#Netflix: to exit or not to exit?

Netflix’s stock price (Nasdaq: NFLX) was up more than 19% in the latest after hours market trading due to beaten Q3-2016 earnings and subscriber expectations.

In fact, the streaming company generated net income of $51.5M, up 75%, or 12 cents a share (vs 6 cents expected) vs the period last year, on revenues of $2.29B (vs $2.28B expected), up 31.7%.

Just as important: streaming subscriptions beat forecasts. Netflix ended the quarter with 47.5 million domestic subs, an addition of 370,000. International was up 3.2 million to 39.25 million. They expect to add 1.45 million domestic subscribers by year end, and 3.75 million internationally.

“We are now in the fourth year of our original content strategy and are pleased with our progress,” CEO Reed Hastings and CFO David Wells say in a letter to shareholders. “In 2017, we intend to release over 1,000 hours of premium original programming, up from over 600 hours this year.”

All told, “we will continue to operate around break even, and then start generating material global profits in 2017 and beyond, by marching up operating margins steadily for many years.”

The execs reiterated their plan to raise debt “in the coming weeks” to support their expansion plans. The company had $14.4B in streaming content obligations at the end of September, up $1B in the quarter due to “the addition of both new original and non-original content to our library as well as expanded rights for our new territories.”

Netflix expects to spend $6 billion next year for content.

“Over the long run, we believe self-producing is less expensive (including cost of capital) than licensing a series or film, as we work directly with the creative community and eliminate additional overhead and fees,” the company note says.

However, if the post-market increase in the stock price holds tomorrow, then Netflix shares will be back to where they traded around the beginning of the year. Based on today’s closing price, the company is down 12.8% in 2016.


Despite the shift toward original content continues, Netflix is still starving for cash. Net cash used in operating activities was $462M in Q3-2016 and Non-GAAP free cash flow was negative $506M, which means that the company is burning cash every quarter, reason why they need to issue new debt. Proceeds from issuance of new debt was $1.5B in 2015, it is still none so far in 2016.

“With a debt to total capitalization ratio of about 5%, we remain underleveraged compared both to similar firms and to our view of an efficient capital structure.” – they say in the letter, but that can be as well read as an admission of financial struggle.

Netflix still uses the majority of their revenue to pay studios for licensing agreements– The Wall Street Journal reported in 2015 that of the Major Three, Netflix had planned on designating the most funds toward acquiring content, more than what Hulu and Amazon had projected on spending, combined – so its profit margins are low because they forfeit a lot of said revenue to overhead, distribution, and operating expenses. The ability to acquire strong content also depends on the willingness of producers to accept lump sums without any back-end.

The shift toward original content began in 2011 with a $100 million, 26-episode bet on ‘House of Cards’ which may however actually be seen as a shortsighted move since it did not entail their international expansion strategy because they left on the table the foreign rights to the producer MRC Studios.

Most of the content that Netflix brands as “original”, is actually licensed exclusively for SVOD exploitation, so if they want to control worldwide rights they will need to pay substantial sums, usually at least 120% of the production budget.

To be precise, in a negative pickup deal the show is never physically made by the network but by an associated production company, which in the studio model can be affiliated to the distribution entity. The same dynamic has allowed Netflix to neatly insert itself into the television ecosystem, first by licensing shows for online streaming, and then by simply joining traditional cable and broadcast networks as a fellow buyer. But the scenario leaves Netflix with being nothing more than a distributor, securing programs for a fixed period of time before agreements lapse and competitors have the opportunity to step in. By producing its own content from development to release, Netflix could ensure its new shows remain on Netflix and only on Netflix, an increasingly vital point as the dynamics in the streaming space shift more toward a battle for exclusivity. But they will need to form strong financial alliances and output deals, just like the major studios do.

Netflix seems now to be nearing its startup peak: so to exit or not to exit? They can certainly enlarge their customer base, especially internationally, but can they keep making/licensing great original content that drives organic growth without a studio/conglomerate attached? Data intelligence certainly helps.

As they increasingly rely on debt, and following the announcement of the exclusive streaming deal with Disney and the strong and reinforcing creative ties with Marvel TV, we may argue that we have a prime suspect. Nevertheless, for the love of innovation we should probably hope that they can stay independent and keep breaking rules for much longer.

The current enterprise value of Netflix is $44.04B or about 140.34x EBITDA (vs Amazon’s $391.46B or 37.97x, or Apple’s $656.17B or 8.87x), its trailing P/E is 311.88 (vs Amazon’s 202.18, or Apple’s 13.70).


Sources: Netflix IR, Yahoo Finance.

p.s. for past analysis of Netflix check The FlixBiz.

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