Netflix Leads The Change In Economics Of Content Production And Subscriber Leverage

About: Netflix, Inc. (NFLX)
by: Hans Centena

Netflix's content investments, distribution partnerships, and marketing spend would drive subscriber growth significantly.

The company continues to issue significant debt in the market to finance its negative cash flows and to align its capital with the larger size of the business.

Netflix is testing the waters in the international markets to boost accessibility to its content.

The threat of competition with Disney+ puts Netflix slightly ahead with its broader service and bigger programming budget.

Image credit: Company website

Media companies are seeing growth returning in the US given the adverse effects of the market sentiment slowdown as a result of trade concerns. A few companies have issued a change in demand with strength returning while more investors see a near-certain second-half recovery. Among the most innovative companies is Netflix (NASDAQ: NFLX). It comes with an ambitious growth target that does not come cheap. However, this streaming giant has significant debt. Nevertheless, its cash flow story is expected to bring a happy ending.

Presently, NFLX's share performance survives on its current subscriber growth. And subscriber growth is good for the investor perception as it is solid evidence of a recurring revenue stream. As more competitors enter the industry arena, it obviously threatens NFLX's stock. Growth could come under pressure, particularly in the US.

Accelerating Content Spend and Subscriber Additions

Deutsche Bank (NYSE: DB) remains Buy-rated on NFLX. They believe that NFLX’s content investments, distribution partnerships, and marketing spend will drive subscriber growth significantly. Added to that, the company has approached an “inflection” point in cash profitability.

However, DB’s long-term outlook for NFLX has not changed all that much. They have low confidence over NFLX on account of currency headwinds. Also, NFLX is experiencing some bumps on the demand curve in each international market. Surprisingly, the company has low visibility in each of those country-specific demand curves (like India).

International net additions are expected to climb modestly this year. Despite that their 2018 forecast is now lower, the 2018 international net additions remain 15% higher than 2017. NFLX will aim to strengthen further its popularity across all key international markets.

In one of the company’s shareholder meetings, Goldman Sachs (NYSE: GS) noted that NFLX's subscriber churn is increasing. However, NFLX attributed this negative to the lower gross additions. Thus, investors maintain a cautious stance toward the subscriber outlook, which was rooted in lower gross additions rather than subscriber churn. This further supported the company’s forward-looking statement that they missed the net addition guidance because “fewer” subscribers signed up for Netflix last year.

I’m optimistic about the subscriber outlook of NFLX given its strong slate of content that awaits this year. Their content portfolio includes new seasons of some of the most exciting series such as The Crown, Stranger Things, La Casa de Papel (aka Money Heist), Martin Scorsese’s The Irishman, Orange Is The New Black, 13 Reasons Why and Michael Bay’s Six Underground.

With that, I believe that cost efficiencies and scale would help the company mitigate the revenue and margin pressures. Their industry competitors who will be unable to mitigate these pressures will suddenly drop-off, leading to a “winner takes all” market – and that winner is NFLX.

The Threat of Competition with Disney+

A formidable adversary of NFLX would be Disney+ (NYSE: DIS). A couple more would be NBCUniversal and AT&T’s (NYSE: T) WarnerMedia. DIS has already prepared the groundwork for its own streaming service towards the latter part of 2019. Meanwhile, NBCUniversal will debut its streaming video service in the year 2020.

The cutthroat competition comes in when DIS and NFLX are head to head with their rivalry this year. NFLX is slightly ahead of the competition with its much broader service supported by a much higher programming budget. On the other hand, DIS boasts of its programming, which is a cut above the rest for its impeccable genres. However, the only disadvantage of DIS is its trade name, in which consumers will stereotype its streaming services to feature mostly DIS films. Deutsche Bank (Upgrading To Buy. April 2019)

GS believes that Hulu (60% owned by DIS) is a more appropriate competitor to NFLX, given Hulu’s broad streaming service. Subsequently, Hulu and NFLX are not considered as industry “substitutes” given their respective unique content. Hulu is still in the stage of establishing its international streaming strategy, thus giving NFLX a wider head start. In terms of subscriber count, Hulu is also a winner but creates no adverse effect on NFLX’s subscriber growth trajectory.

Source: Goldman Sachs Global Investment Research

On that note, I expect higher levels of competition in streaming video on demand (SVOD) from big traditional companies like T and DIS. In the medium-term horizon, I noted that broadening options for SVOD would slow down the growth of NFLX in newer markets. This despite that the programming offered by each of these companies varies.

Mr. Reed Hastings, Founder & CEO, gave his assurance of a promising outlook:

"I don't think investors have too much to worry. We've been going for 20 years, we've done one or two micro acquisitions but no big appetite, no big need. We got clear sailing ahead. If we can produce the world's best content, we can deliver it with the best user interface, then we can grow for many, many years ahead. So that's what we're focused on. It's a lot of tough execution, it's keeping ourselves all focused on that and then we're letting other companies do many different strategies, but we know what ours is and we're having a lot of fun just executing on it."

Subscriber Statistics: International Outpace Domestic

International subscribers continue to outpace domestic growth due to the US price hikes recently. NFLX registered 1.74 million subscribers in the US alone and 7.86 million international paid subscribers. The subscriber growth attributed the additions in international subscribers to its local content investments in Europe and Asia. This translated to stronger Earnings before Income Tax Depreciation and Amortization ((EBITDA)) of $584 million following the US price hikes.

NFLX issued guidance for the succeeding quarters that paid subscribers would grow by 0.3 million in the US and 4.7 million in the international market, as hikes in prices continue in Latin America, some parts of Europe and the United States.

International Strategy: Pricing Experiment with Developing Markets

In the first quarter of 2019, average streaming paid memberships rose 26% year over year, while average revenue per user (ARPU) decreased 2% year over year due to currency headwinds. Excluding forex, global streaming ARPU improved 3% year over year. The company issued guidance of an acceleration in both streaming ARPU of +2% and total revenue growth of 22% in the second quarter of 2019.

Domestic price hikes were more predominant in the first quarter than in the past. Though, the company still saw consistent levels of cash churn due to its widening margins in the first quarter. As a result, the company is testing the waters in the international markets to boost accessibility to its content.

I believe that the correct timing for marketing would lead to a quicker than expected improvement in the EBITDA margin of 13% (guidance for FY2019). I anticipate that they will possibly offer a mobile-only lower price option in developing economies such as India and other emerging markets to promote accessibility.

Cash Flow: Modest Cash Burn

Source: CNN Business

Free cash flow yielded a negative $460 million in the first quarter of 2019, as compared to negative $1,315 million in the fourth quarter of 2018. They issued guidance that 2019 free cash flow deficit will be higher by end-2019 at negative $3.5 billion as a result of:

  • cash outflows from investments in real estate/infrastructure,
  • heavier cash taxes, bigger taxes, and,
  • content spend growth (which rose by 26% year-on-year in 2018).

The growth from operating income and the easing of the working capital burden from content spend will allow a lower cash burn level, as NFLX anticipates cash flow gains by the year 2022.

Balance Sheet: Debt-Laden Capital Structure

NFLX booked $3.35 billion cash on the balance sheet as of first quarter of 2019. It implied a cash burn of $1 billion over the next three quarters after the company sourced financing from the debt market. Additional debt funding was sourced to align with the larger size of the business.

The company factored in its balance sheet equation $1 to $2 billion in fresh senior debt in the second quarter of 2019. This will allow them to sustain $3 to $3.5 billion in cash to fund their content spend.

According to CNN Business, the company has raised $12.8 billion of high yield debt since 2009 (data from Dealogic). More than three-quarters of that capital raising activity has come just in the past three years which explains why NFLX has an increasing cash burn. The company has burned through $7.6 billion over the past four years.

On that note, I remain positive that the company has a sound balance sheet. Their strong EBITDA growth exceeds the growth in content spend and in debt levels. EBITDA grew from $534 million in the first quarter of 2018 to $584 million in the first quarter of this year. Total debt is posted at $10.4 billion in the first quarter of 2019 with a gross debt-to-EBITDA ratio of 5.0X.

Improving Debt Ratios

Based on the latest rating report of Moody’s, the ratings agency has been expecting that leverage would decline over time despite the continuing issuance of debt to finance the company’s negative cash flows. They noted that the transition from licensed content to produced original content levels off, while newer international markets begin to contribute profits and overall margins improve.

Moody's also believes that NFLX is on a growth trajectory. The company will outpace the 200 million subscribers towards the end of the year 2021. Thus, NFLX will be able to achieve cash flow breakeven within five years following the growth of total margins to the low 20% range. All in all, gross leverage has slid back to 6.0X in 2018 and forecasted to be below 5.0X by end-2020.

They added that the company’s strategy to obtain its proprietary content creates a positive long-term implication. It builds its own library of assets as against pure licensing of content. This will offer scale benefits for NFLX and render proprietary value to consumers. It also offers a valuable asset base for investors. NFLX has the capability to create content at a fixed cost and scale it across a near global footprint.

My Takeaway

To recap, NFLX has changed the economic landscape of content production and subscriber trends in streaming media. They led the change in the strategic direction of the media industry, leading its peers to follow their direct-to-consumer revenue model.

The company continues to thrive into the competitive environment by capitalizing on user experience, distribution, marketing, and content. This corporate strategy allows NFLX to leverage its significant number of subscribers. As an industry leader, NFLX is pushing the right buttons to render a competitive advantage in driving revenue and cash flow growth.

I believe that the stock of NFLX will continue to outperform. I like their secular growth story. The content itself is a one-stop shop for consumers who just want to watch something (other than YouTube). The scope of its market encompasses a wide reach and there are no other competing platforms like pay TV that can get close to NFLX.

In terms of valuation, I believe that the company is still struggling as I see a larger level of investment will be required to grow the international business relative to the market’s expectations.

NFLX has to face other challenges such as stiff competition from new streaming video companies, higher content costs, intensifying emerging market exposure as well as international expansion. But given the company’s resources and creative talent, this streaming media giant should be able to drive a higher content quality for their growing subscriber base.

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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