If you want to understand what Netflix, Inc. (NASDAQ:NFLX) is all about — and why I would never buy it for my stock advisory newsletter, The Liberty Portfolio — you have to have a clear understanding of Netflix’s financials. That, in turn, means having a clear understanding of the NFLX business model.
You should forget what Netflix used to be, which was a dumb pipe that delivered content; first via DVD through the mail, and now increasingly through streaming. At the time, NFLX stock was a problematic investment because Netflix wasn’t, well, Netflix, without content.
Understanding NFLX Stock
That meant CEO Reed Hastings had to pay for content. So the studios demanded a lot of money to access that content, and because everyone knew what the financials were for NFLX stock, they could just bleed Netflix dry of free cash flow every quarter.
As I wrote long ago, every studio and content creator would eventually have their own streaming service at some point. It is the most efficient way to monetize content, although licensing it to third-party websites may make sense in some cases.
Once streaming services started to grow, Netflix had to pivot from the distribution business model. If it had some kind of proprietary method of streaming, then it would make all the sense in the world to invest in it. That’s not the case.
So Netflix moved increasingly into original productions. At first, it did so modestly. It did this to become a kind of value-add, to show it was worth owning because it offered some original quality programming. It also would mean it wasn’t as reliant upon third-party content. Since streaming is now ubiquitous, however, it has had to throw itself headlong into original production, which is very expensive.
Not only has Netflix moved into that arena, it has moved into that arena in a very big way. It produces a ton of content, with the idea that it wants to compete with HBO and Showtime and other pay TV outlets.
The math then becomes simple: Netflix must earn more in subscription fees than it spends on production and running the actual company. If it does that, it has free cash flow. It it doesn’t, it must raise additional capital via debt or equity markets to continue to finance content and operations.
Bottom Line on NFLX Stock
NFLX stock is in a terrible position right now because it is burning lots and lots of cash. It burned $390 million of cash in Q1 alone. NFLX stock has less than $1.1 billion of cash on hand, so it will be out of money by the end of the year. That is, it would have been if it hadn’t offered another $1.4 billion in debt, this time coming from overseas, for a mere 3.625% interest rate.
So this will continue to be the case for some time according to the first-quarter shareholder letter. That is, increasing debt for more original content. In the meantime, the question is if subscription revenues sustain the cash flow on its own.
That will be tricky considering that the higher-margin DVD business is slowly dying, replaced by slowing domestic streaming, leaving international streaming the only remaining high-growth arena. Meanwhile, international streaming finally turned a profit this quarter. At some point, once growth slows and markets are saturated, Netflix will raise prices.
The advantage Netflix has is that its content is generally excellent, so there should be demand. The question is what price point will consumers accept?
Regardless, this cash flow situation won’t be resolved for years to come, which means more and more debt for NFLX stock. Paying more than 200 times earnings for NFLX stock is ridiculous at this time, and I’d need to see a massive trim in price before I could even think about getting involved.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
