Why Netflix Is Strong, Despite A $3 Billion Negative Cash Flow

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About: Netflix, Inc. (NFLX)
by: Edward Ambrose
Summary

Netflix grew 2018 revenue by 35% and net income by 117%.

Expansion into producing films and series leads it to have a negative cash flow of $3.0 billion.

Netflix has recovered nicely from the December low price of 246 to the March price of 349, which is a gain of 42%. It is a strong buy.

Netflix Stock Price

Source: Finbox.io

Should you buy a stock with a price earnings ratio of 130 and a free cash flow of negative $3 billion? Only in unusual circumstances where the growth is likely to remain phenomenal and the cash outlay can be quickly cut back. Netflix (NFLX) meets those criteria. It is a strong buy.

History

The following chart illustrates that Netflix has grown more than 500% in the last five years. Looking at shorter-term data, it has a high Beta.

Source: Netflix

Netflix started out renting DVDs delivered by mail. Then, they jumped into the online streaming of film and TV content. They are moving from licensing content to producing it. Now, Netflix is beginning to distribute their films to movie theaters before they are streamed on line. "Roma", which just lost the Oscar for best picture, was in limited runs in theaters. The current releases are no longer in limited runs. Netflix will license, co-produce or produce content themselves. They have built production facilities outside California for lower cost production. They have hired first rate producers and directors. They are willing to spend big. The series "The Crown" cost an estimated $120 million. The next episodes in The Crown series have an older queen played by Olivia Coleman who won this year's Oscar for best actress.

Historical Growth

In 2018, Netflix revenue was $15.9 billion, which is a 79% growth in two years and an average growth of 33% per year. The biggest cost is that of revenue. It grew at 59% in the two-year period. Net income in the two-year period was up 549%.

Growth

The following chart shows the two major streaming sectors, the U.S. and international. A smaller operation renting DVDs is excluded. It is declining. In 2018, Netflix paid membership reached 139 million, up 56% in the two years. Revenue per month grew by 20% in this period.

Domestic Streaming revenue grew by 51% to $7.6 Billion with a 22% growth in memberships and a 24% increase in monthly revenue. Netflix market position was so dominant that it was able to raise prices to maintain a profit contribution margin of 34%. It still grew 10 to 11 percent in paid memberships despite the 24% increase in price.

International Revenue grew 142%. Paid memberships doubled and price increased 21 percent. Netflix International expanded rapidly, losing $517 million in 2016. This turned into a 2018 profit of $662 million. Its margin increased to 9%, which is a fourth of the domestic margin.

Netflix expects to increase domestic and international prices again this year. The domestic paid membership growth is 10% per year. The international growth is 4 times higher than U.S. growth. Total Netflix membership growth is 25% per year, so revenue is increasing 35% per year.

Competition

Netflix closest competitor is Amazon (NASDAQ:AMZN) Prime streaming video. Netflix has cut the ability of cable TV to charge for premium cable channels. As time goes on, fewer consumers will use cable. There are new entries into the streaming market. AT&T (NYSE:T) has acquired Time Warner, which it plans to change into a streaming channel with HBO and other properties. Disney (NYSE:DIS) is expected to become an aggressive competitor. Apple (NASDAQ:AAPL) will probably announce its streaming channel this year. Netflix is driven to gain share to become even more dominant, before the new entrants get established.

Cash Flow Risk

For every one percent growth in revenue, operating income increases by a factor of eight. The business has a high fixed cost of revenue, which is the cost of the content. So, why is Netflix cash flow running increasingly negative? Cash in 2018 was $ 3.0 billion negative, up from $1.7 billion negative two years earlier. Netflix guidance is for 2019 cash flow of negative $3 billion with a decline in future years as the profits from the business reduce the negative cash flow.

Gaining market share in a fluid market is a key reason. Netflix could still grow without the negative cash flow but not as rapidly. Secondly, Netflix wants to be a content creator. They are creating more of the series and films for streaming. Netflix states that producing its own content is more profitable than licensing, but that production requires large upfront investment.

Internally produced content is included with co-produced and licensed content. All three approaches will continue to be used, but internal production will take a larger proportion of content.

2019 Projection

Management's objective in 2019 continues to be growth. Under that scenario, Netflix should exceed revenue of $20 billion and net income of $2.4 billion. The next five years will see lower revenue growth but also lower cost of revenue and income from movie theaters, which should increase margins.

Conclusions

Netflix's main competition is now the premium cable content. This content is overpriced, and cable is suffering without a good way to respond. Netflix and other streaming providers are growing rapidly. As the business matures, growth will slow down but, by then, Netflix should have a large profitable content business with high market share. It is a strong buy.

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.