Netflix (NASDAQ:NFLX) has begun amassing huge growth in free cash flow as of its latest quarter ending June 30. Moreover, Netflix stock will likely continue to benefit from further gains in positive free cash flow (FCF) for the third quarter. Those results will be released on Oct. 20.
By the way, Netflix is one of the few large firms that provide excellent access to its financials. For example, on its investor relations page, the company provides a direct download link to an Excel spreadsheet that shows all of its financials. I highly urge anyone interested in the company to use this.
Free Cash Flow Is Positive and Growing
But here is the main point that is very exciting about Netflix. It is now producing positive free cash flow. Q2 was the second full quarter where this occurred, and it was on a full basis.
For example, during Q2 Netflix produced $899 million in positive free cash flow for the quarter. You can see this in the financial download spreadsheet and then go to the tab entitled “Cash Flow.” Moreover, the company made $1.06 billion in positive FCF in the first half.
I believe that Netflix will continue to show large amounts of FCF for the quarter ending Sept. 30, which will be released on Oct. 20. The reason is simple. Its FCF margin in Q2 was very large and likely continued to be so during Q3.
Here is how that works out. Netflix made $6.148 billion in Q2. Therefore its FCF margin was 14.9% during Q2. This was up from 2.8% in Q1, and so indicates that the FCF margin is likely close to a normalized rate.
Now since analysts expect revenue to hit $6.38 billion, its FCF, at the 14.9% margin rate would be $950.6 billion. On an annualized run rate that would be $3.8 billion in annual FCF. This will be important in valuing Netflix stock.
Membership Growth Propelling Positive FCF
The root cause of the massive move into positive FCF was its membership growth in the last two quarters. Netflix’s subscriber growth continues unabated. This is likely to continue in Q3 and the rest of the year.
For example, the number of new paid memberships in Q2 was 2.657 million. Much was made about the fact that this was lower than the 3.6 million in new members in Q1. But investors forgot to look at the bigger picture.
First, its Q2 2020 membership numbers were significantly higher than a year ago when the company was still producing negative FCF. You can see this in the tab named “Regional Information” in the Netflix spreadsheet mentioned above. In Q2 2019 the number of new paid members was just 801 thousand. So the jump to 2.657 million in Q2 2020 showed enormous non-linear growth.
Second, typically the second growth new paid membership numbers lag the first quarter’s numbers. Third, due to the lock-down effect, the total of 2020 new paid memberships in the first half of 2020 exceeded all of 2019.
For example, there were 6,259 new members in the first half of 2020. There were only 5.626 million new members in 2019. So whatever happens in Q3 and Q4 is pure growth.
Therefore, when the numbers come out on Oct. 20, don’t get too wrapped up in the growth aspects. Don’t fret if the memberships turn out to be lower than in Q2 or even Q1. What matters is whether it remains net FCF positive.
For example, the quarter might show lower absolute new memberships while the company still shows higher net positive FCF. This is because the base is now beyond the inflection point of remaining free cash flow positive.
Why Positive FCF Is So Important for Netflix Stock
The reason is simple. Netflix is loaded with debt. It has $15.8 billion in gross long-term and short-term debt on its balance sheet. However, Netflix also has $7.15 billion in cash. Therefore, its net debt is $8.64 billion.
Now, as I mentioned above, if the company remains on a run-rate of producing $3.8 billion in FCF, it could afford to pay off the total amount of debt in about four years. (This can be seen by dividing $15.8 billion in debt by $3.8 billion in annual FCF).
What is more likely to happen is the company will pay down its debt so that it is either net cash positive or close to it. As long as this net debt number is no more than 25% or so of equity the company is not considered highly leveraged.
This is what UK and European analysts call “gearing.” For example, Netflix has $9.3 billion in shareholders’ equity. As long as its gearing ratio is no more than 25% or so of this number, or $2.325 billion, it will be safe. Right now Netflix has a gearing ratio of 92.9% (i.e., $8.64 billion divided by $9.3 billion).
Therefore it just needs to reduce its debt by less than two years of FCF. For example, two years of FCF of $3.8 billion would reduce the net debt number to $1 billion. This would result in a gearing ratio of just 10.75%.
What To Do With Netflix Stock
I suspect that Netflix stock could take a hit if the Street does not like its consecutive membership growth numbers. But you know better. If FCF is positive, it will mean that the company’s net debt ratio compared to its equity is much safer.
Therefore, I would take the opportunity to buy stock or go long in any form if Netflix stock shows any weakness.
In the next year or so, that could potentially allow the company to begin paying a dividend. Watch out for what will happen to Netflix stock if that happens.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.