Netflix Puts Content Above Costs but Is the Policy Sustainable?

Netflix (NFLX)NFLX briefly overtook Disney as the world’s biggest media company this week but some analysts are wondering if the streaming service’s rapid growth is sustainable. The company behind Stranger Things and The Crown must continue producing hits, poaching Hollywood talent and gaining subscribers at a rapid rate if it is to justify the faith of an investment community that pushed its valuation to nearly $162bn (£121bn) on Thursday – $10bn ahead of Disney (DIS)DIS.

Netflix had reverted to second place by the close of trading but the trajectory is clear: the California-based business that started out as a DVD rental outfit in 1997 is putting Hollywood and conventional broadcast networks in the shade. It has 125 million subscribers worldwide – including more than 55 million in the US and more than 8 million in the UK – and this year the company is spending $8bn on content, including 700 original TV shows and 80 movies.

This week, the company announced yet more of the high-end content deals that underpin its growth, signing up Barack and Michelle Obama to produce films and documentaries, and announcing a $150m blockbuster, Six Underground, starring Ryan Reynolds.

The expenditure behind the casting coups and award-winning content, however, is significant. Netflix expects a negative free cash flow of between $3bn to $4bn this year – meaning the amount its spends on content, marketing and other costs in 2018 will exceed what it earns from subscribers by at least $3bn. It needs debt, and willing banks, to do this. Last month, Netflix raised almost $2bn in debt – its largest raise to date and the second time in less than a year it has turned to the debt market – to continue to feed film and TV content to the binge-watching generation it helped create.

“They need to keep on borrowing as they are investing so much so quickly in content and have to stay ahead, there’s nothing else they can do,” Tom Harrington, an analyst at Enders, says. “They have to stay ahead of Amazon (AMZN)AMZN and Apple (AAPL)AAPL, and soon Disney. They are at the moment but there are very well funded, larger, competitors starting to get their act together.”

The Amazon founder, Jeff Bezos, does not like to come second and showed his intent to take the fight to Netflix with an edict to find a Game of Thrones-style hit for its Prime Video service resulting in executives striking a $1bn deal to bring the Lord of the Rings to TV. So, too, Apple, which outbid even Netflix’s seemingly bottomless pockets for a TV series starring Reese Witherspoon, who on top of her Hollywood star premium commands astronomical fees after the success of HBO’s Emmy-winning Big Little Lies, and Jennifer Aniston.

Disney has pulled its vast array of content – from Star Wars and Toy Story to Beauty and the Beast and the Marvel universe of superhero films – from Netflix before launching its own streaming service next year.

In the global quest to win subscribers Netflix has sparked a content arms race that is becoming an increasing financial burden on the company.

Netflix declares a small profit – net income was $290m in the first three months of 2018 – because it is able to spread the spiralling costs of making programmes over a number of years. However, the company has almost $30bn of debt and liabilities across its balance sheet.

Netflix’s total streaming obligations, for making and licensing TV and film content, will cost $17bn over the next few years, while its long-term debt as of 31 March was $6.5bn. It also has $3bn to $5bn in costs it expects to pay relating to “traditional film output deals or certain TV series license agreements where the number of seasons to be aired is unknown”. Including the recent debt raising, the company’s total liabilities are around $30bn.

In Netflix’s favour, it remains in high-growth mode, a 20-year old business with the profile of a digital startup, that makes it a darling with investors that has kept it insulated from negative market sentiment. Revenues surged by 32% to $11.7bn, thanks to millions more subscribers agreeing to pay from £5.99 per month in the UK and $10.99 a month in the US.

However, Netflix’s practice of spreading the cost of programmes over a multi-year timeframe – an industry standard – is being questioned by some analysts who argue that the binge-watch nature of an on-demand world means the value of a programme or film expires much quicker than on traditional linear TV.

“Nominally Netflix looks profitable,” Richard Broughton, an analyst at Ampere, says. “That is because all of the cash burn on productions and acquisitions is amortised over a number of years. But on-demand is different to traditional broadcast. The schedule is compressed and there are questions over that [practice for Netflix] and does it feed through to profit and loss in the same way and is it realistic.”

Meanwhile, the content deals keep coming. It has an agreement with Shonda Rhimes, creator of hits including Grey’s Anatomy, Scandal and How To Get Away With Murder; a $300m deal with Ryan Murphy, whose credits include Glee, Nip/Tuck and American Crime Story; the Friends co-creator Marta Kauffman, and Jenji Kohan, who is behind Weeds and Orange is the New Black. All of these cost a lot of money and are driving inflation in Netflix’s content costs.

“Netflix is trying to solve a problem of its own making,” Broughton says. “There are two elements here. Netflix wants to make sure it has brand strength associated with its own titles – like [pay-TV channel] HBO with Game of Thrones – and it also increasingly can’t afford to be beholden to anyone else for too many killer show brands. Netflix can’t be at the mercy of content suppliers, some of whom like Disney would rather pull content to protect themselves.”

Netflix anticipated the threat of studios pulling their content. Over the last five years it has been trying to insulate itself against the inevitable content backlash. So Netflix has been rapidly boosting its spend on original productions. Ted Sarandos, Netflix’s chief content officer, recently said the goal is to spend 85% of its total budget on its own content.

Netflix is adamant it can continue growing at a healthy rate. Its backers argue: 700m broadband and pay-TV homes around the world (excluding China) have yet to take up a subscription; Disney and its ESPN sport unit happily shoulder sport programming commitments of $50bn; and the S&P credit rating service has put the company’s debt, which carries the riskier junk status, on a positive watch.

The question is, can Netflix add enough new subscribers – and hopefully raise subscription costs – to keep up its increasingly costly spend on content, and service its debt.

“Providing Netflix’s growth on subscribers and revenues remains at the same trajectory it is sustainable,” Broughton says. “Netflix has been adept at increasing pricing without losing subscribers but that is going to be difficult in its new growth markets like Asia and Africa, where there are cheaper competitors already. This year could be when Netflix starts to see slower growth. If the growth slows they are in trouble.”