A recent Wall Street Journal article, "No Reason for Netflix Investors to Chill," is another piece among many claiming that Netflix's reliance on debt is problematic for the company.
Netflix detractors often cite the debt the company has accumulated as a key reason the company isn't well-positioned for long-term success. Its reliance, the argument goes, on credit markets as its capital of choice to fund its business is a risky move and potentially a bad strategy.
Creating content is a capital-intensive business; to create more content Netflix will have to continue to borrow, digging itself deeper into a cash-constrained hole. And debt, many argue, is only exacerbating this problem.
As it happens, I had been researching a piece on this very topic.
The Cash Concern
Let me start by confirming that the cash concern is real. Content might be king in media, but cash is king in business. Cash is the lifeblood of any company. And Netflix blazes through cash like a wind-backed fire. In 2019, Netflix is expected to generate a cash loss of $3.5 billion. The driver of its cash problem is hefty content costs. Assuming Netflix content continues to attract more subscribers, all should be well and good. The concern is if it stops growing, it won't be able to meet its debt obligations and it will quickly throw the company into bankruptcy.
When critics complain about Netflix's cash problem they often conflate it with leverage. Content businesses require large capital infusions to create the content. And Netflix, like most companies, spends an inordinate amount on content. There are different ways to fund it and Netflix has incurred a lot of wrath for choosing to fund its capital needs using debt.
But it's worth noting that the credit market isn't concerned. To understand why, we have to look at the whole strategic picture.
Netflix's Capital Efficiency
Netflix's debt to equity ratio has been increasing since 2015, reaching 1.81 in Q1 of 2019. Is that a bad thing?
In its most basic form, debt is the ability to get access to money you wouldn't otherwise have, invest it in something, and come out the other end with more than you would have been able to produce in a debt-free world. Done right, debt is a powerful tool. And taking on debt strategically, in the long run, is better for shareholders.
Financial indicators signal that Netflix is leveraging its capital efficiently. Netflix has increased its return on invested capital since 2017. Compared to competitors, Netflix's ROE is also performing well, an indicator of a company's long-term health and the effectiveness of its current operating structure to generate cash. And in 2018, it ended the year with a 10% operating margin compared to 7% one year earlier – the primary driver of which was increased revenue.
Optimizing Capital Structure
Netflix chooses to finance its business with more debt to optimize its cost of capital. And, frankly, that's already saying a lot since many businesses don't know or care to calculate their cost of capital.
As mentioned above, content costs make Netflix a high capex business. Like the capex of any other industry, it serves as a barrier to entry. Netflix spent ~$13.04 billion on content in 2018. In 2018, it expensed $9.97 billion. The ~$3 billion or so difference can be categorized as capex.
As Netflix looks forward to the high capital requirements needed to continue to grow its business, it has to continue to choose financing according to its cost of capital. And Netflix has chosen to finance its content investments both by operating profits and the remaining needs with debt.
Netflix explicitly states that "in optimizing our balance sheet, we strive for the capital structure that results in the lowest weighted average cost of capital. Given low interest rates, the tax deductibility of debt and our low debt to enterprise value, financing growth through the debt market is currently more efficient than issuing equity."
A High Fixed-Cost Business
This leads us to perhaps the most important point: the moat Netflix is in the midst of building. The WSJ article states: "It is a treadmill that is difficult to get off of. If new content helps gain subscribers, then logically cutting spending, and content, risks losing them too." What this fails to account for is the fact that Netflix's content is a fixed cost. Like any high fixed cost business, it incurs more costs than incoming revenue until revenue growth eventually tips the scale. The underlying structure of a high fixed cost business model is a volume play – which Netflix is aggressively pursuing.
That shift may be underway. As of 2020, while still negative, free cash flow is expected to improve. As operating margin and profits improve, so will working capital needs. And the way I read their financials, I expect that to be the start of the inflection point.
Digging A Competitive Moat
A high fixed cost acts as a barrier to entry for other businesses trying to enter the space – and in VOD there are many. With TV the last bastion of media revenue as other revenue sources have collapsed, more and more players are trying to tap into the rare alternatives for growth.
The capital Netflix is willing to spend on content compared to its competitors will not only accelerate but also widen the moat Netflix is building. This is why Netflix's business model can't be replicated by other media companies vying for a bite of SVOD. Netflix should be working to maximize subscriber growth.
While I won't dismiss the imperative for Netflix to get cash under control – one speculated reason behind the recent hire of their CFO – I don't believe you can judge Netflix's performance with that metric in isolation. It is critical to look at how Netflix is using its resources within the context of the rest of its strategy and business. If Netflix has proved anything, it's that it's a data-driven company. And if it has made a specific, albeit unpopular, financial choice, we can almost be certain there is a compelling reason behind it.
And follow Stephanie Denning on Twitter: @stephdenning
Also Read:
Why Disney+ Isn't A Threat To Netflix
The Netflix Pressure-Cooker: A Culture That Drives Performance
Incubating Culture: How Netflix Is Winning The War For Talent
