Netflix: What Happens When The Growth Ends?

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About: Netflix, Inc. (NFLX)
by: Trapping Value
Summary

Netflix has struggled with producing Free Cash Flow.

The Negative Free Cash Flow model has, however, produced great subscriber growth.

Netflix has a range of options to create a strong cash flow positive endgame.

Netflix (NASDAQ:NFLX) has been called everything. From the best investment for the future to a bubble in search of a pin. Just last week I addressed one growing concern that Netflix was not amortizing its content quickly enough. I analyzed the numbers and I thought it was doing a wonderful job, and perhaps was being too hard on itself. Still, the bigger issues remain. The cash flow statement looks atrocious.

Source: Netflix Annual reports

This is in spite of the income statement showing consistently positive earnings.

In fact, Netflix itself recognizes this issue and you can find it emphasizing this in its financial statement disclosures.

Yes. Straight from the horse's mouth. Warnings aside, one must be cognizant of the fact that Netflix has produced very large membership growth with this negative cash flow.

It is, however, hard to visualize whether this has been worth it and what the non-growing, steady-state company will look like financially. To do so I modeled 3 scenarios. In all 3 scenarios I have assumed that the annual streaming spend is also the cost of revenues. That is the annual amortization ultimately matches the annual streaming spend. I am also assuming steady state being reached at the average $9.99 plan level.

Scenario 1:

Netflix aims for a complete and abrupt halt to subscriber growth with a focus on generating free cash. It has a large amount of spending it is committed to over the next 3 years. Nevertheless, it could get to this point pretty quickly if it wanted. The key question here would be how much would it need to spend in order to sustain its current membership rate. This is the hardest number to get to but remember that at current spend rates, Netflix is adding almost 15 million members annually. So to keep membership static it would require a vastly lower spend number.

To model this I used $6 billion annually. While this may seem small, remember that Netflix only annually exceeded this number for the first time in 2016.

Prior to that it spent way less than that and still added members. All other expenses would roughly be at 2016 annual levels. This scenario results in $4.6 billion in Operating Income which would also be approximately the Pre-Tax Operating Cash flow (with small timing differences).

Scenario 2:

Netflix peaks streaming spend at current rates and refuses to spend more. Subscriber growth still occurs but steady state is reached quickly in 3 years at 130 million subscribers. This models 15 million members added in 2017, 10 million in 2018 and 5 million in 2019. All other expenses are ultimately 25% higher than today.

Scenario 3:

Hypergrowth continues and steady state is reached in 5 years at 175 million worldwide members as Netflix adds 15 million subscribers annually over 5 years. Streaming spend required to keep this base of subscribers happy is 50% above even currently high levels. All other expenses are also modeled 50% above current levels.

In all 3 scenarios, Netflix creates very strong positive Operating Income. I think the assumptions here are quite reasonable and perhaps leaning towards pessimistic.

Netflix also benefits from

a) Economies of scale as it gets larger and has more negotiating power

b) It is permanently developing a large amount of content for first-time subscribers to watch with each passing year.

I have not modeled either of these two positives. I have also assumed that Netflix does not raise prices. I am 100% certain it could raise prices in the future. A majority of households paid $100 for cable with very limited content littered with advertisements. Netflix is a very good value at current prices and should be able to raise prices gradually to match content price inflation.

Based on these very reasonable assumptions, Netflix is certainly viable under many different scenarios. While it can be debated what valuation you would apply to a company that could produce $2.5-3.0 billion in after-tax income ultimately, a complete "failure" and bankruptcy as many bears have predicted seem highly unlikely.

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.

Additional disclosure: The author thinks that Netflix (the company, not the stock) is the best thing since sliced bread.