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Netflix, Inc.: A Credit-Strength Analysis

|About: Netflix, Inc. (NFLX)
Summary

Netflix announced the raise of additional debt during 2019.

The company is already holding quite the amount of debt capital.

Netflix is using debt to acquire streaming content assets in order to add to its growth.

It seems that there is no credit danger and leverage problem at the moment.

Netflix, Inc. which is a company known for its streaming content services and has launched a lot of successful series, announced that will raise an additional 2 billion in debt during the fiscal year of 2019. Netflix already holds quite the amount of debt and it seems that it doesn’t afraid to keep on increasing it.

In this article I am about to conduct a credit strength test on Netflix and analyze the company’s strategy of supporting its growth via its debt capital.

Profitability:

The graphs below present the increase and decrease in important profitability metrics. (All values in USD millions)

(Values taken from: The Wall Street Journal & Breaking News, Business, Financial and Economic News, World News and Video, 21/06/2019)

We can clearly see that Neflix is generating a steadily increasing profit but despite presenting strong revenue power, operating and net income seem to be quite low despite their stable growth. The two main reasons are high operating expenses and high depreciation and amortization. Specifically, the company presents high levels of amortization due to high-value intangible assets. Entertainment companies and companies like Netflix that generate sales mainly from streaming content, own a high share of intangible assets that they have to amortize.

The next graph below is about the company’s cash flows. We can already grasp how Netflix operates and plans its growth by looking at the cash flows.

(Values taken from: The Wall Street Journal & Breaking News, Business, Financial and Economic News, World News and Video, 21/06/2019)

As we can see, the operating cash flow keeps on decreasing and is negative. The same thing happens to the free cash flow and the only cash flow that’s increasing is that from financing activities. The increasing financing cash flow and the decreasing operating and free cash flows, indicate that Netflix is using large amounts of debt to finance its growth. The question is, if the company is in risk by doing that.

In order to understand the above strategy, we must understand why the operating cash flow is negative. In the company’s annual report for the fiscal year of 2018 we can see that the operating cash flow turned negative because of additions to streaming content assets, which are the main profit-generating assets of Netflix. The addition of content assets covers 98% of total operating cash outflows. These asset additions are also ten times the company’s net income, so it makes sense that the only way such assets can be acquired is through debt.

Credit-Strength Test and Analysis:

The way I chose to analyze Netflix’s credit-strength and leverage is by using values based on the latest fiscal year and forecasts to reflect the next fiscal year after the raise of additional debt.

Altman Z-Score:

I chose to start the credit analysis by using Altman’s Score. The Altman score is used in order to predict if a company will go bankrupt soon, mostly within the next two years. The score was first used for manufacturing firms but they are also two modified formulas for emerging markets and for non-manufacturers. I calculated the standard Z-Score and the score for non-manufacturers for the year of 2018. I also used projected future values in order to calculate projected Altman scores for the year of 2019. (All values were calculated in 21/06/2019)

Year

Standard Altman Score

Non-Manufacturer Score

2018

5.52

9.29

2019 (Projected)

5.24

8.85

(Table 1: Altman Scores)

A company is considered to be in the safe zone as long as its Altman score exceeds 2.99 for manufacturers and 2.6 for non-manufacturers. We can see that Netflix seems absolutely safe both in standard and non-manufacturing score. The projected values are lower but still at fine levels.

Fundamentals:

In order to get a better understanding of the company’s position, I chose a number of fundamental ratios and metrics in order to analyze liquidity, operational ease and its general leverage and health. (Metrics based on fiscal year of 2018 and were calculated in 21/06/2019)

Metric

Value

Defensive Interval

312 (days)

Quick Ratio

1.49

Non-Content Quick Ratio

0.7

Interest Coverage

3.82

(Table 2: Liquidity and coverage)

  • Defensive Interval: The number of days the company can operate without the access of non-current assets. I like to use defensive interval alongside with Quick Ratio when the company’s current assets can be of uncommon types and blur your assumptions of liquidation when calculating liquidity ratios. I excluded current content assets from the calculation as I believe some streaming content cannot be liquidated as fast as other assets and I treated content assets as inventories.
  • Quick Ratio: The first version of Quick Ratio I used includes current content assets and it seems satisfying. I excluded the said assets from the non-content version for the same reason as I did for the defensive interval. The non-content Quick Ratio seems okay as it is close to 1 but at the same time, it could be better. Content assets are different from each other and can start creating value in different time periods. For that reason I will accept the ratio of 0.7 as good.
  • Interest Coverage: Netflix presents a good coverage ratio. This is possibly an indication that the company’s operating profit could support debt and that the assets that are acquired via that debt bring growth.

Metric

Netflix

Peer Group

Debt/EBITDA

1.12

3.72

Debt/Equity

1.98

1.56

(Table 3: Leverage)

A high debt ratio doesn’t always mean that the company is in bad position. Sometimes under-leveraged companies lack growth momentum and therefore in certain sectors, leverage is mandatory.

I believe the entertainment and streaming content industry is a “debt-lover” due to their type of assets and investments. When we compare Netflix’s debt ratios with its peers, we can clearly see that despite having a higher Debt/Equity ratio compared to the average of the peer group, the company’s Debt/EBITDA is lower than the group average and it seems to be at fine levels too. I chose to use Debt/EBITDA because taking profitability into consideration when analyzing debt is important and EBITDA can act as a operational cash flow proxy when said value is negative, something that happens with Netflix.

The lower Debt/EBITDA could indicate that the company’s profits are at satisfying levels compared to the debt it carries. Safety points are gained as long as this metric stays at considerable low levels.

Capital Structure and Performance:

Because we are analyzing an increase in debt, it is important to evaluate the company’s performance based on its capital cost. The capital structure will change after 2 billion of debt will be injected into the firm and for that reason a projected WACC (Weighted Average Cost of Capital) must be computed in order to gain a better insight.

I chose to use the EVA (Economic Value Added) as Netflix’s performance indicator and I also calculated a modified lagging ROC (Return on Capital) that I believe will help us quantify the lagging affects of growth from the intangible assets. (All metrics were calculated in 21/06/2019. EVA values in USD millions)

Metric

2018

2019 (Projected)

WACC

10.76%

11.93%

EVA

-1889

-2707

(Table 4:WACC and EVA)

Both WACC and EVA seem to worsen in 2019. Increasing WACC means that Netflix’s capital is becoming more expensive to acquire, this is due to the increase in debt. Negative EVA indicates that Netflix doesn’t create additional value through its operations. This can change in the long-term, if the company’s assets will start accumulating growth and creating profit that will exceed the cost of acquisitions of new assets.

Metric

Value

Modified Lagging ROC

16% (5 year median)

Correlation (Content Assets and EBIT)

0.93

(Table 5: ROC and Correlation)

Modified Lagging ROC: I tried to use a ratio that could show me how well the company uses its capital and at the same time, how much profit is created from the content assets. The firm’s intangible assets (content assets) were taken into consideration when calculating the modified ROC. I also used the value of capital from the previous year each time and the net operating profit (NOPAT) from the current year to arrive at the capital’s rate of return. After calculating ROC for five years, I used the median as a general lagging return on capital. I accept this metric as fine as long as it exceeds the company’s capital cost, which is a WACC of 10.76%.

As we have stated before, Netflix is using its debt to acquire intangible assets, it can take time thought for these assets to create value and add to growth. For that reason, apart from using the modified and lagging ROC to check their effectiveness, I also calculated the statistical correlation between these assets and EBIT.

I thought about using this method as an alternative way to get some better insight. A correlation of 0.93 is high enough to assume that the content assets add value in the long term.

Conclusion:

Netflix is raising debt in order to acquire streaming content assets, which create revenue and profit. These valuable assets add to growth as Netflix is an entertainment company which profits via streaming content, investing in intangible assets like these is what it takes for such company to grow, given that profit is generated. I believe that Netflix is aggressively using debt capital to establish a strong income generating asset pool.

I believe that Netflix is not in any short-term credit danger and it seems that it can operate fine in the long-term too. As long as the company can generate enough income to support its expenses and liabilities, assets will have sufficient time to create more profit which can bring the firm into a point where content will be generating higher income and the need to acquire more of these assets at the same rate will decline.

An indicator of non-toxic debt use is that Netflix is using its debt capital to invest in new assets and not to pay expenses, dividends or cover any liabilities that give company a hard time. Generally, I believe it is too soon for someone to start worrying about Netflix’s debt levels.

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

Additional disclosure: This article is a personal opinion on the particular company and it is not an advice of investing in the said company or in any related securities and instruments.