Binge Borrowing: The Story Of Netflix

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About: Netflix, Inc. (NFLX)
by: William North
Summary

Netflix has been increasing its cash burn for years with the most optimistic estimates having Netflix being cash flow positive in 2025.

Interest rate payments are expected to drastically increase as Netflix continues to finance operations with debt. The extent of this increase will be largely dependent on macroeconomic conditions.

This increase in debt can leave Netflix susceptible to credit downgrades, unable to improve its product, vulnerable to competitive pricing, or even drastic business model changes.

Even most optimistic scenarios still have Netflix being cash flow negative for a number of years.

Netflix (NFLX) is in a peculiar spot with increased competition (Disney, HBO Max, Prime Video, etc.) and the removal of much of its leased content (Friends, The Office, Disney movies, etc.). Meanwhile, since 2016, Netflix has had billions is negative cash flow with no end in sight. In this article, I will explore Netflix's rapidly increasing debt and the negative impacts it will have on the business in both the short and long term.

Background Information

Many other companies, such as Disney (DIS), are taking back its content from Netflix in order to have its content specifically on its platform, incentivizing consumers to subscribe to its streaming platform. Consequently, it is not surprising that Netflix has to ramp up its content spending to the tune of $3.5 billion this calendar year (the graph below shows projected cash flow prior to Netflix's guidance revision in April). Netflix had to revise cash burn to $3.5 billion after guiding for $3 billion only a few months earlier, raising questions on management's guidance accuracy, especially since they promised investors this year would be the peak of cash burn for the company. However, this is unlikely as Netflix is projected to spend $15 billion this year on content and $17.8 billion in 2020, according to BMO analyst Daniel Salmon. Given current estimates, there is no reason to believe that Netflix will be cash flow positive in 2020 (the most bullish estimates suggest 2025), meaning they will need additional funding in 2020, likely through at least 2025.

Debt Financing

There are two ways to fund such a venture, debt finance or equity finance. Netflix has historically relied on the first of these two types, which has left it with over $10 billion in long-term debt. Moving forward, Netflix will likely continue this trend of financing operations with more debt, which could prove to be even more harmful in the coming year. As debt becomes due, the cash flow negative Netflix will need to take out additional debt to finance the expiring debt. Although this is not too big of a deal as companies do this all the time, it may be more tricky for Netflix given its current Ba3 (equivalent to BB-), classifying it as a junk bond. As is evident by the chart below, any time there is a macroeconomic scare, these bonds yield much higher (over 15% in 2008), making it more expensive for the companies to issue debt. If there is a recession in the coming years and junk bond yields skyrocket, Netflix would have no other choice but to take on the expensive debt from continued operations and refinance its expiring debt at a higher debt as well, leading to the second financial: interest payments.

(Source: St. Louis Fed)

(Source: Real Money)

Interest Rate Payments

As debt increases, the interest payments are going to increase as well. As shown below, interest payments have drastically increased over time and the payments are only going to continue to increase as more debt is taken on. Additionally, higher interest rates on junk bonds will just add salt to the wound. This is an important metric to look at as high interest payments will just make it harder and harder for Netflix to ever reach its goal of becoming cash flow positive.

(Data from Seeking Alpha)

Debt Risks

The debt and the interest rates should worry investors for three main reasons. First, large debt makes Netflix a risky investment. Netflix's gross leverage of 7.5x is quite high, which was the reason for Moody's downgrade to its credit. The longer Netflix is cash flow negative, the more debt will result, making Netflix even riskier, and leading to more credit downgrades and more expensive debt.

Second, a large amount of debt may make it harder for Netflix to invest in content, international expansion, and technology, which would set it behind many of its competitors that have the bankroll to invest heavily in all of these things, such as AT&T (T) and Disney. On July 3rd, it was reported that Netflix's chief content officer told entertainment executives that Netflix's original content needs to be more efficient, highlighting the pressure that debt can have on its ability to invest in itself.

Thirdly, given that some competitors are cash flow positive, Netflix is in danger of being undercut for a long period of time. For Netflix, many of its main competitors, such as Disney, AT&T, and Amazon (AMZN) are already cash flow positive in other parts of its business, meaning it can all afford to price its content at a very low level where they can lose money for an indefinite period of time. Netflix, however, does not have that luxury as streaming is its business and any losses have to be financed by debt. This is likely why Disney started a price war on streaming content, listing its highly anticipated Disney+ at a "fire sale" price of $6.99.

I'm sure this was a signal to Netflix and everybody else out there that's charging $4, $5, $6 more than this. They're here to take market share and eyeballs away from the competition.

- Trip Miller, managing partner at Gullane Capital Partners.

Lastly, an increasing debt load could cause Netflix to change its business model in order to fund its debt. The most obvious way Netflix could increase revenue would be to add advertisements to its platform, similar to the way Hulu offers an ad-based subscription model. However, if Netflix were to just add advertisements to its existing pay-per-month subscription, consumers would likely be unhappy with paying monthly and having advertisements. This is supported by Hub Entertainment Research's recent survey finding that 23% of current subscribers would drop their subscription if advertisements were added; however, I would suspect the number to be much higher.

Risks to Thesis

A main assumption of this thesis is that Netflix will not be able to become cash flow positive for many years to come. A challenge to this thesis is that Netflix will be able to grow its subscriber number, thereby increasing revenue and becoming cash flow positive earlier than expected. However, I find this very unlikely given current trends. In the model below, I give Netflix 20% revenue growth through 2022 and 15% revenue growth through 2024 with the bull case for interest rates on debt, which assumes no type of macroeconomic downturn. Even if Netflix is able to maintain a high revenue growth rate over the next five years and if interest rates on junk bonds remain historically low, Netflix still would not become cash flow positive until 2024. However, this is a lot that needs to go right for Netflix and any minor negative, may it be interest rates going to 9% or revenue growth decelerating over the next few years, will just further increase borrowing and interest expenses, thus making it harder to become cash flow positive, which will increase borrowing and interest expenses and so on.

(Data from Seeking Alpha)

Conclusion

It is unclear when Netflix will become cash flow positive; however, until the day it does, it will continue to finance operations with massive amounts of debt. There are many dangers to having such a large quantity of debt, including, but not limited to, the inability to invest in improving the business and the ability to lose market share to companies with the bankroll to undercut its product for an indefinite period of time.

Disclosure: I am/we are short NFLX. 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: Long DIS, Long T