opportunity for investors looking to jump in.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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