I adore Netflix (NFLX) . My wife and I have been subscribers for a number of years and routinely binge-watch movies and television shows over the weekend. While the network originally rented or leased a majority of its programming, it is now becoming a premiere source of original programming, this year becoming a leading candidate in Emmy nominations.
But the stock took a major dive yesterday. Other columnists for TheStreet.com have covered various aspects of that story. I want to cover a different angle of the story: how viable are Netflix's financials when looking at them from a fixed income perspective? Or, put differently, are the company's bonds attractive?
Let's begin with an objective measure of just how much debt Netflix has. In 2013, the company had $500 million of debt. That number increased to $6.5 billion in 2017 - a 13x increase. According to their cash flow statement, they have done little refunding (where a company will exchange debt available on the open market with new debt that is usually issued on more favorable terms). The debt/asset ratio has increased from 9.2% in 2013 to 34% in 2017 - hardly a level to raise concern.
Can the company afford all this debt? To answer that, we first need to look at EBITDA. This metric tells us how much money the company generates to pay interest and taxes. Netflix generates remarkably little EBITDA. Over the last five years, EBITDA/gross revenue has fluctuated between 4.97% and 8.24%. It was 7.13% in the latest trailing 12 months. This tells us that the company is very expensive to run, which doesn't leave nearly as much leftover for bondholders as they would like.
Next, we need to compare EBITDA to interest payments using the "interest coverage ratio." All we do is divide EBITDA by total interest payments, which tells us how much larger EBITDA is relative to fixed income charges. This number was 8.5x in 2013; it was 3.3 in 2017 and the latest trailing 12 months. So, interest coverage is positive but narrowing. While not fatal, it does raise modest concerns.
And then we have to figure out if the company has to continue issuing debt. And the answer to that is most likely. According to the company's cash flow statement, operations have provided negative cash since 2015. For the years 2015-2017 the company's cash from operations was (in millions), ($749), ($1,414), and ($1,786). This means the company is generating no money from the sales of its services - a problem that is getting worse. Netflix is therefore entirely dependent on the bond market (or equity market if they want to issue more shares) for their cash needs.
And this leads to a final observation about the debt/asset ratio. The idea behind this calculation is that, should the skies fall and the company have to pay all its creditors at once, the company could sell its assets to do so. But that assumes the assets could be sold at the value stated on the balance sheet. When the company has hard assets - property, equipment, and the like - it's east to run back-of-the-envelope calculations. But most of Netflix's assets are digital. According to their latest 10-K, they have $11.7 billion in leased assets, which the company would probably have a hard time selling - if they could at all (this would depend entirely on the contracts terms and conditions). And then there's the question of the actual value of the remaining assets. Could Netflix really sell/license its programming to a non-Netflix platform for anything like full value? I don't know the answer to that question. But it does raise some interesting possibilities. The point of this discussion is that Netflix's primary assets are very unique, so valuing them for these purposes raises some interesting questions.
Netflix is in the classic growth company bind. Even though they are wildly successful, they haven't yet reached the stage where they are financially self-sufficient. That makes them largely debt dependent for their cash needs. Right now, their financials indicate they can do this. But they're issuing a lot of debt, which, when combined with their unique asset base, raises interesting questions about the viability of their strategy.
