Netflix's Race Against Time

If someone offered you the opportunity to invest your money in a company that has been around for well over a decade, hasn’t had positive cash flow in over four years (in fact, actually burned more cash each year), and can’t really define when they’ll start making positive cash flow, all for the low price of $345 per share, would you take it?

Even though this should sound like a scam, it’s exactly what Netflix, Inc. NFLX asks and receives from investors. To be fair, Netflix did have the positive cash flow for many years, and their current spending is their way of expanding their content and their international presence (we also may have added some hyperbole for effect). Nonetheless, investors are giving Netflix a lot of leash, and with share prices at 159x earnings, they’re not discounting much in the way of failure.

However, the focus on the lack of cash currently being generated obfuscates some important pieces of information that bears may be missing, but bulls see clearly. Netflix may actually be able to flip the switch and generate returns that make the current share price seem like an exceptional bargain. The future of Netflix really becomes a question of execution before the bill collectors come knocking.

Content Is Costly

Although plenty of opinion pieces have noted the cash spend of Netflix, indulge us for a moment. The excel screenshot comes directly from Netflix’s investor presentation. Right now Netflix is running through approximately $1.8 billion per year. Currently, the company makes just under $14 billion in revenue annually. But what really stands out are the investments in content. On a 12-month rolling basis, content spend stands at $10.8 billion. Essentially 80 percent of all revenues are turned right back around into making content.

Should Netflix Slow Down?

On their face, these numbers may seem completely ludicrous. Netflix made healthy profits by providing customers with a plethora of B-rated movies to peruse when there was nothing on television. However, look again at the content spend growth rate for the last 12 months vs. that of the revenue growth rate. You’ll notice that revenues grew 36.2 percent vs. content spend of 13.1 percent. Simply put, for every $1 Netflix puts into content spend they turn out $3 in revenue.

Let’s take a step back for a second and understand briefly how Netflix treats its content expenditures. While they may take the cash hit immediately, the content is amortized (Netflix says 90 percent is fully amortized within four years) and expensed under Cost of Revenue. Right now that amortization specifically accounts for 50 percent of revenues. So, it’s reasonable to assume that if Netflix slowed or stopped their content production, all other things being equal, they would see a drop in their Cost of Revenue and increase in earnings within a few years.

Now, what will happen if Netflix maintains the same pace through 2022 growing in both revenues and content expenditures all other things being equal? Take a look at the table below which uses a 20 percent growth rate to be conservative:

If you keep all the other income and tax items roughly in line, you’re now sitting somewhere at $10-12 per share in earnings in 2022. Given the current stock price, that’s multiple in the 30s. This isn’t that far-fetched, especially when considering the company could grow much faster or realize economies of scale with content they produce.

Tick-Tock

Looking back at the chart above, carrying the same assumptions through, Netflix should turn cash flow positive next year. Now did we oversimplify things a bit? Yes. The goal wasn’t to give an exact prediction of when and where Netflix will go. Instead, we wanted to highlight what reasonable outcome calculations would permit. Yet, there is still one more chapter to this story.

Anyone who has done some research on Netflix knows they financed their growth with a lot of debt. Right now the company has a whopping $8.3 billion of debt outstanding. Below is a snapshot of the clock they are working against:

For a company that doesn’t have any positive cash flow yet, they have less than two years to pull their act together. That’s a pretty tight timeline to work with, leaving virtually no room for error. Consequently, as we saw with the last earnings call, any hint that the company might miss its growth targets puts the debt clock a bit more into focus.

Conclusion

There aren’t too many articles that we read where the author doesn’t go on to say that the upcoming quarters are critical for X or Y company. We won’t disappoint you either. Netflix needs to put up, or it will be shut up very quickly. Their recent bond offerings in April left them with a B+ credit rating from S&P, which doesn’t put them in the junk category, but doesn’t make them quality either.

Still, it’s unlikely Netflix will fail to hit its goals in the near term. It could easily scale back on content spending to drive cash flow, but that’s not likely. The company will probably take every opportunity to push all their dollars into growing as fast and as large as quickly as they can. Whether they achieve some form of economies of scale on content or finally start gaining traction in the international marketplace remains to be seen.

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