Netflix Won't Be Felled by Recession, Bond Markets, Debt or Cash Losses (Netflix Misunderstandings, Pt. 8)
My first essay on Netflix was six years ago. In it, I focused on what is now a quaint subject: the why behind Netflix’s entrance into original content. There were strategic advantages to such a move, but the implied business case showed that the company believed it would begin losing customers without these investments. And, of course, Netflix knew it would eventually lose access to much of its licensed content, too. Original content was necessary for survival.
Since then, the following story has tended to circulate across Silicon Beach (I’ve confirmed it with two people close to the incident, specifically for this essay). It surrounds how the 2011 announcement of House of Cards was discussed during a subsequent Hulu board meeting. At the time, Netflix had $2.2B in revenue, $160MM in profit and an $11B market cap and no experience in developing, producing or marketing original content. Hulu’s owners – Disney, Comcast/NBCUniversal & 21st Century Fox – held a combined $109B in revenues, $10B in net income, $185B market cap and a majority share of the domestic TV and film markets. Accordingly, one chief officer is said to have expressed bemusement at the idea that a “tech” company known for shipping DVDs could create good content, let alone become a threat through it. Another executive pushed back. The conversation was relayed as follows:
Participant #2: “Well, how many movies do you make?
Participant #1: “Between 20 and 25 a year”
#2: “No, how many does your studio, specifically, develop, oversee & shoot”
#1: “Three or five”
#2: “And you pay other studios and production companies and talent to make the others”
#1: “We finance them, license the content, market it”
#2: “Is your money better than Netflix’s? It’s money”
#1: “We have relationships”
#2: “And how much more does that make Netflix spend? All they needed to do was guarantee a second season that HBO wouldn’t commit to”.
This story is probably indulged (if it even happened). And maybe the pushback was only thought, not said. But the spirit is true. Over the long run, money is money. And Netflix has used this to great effect over the past eight years. The service has used its bankroll to do everything from stealing projects (MRC is said to have reneged on a handshake deal with HBO for House of Cards) and (mega-producers Kenya Barris and Shonda Rhimes exited their deals with Disney-ABC Television with years left on their contract in order to join Netflix under unprecedented deal terms) to getting addicted to selling their content to their most threatening competitor.
Six years after House of Cards, the company’s financial advantage has grown so large that it spends more than any other media company on TV and film content (even the combined Disney-Fox, excluding sports rights). Furthermore, the company can now economically outspend its competitors even when it comes to buying its own content. The best proof point may be the fact that Netflix, as per unnamed executive #2’s point, isn’t even responsible for most of its best “Originals”. Instead, they pay – at substantial premiums – for Sony to make The Crown, for Universal to make Narcos, for Lionsgate to make Orange is the New Black. And outside the United States, they pay the likes of AMC, ABC, CBS, FX and more for the right to call shows they made “Netflix Originals”.
Many argue that Netflix’s success stems only from its financial advantage (which is often characterized as profligacy)… which was only possible because capital markets indulged the company’s wastefulness… which itself was due to the good luck of having spent most of its OTT history during a record bull market run… and which was particularly effective because Big Media offered up its most valuable content rights at incredibly unvalued prices. Accordingly, and despite all of Netflix’s success to date, many Hollywood executives believe the very forces the company benefited from/exploited/is entirely the result of… will yet destroy, or, at minimum, severely diminish the company we know today.
Specifically, these critics argue that when a recession hits and/or economic growth slows and/or capital markets decide they’re done indulging Netflix and/or Netflix’s subscriber growth stalls, Netflix will be crippled. It has too much debt, too many content liabilities (almost all off balance sheet) and too much negative cash flow to survive in its current form. Conversely, Big Media companies have nowhere near Netflix’s debt ratios and instead boast large capital and content/IP reserves and, well, they tend to generate a lot of cash, too. Put more simply, nothing has gone wrong for Netflix yet. But it will. And then the tables will turn. (Some even argue that this reversal will show that Big Media was smart all along to wait, while drawing out every last dollar from the aging Pay TV ecosystem).
This simply isn’t true. Netflix is not on the financial precipice, nor a recessionary one.
So Why Won’t Netflix Collapse?
(Sequence below isn’t in order of significance, but instead upon connective tissue)
#1: Recession-Led Growth
The argument that a recession will break Netflix is particularly strange. An economic downturn will affect debt markets and place additional share price pressures on Netflix. These are both important (and I’ll get to them below), but a recession is more likely to be a gift for Netflix than a death-knell.
Today, Netflix is the cheapest source of high volumes of high-quality entertainment. Should a recession hit, economic history suggests that the service is likely to be one of the last discretionary expenditures a consumer will look to cut. Instead, consumers are likely to cut back or eliminate higher-priced services such as Pay-TV (which still reaches 90MM US households) or those with smaller libraries, such as Showtime or Starz. Not only will this free up $15-150 in monthly spend per household (which is good for Netflix’s pricing headroom), it will force these homes to either adopt new video solutions (good for Netflix’s penetration) or concentrate more of their video usage on them (good for Netflix’s pricing power). In addition, reductions in full-time and part-time employment will lead to additional leisure time – for which Netflix (and its famously unfinishable catalogue) will be a leading candidate. This will also improve Netflix’s price-value equation.
This will produce several other knock-on effects. Netflix’s newest would-be SVOD competitors (AT&T, NBCUniversal and Disney) are just now preparing to launch their own services. However, they’ve also taken on historic levels of debt to power these services. Comcast and AT&T, for example, are the two most indebted public companies in the world after buying Sky and Time Warner/DirecTV. Thanks to its acquisition of 21st Century Fox, Disney holds twice as much long-term debt ($40B) than ever before in its history. And each of these companies is still expected to make dividend payments. Reductions in Pay-TV penetration/spend will mean defunding these companies right when they need to invest in and tolerate multi-billion-dollar losses from their incipient, sub-scale services (something they have culturally struggled to do for years). This will also make it hard to say no to Netflix’s highly priced and 100% margin licensing fees, something these companies have mostly sworn off. While Netflix faces its own debt challenges and must also prove the viability of its SVOD service with shareholders, shareholders have no expectation of dividends nor near-term cash generation. The company’s culture is committed to losses in the pursuit of growth.
Sirius XM is perhaps the best case study for what might happen to Netflix during a recession. Like Netflix, Sirius XM offered customers a $10-15 ad-free subscription that would be added on top of existing consumption channels (e.g. terrestrial radio), some of which were free. Monthly churn among self-paying customers increased by only 20 basis points – 10 basis points above the company’s long-term average. There was a much larger hit to growth, but this also coincided with a 21% (2008) and 38% (2009) reduction in new vehicle sales, which drive the majority of Sirius XM’s customer acquisitions. And after just a year, the company returned to what became its long-term growth rate. And unlike Netflix, Sirius XM was the most expensive audio solution in the market and was not cannibalizing pre-existing spend but earning it incrementally. Netflix should do better.
Another adjacent case study is the penetration of wireless versus landline phone service in the dotcom crash. Many believed that this recession would lead many to ditch wireless service, which offered greater functionality than landlines but at much higher prices. This never happened, though growth again slowed – albeit not far off its longer-term trendline. Conversely, the dotcom crash led to the first-ever decline landline penetration. Furthermore, this was the start of a secular trend that has persisted in every year since but one (the 2008 recession, during which mobile phones still grew).
#2: Controllable Losses
One of the most common criticisms around Netflix’s long-term viability is that while the company continues to grow, its cash flow losses continue to widen. This is true, though the point is usually disconnected from the fact that revenues and subscribers continue to grow at roughly the same amount – and that in this stage of digital consumer media, the most important asset for any company is the size of its subscriber base. And here, Netflix’s advantage continues to widen. Regardless, the enormity of this cash loss is in large part the result of the unique accounting implications of SVOD and Netflix’s annual content spend growth (which it has significant control over).
For example, Netflix’s cash spend on content grew from $9B 2017 to $12B in 2018. Almost all of this incremental spend funded content that would be released in calendar 2019 and 2020. Yet, while the benefits of this spend are therefore received outside of 2018, it’s financially accounted against 2018’s operating income. All companies operate like this, but as Netflix’s cash spend has been growing 15-45% annually over the last five years, the disconnect is substantial (most networks grow their budget 3-5% per year). In fact, Netflix’s content spend has grown by HBO’s entire budget during each of the past four years. Few high growth companies can generate cash when matching today’s revenue with tomorrow’s costs.
Not only does this optically inflate Netflix’s cash burn, it also means the company can halt losses and even generate cash on demand. Had Netflix chosen to stabilize its 2019 content offering (which was paid for mostly in 2018) at 2018 levels, it would have had cash spend of $8.9B instead of $12.0B. Given cash losses in 2018 were $2.7B, this $3.1B reduction would have led to +$400MM in cash. Obviously, this is simplified. Without this increased content spend, Netflix’s subscriber growth would likely slow, thereby reducing revenue. That said, the company probably wouldn’t have grown marketing spend from $1.4B to $2.4B either. And because Netflix’s content is often funded in advance (hence the cash disconnect), subscribers will benefit from one to two years of increased output even after Netflix pulls back on spend.
#3: Expungable and Exaggerated Obligations
Accounting rules have meant that Netflix’s obligations are materially greater than they appear on the company’s balance sheet. For example, the company owes roughly $13B in debt, but on top of this, it recognizes nearly $20B in “contractual streaming content obligations”. This latter figure is not carried on Netflix’s balance sheet, and the company states that it holds further but presently unquantifiable content obligations of between $2-5B.
And as Netflix has negative cash flow, it needs to continuously raise more debt to pay down the debt and content spend it already has. This does sound like a Ponzi scheme in abstraction. But unlike that fraud, Netflix is in pursuit of a clear endpoint: category domination. Not only do the odds of achieving this goal feel increasingly likely, it would involve leveling off spend (which Netflix has stated and would allow for rapid cash generation, per above) and unprecedented control over licensing fees. But more broadly, the crisis situation tends to be overstated and often reflects double counting.
Of Netflix’s $18B in total debt payments (i.e. including interest and principal), nearly $14B (76%) or is more than five years out. That’s a long runway for a company with $20B in 2019 revenue, growing at an estimated 17% CAGR through 2025 (per Morgan Stanley).
Where companies get into trouble is when they have a large maturity tower that occurs near the start of a downturn. In Netflix’s case, front-end maturities are fairly low ($500MM in Q1 2021, $700MM in Q1 2022, $0 in 2023, $400MM in Q1 2024, etc.). This is not a prohibitive maturity profile, nor will a company with Netflix’s revenue struggle to roll $500MM in annual debt. And by the time Netflix is expected to have a $1B+ debt repayment (2026), Morgan Stanley projects Netflix revenue will exceed $55B.
Collectively, this should disabuse skeptics of the idea that the company might collapse in the years to come – regardless of whether the economy enters a downturn or credit markets begin to dry (more on this below). The company faces no substantial debt payments for years (and can keep pushing this drop date further out with additional raises) and has considerable control over the extent of its cash burn, the largesse of its annual content budgets and its long-term content commitments.
More importantly, the company’s content payments have the reverse timing. Just under half of Netflix’s $19B in content obligations is due this year.
Separately, Netflix critics often end up double counting the company’s content obligations. Netflix’s forecast cash burn is so great because of its content spend – it’s therefore not correct to wonder how the company will be able to afford them given the extent of its losses. They are already embedded in the forecasts as programming spend. You either focus on the losses or the obligations. Furthermore, most of these same forecasts anticipate far greater overall content spend. Morgan Stanley projects Netflix will spend more than $52B on content over the next three years alone (2020, 2021 and 2022). Considering the $19B contractually committed, 45% of which will easily be paid next year, as an existential threat is… rather misguided.
To a similar end, it’s important to understand what is and isn’t unique about this figure. With its streaming content obligations, Netflix is essentially quantifying a (small) portion of forthcoming operating expenses – programming. Every media company, whether it quantifies these obligations, presumes them. Viacom, for example, doesn’t (via accounting standards) specify its forward contractual content commitments – but as long as it’s a media company, it will be spending billions a year on content. Disney reports $42B in comparable content obligations, but $40B of those are for sports rights. Because Disney’s business model differs from Netflix’s, it need not (yet) speak to how much it believes it will need to pay, at minimum, for content in the years to come. And again, every single third-party forecast anticipates Netflix will spend several times more than its reported $20B in obligations… in the next few years alone.
What’s more, many of Netflix’s content obligations are incredibly liquid. I suspect Disney would happily buy back the rights to American Crime Story, for example, at – if not above – its deal terms. Not to mention Disney’s Marvel and Star Wars titles, which will be in the Pay-1 and then Pay-2 windows for years to come. In an emergency, Netflix would have little difficulty shedding its costs substantially – or even trimming them marginally.
Any changes to Netflix’s spending growth, let alone a year-over-year reduction, would doubtlessly affect subscriber growth. However, it’s more likely that the growth rate slows, rather than go negative (or that Netflix has to hold its pricing for longer than the typical six quarters). Netflix is still benefiting from significant overall growth in online video consumption, fueled by massive reductions in Pay-TV video viewing that has to end up somewhere. As Netflix has the largest content catalogue in the US and the widest on-demand/any device distribution, it will continue to receive a material portion of this time even if its library stabilizes, or even if it shrinks. To point, domestic growth has been stable even though the company’s catalogue has shrunk 66% over the past six years, annual increases in the company’s US content spending has oscillated, new entrants have entered the market and Netflix has grown its pricing by nearly 50%. Logically, today’s subscribers also shouldn’t need more content to stay with Netflix – the current offering is, by definition, enough. And even if they did need more content, it would take months for these consequent cancellations to occur. This delay would then help Netflix generate the cash needed to survive a storm or to rally debt or equity markets.
#4: Investment in Complete Content Rights
While Netflix is often willing to pay more than any other party, its content costs are high in part because it (1) buys out all back-end participations to talent, such as syndication residuals, home video profit sharing, etc.; and (2) purchases all rights to its content, i.e. every window, worldwide, across every media type. Both of these decisions grow Netflix’s share of the upside from producing a hit. To point, Warner Bros. Television has paid Chuck Lorre a reported $1B in profit sharing to date for Big Bang Theory. No matter how big Lorre’s Netflix show The Kominsky Method becomes, the streamer will owe only a few million in performance kickers.
However, this same dynamic means that Netflix has a higher minimum cost for a show and pays all of it upfront rather than over time as DVD and syndication sales occur (this also exacerbates the aforementioned cash issues). If the company wanted to, it could stop buying out all rights (in fact, Netflix held only select rights for several early Originals) or offer greater backend flexibility. Either decision would allow the company to reduce its content costs while maintaining current volumes and help smoothen the company’s overall spending ramp (thereby reducing annual losses). These are important “pocket cards” in case of emergency, even if they harm long-term profits.
This last element hits on an important aspect of Netflix’s negative cash flow losses. While Netflix’s old media competitors generate abundant cash, they do so by selling off and renting much of their core product: content. 21st Century Fox, for example, used to boast that it generated more in cash flow each year than Netflix lost. Yet, it achieved this by selling many of the most valuable rights to its most valuable content – usually to Netflix. American Crime Story, for example, is a Netflix Original in most global markets, licensed title in many others and doubtlessly more watched on Netflix US than its original network, Fox’s FX.
In mature markets, it can make sense to optimize every part of your business individual. During platform shifts, however, this model can prevent a company from making the strategic decisions it need to in order to grow or survive. Growth in Netflix’s market capitalization shows, for example, that the company has extracted more from its licenses than it paid to its owners. Having bought 21st Century Fox, Disney would assuredly love to access the company’s feature films. Unfortunately, these films are locked into WarnerMedia’s HBO until as long as 2030 (though some are available years earlier). As a result, Disney+ will have Avatar 4 before it gets Avatars 2 and 3. This approach was good for cash during the heyday of Pay-TV and home video, but it’s bad for building a business in streaming.
Furthermore, Netflix’s rights retention and overwhelming focus on Originals (85% of “new spending”, though what this means is a little fuzzy) means that over time, it will be replacing portions of its licensing spend with fully-capitalized library cost that costs it nothing to offer customers. To use an example, Netflix reportedly pays $100MM a year for Friends just in the United States. Stranger Things S1 cost roughly $35MM to produce, but Netflix doesn’t need to pay another dollar in 2017, 2018, 2019 or even 2030 to keep airing it – just as HBO’s The Sopranos continues to be watched. To this end, Netflix will eventually be able to reduce its annual content outlays even as its library accumulates over time. This doesn’t mean all Netflix Originals have long-term value, but only some need to in order for Netflix to cut back on its annual spend.
#5: Capital Markets Support
Netflix needs support from the debt markets in order to finance its ongoing operations and growth. If it lost this support, the company would need to enact many of the above changes or otherwise restrict its growth plans. No one contests this argument.
What’s less clear is why this loss of support would occur. The debt market has supported Netflix for a decade now, even as the company’s debt and cash flow swelled. Indeed, Netflix has also been vocal about the fact it expects these losses will grow, they will be incurred “for many (more) years” and that the company will swell these losses more than projected if it sees the right content opportunities. If subscriber growth were to fall substantially, this might change. But this is only ever offered as a potential outcome, rather than a likely one. Over the past six years, Netflix’s global subscriber growth has been incredibly consistent, growing annually at 36%, 31%, 30%, 26%, 24% and 26% (and against a large base). It’s true the company will see Disney, NBCUniversal/Sky, and WarnerMedia enter the marketplace later this year, but it will take years for the services to launch exclusive original content, reclaim their catalogue rights and launch internationally. And even then, it’s oddly contrarian to assume these new entrants will harm Netflix’s growth. And in the meantime, Netflix is on pace to add 30MM subscribers and $4.5B in revenue in 2019 alone (several times more than any of its competitors on its metrics).
Of equal importance is the fact that Netflix’s bonds have been rated as “junk” for years. An incremental downgrade could still occur (Netflix is currently a ba3 with Moody’s and BB- with S&P and Fitch), but even though Netflix doubled its debt and cash burn in 2018, bond markets remain happy to fund Netflix for ~4.7% yields. In fact, only two weeks after Netflix dropped its quarterly forecast for subscriber growth by an unprecedented amount (5MM v the 6MM expected by wall Street, leading to a 9% after hours selloff in the story), the company announced in May 2019 that its $2B bond offering had $6B in orders. In addition, both S&P and Moody’s upgraded Netflix’s credit ratings in 2018.
Credit markets do dry up during a recession – and would, even if Netflix’s growth accelerated for the same reason. However, critics like to claim that bondholders pay all of Netflix’s budget. Instead, its annual raises represent only 20-30% of annual content spend, which the company can easily cut back just by not spending more. This doesn’t give the company the cash needed to pay down outstanding long-term debt, but that’s also years away.
Debtward Ho
One of the issues with defending Netflix’s cost structure is the implication that Netflix’s share price is fairly valued, or that it might ever be as lucrative as bulls believe. That’s a separate issue. What’s clear is that this spend was critical to Netflix building itself into the competitively resilient, market leading position it holds today. For years, the company did seem to exist in a multiple equilibrium – one where as long as it continued growing, it would survive, but if it shrunk, it would die. As such, a recession, tight lending market or intensified competitive onslaught could have killed the company. But that time has long since passed – perhaps as early as 2015, at which point the licensing deals made by legacy media companies guaranteed Netflix another four years of growth. Today, Netflix has the content, spend and scale to grow from a recession, outlive a credit crunch and rebut competitive onslaught.
But crucially, this achievement wasn’t just about financial advantages, or “profligacy”. The company was first to understand how digital TV was a different game; knew it wasn’t a content company, but a technology one; was obsessively focused on an objective few had ever dreamed of before, and executed essentially without mistake. Easy money helped, as did mispriced deals and competitive mistakes, but Netflix maximized its return on these advantages.
Will Netflix ever generate positive cash flow? Inevitably. Its spending growth won’t continue forever. At some point, the company will maximize plausible penetration, or see the returns to marginal content investment hit zero as watch time itself stagnates. But this end, the mere fact that Netflix hasn’t paused its 36%, 34%, 45%, 49%, 29%, 35%, 20% YoYoYoYoYoYoYoY spending growth doesn’t mean it needs this spending growth to survive. Each year, the company’s first mover advantage only widens; it would be irrational to slow down until the market settles. This is one of the biggest misunderstandings in SVOD. $1B in spending in 2019 produces far less benefit today than it did in 2015 but far more than it will in 2022. Now is the time to spend, especially given that Netflix is beginning to monetize (and thus capture) markets with no real history of consumer spend on TV (e.g. Japan, Portugal). What could be better?
Matthew Ball (@ballmatthew)
