Sooner or Later Content Costs Will Catch up to Netflix Stock

The days of rapid expansion are over for Netflix stock

Amid international expansion and record subscriber numbers, Netflix (NASDAQ:NFLX) faces more competition than ever. Netflix will soon lose Disney’s (NYSE:DIS) content. Moreover, it faces more companies adding a streaming service. Amid these threats, Netflix stock continues its long-term uptrend.

So far, Netflix has maintained this lead with new content and market expansion. However, keeping this current pace could hurt holders of Netflix directly. With a heavy debt load, the company may have little choice but to issue more shares, directly undermining the value of NFLX stock.

Transformation and Netflix stock

Netflix has become arguably the most transformative company of the last decade. Looking back, some might find it hard to believe that the Justice Department once fretted over the attempt by Blockbuster Video to take over its then-largest competitor, Hollywood Video. Netflix made this irrelevant.

Over the last few years, we have also seen consumers increasingly drop pay-TV services in favor of streaming video. The once-loved programming of the major networks only gains scant attention today. Again, we have Netflix to thank.

Consequently, valuations in Netflix stock have remained high for several years. Admittedly, I have predicted Netflix’s relative decline for a long time, and the market has responded with a higher price for Netflix. For now, content and aggressive international expansion have kept Netflix ahead of its competition.

Netflix Stock Isn’t Profitable

However, I think our own James Brumley points to the real problem that true profitability remains elusive. As he points out, Netflix will reportedly spend $15 billion on content in 2019, up from the $12 billion in outlays for 2018.

Interestingly, the company balance sheet states that “cost of revenue” came in at only $9.97 billion for 2018. Content seems like a cost of revenue to me. Regardless, these numbers indicate that if Netflix considered its homegrown material a true cost of revenue, it does not earn a profit.

So far, Wall Street has not punished Netflix stock. Moreover, even though I disagree with my colleague Will Ashworth on NFLX, I think he correctly predicts that Disney+ will not lead to widespread cancellations of Netflix service. But the worries extend beyond Disney+. They extend to Disney’s Hulu, Prime Video from Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), which can afford to outspend Netflix on content, and numerous others.

Stockholders Will Pay

Netflix has now resorted to junk bonds to fund its expansion. As a result, it currently holds about $10.3 billion in long-term debt. This has become a heavy burden on a firm with only $5.7 billion in stockholders’ equity. When the junk bond market ceases to remain an option, the company will have little choice but to cut content spending or resort to issuing more stock.

As it is, NFLX stock trades at about 127 trailing earnings. The equity supports a forward price-to-earnings (PE) ratio of just over 60. Admittedly, many traders will pay that multiple if the predicted earnings increases of 27.6% this year and 71.3% in 2020 come to pass. However, if the supply of shares proliferates, investor sentiment could cool off.

Looking at the charts, one might wonder if it has already cooled off. Since February, Netflix has traded in a narrow range. Time will tell whether this period is a pause before moving higher or an indication of increasing doubts about NFLX.

For this reason, I do not recommend a short position. However, with a steadily worsening balance sheet and negative cash flows, I would not own this name at current levels.

Final Thoughts on Netflix Stock

Netflix may soon have to fund its content budget with aggressive share issuance, thereby undermining the stock’s value. For most of its history, Netflix has built itself on market disruption.

Now, with numerous companies copying its model, it has had to move into new markets and spend heavily on content to stay ahead.

However, the cost of this expansion has forced NFLX to issue increasing amounts of junk bonds. With more debt becoming less of an option, Netflix will have to become just another streaming company or dilute its stock. Both options bode poorly for holders of Netflix stock.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.


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