3 Massive Risks Facing Netflix Inc.

By Markets Fool.com

After becoming a household name in the United States, boasting nearly 40 million subscribers in its home country at the end of 2014, Netflix has set its gaze abroad. The company is aggressively expanding overseas, spending heavily to ensure it becomes the dominant Internet TV service in every country that it enters. Already, Netflix has 18 million international subscribers in 50 countries, and it plans to operate in 200 counties within the next couple of years, generating meaningful global profits starting in 2017.

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It's a compelling plan, and if Netflix succeeds, profitability and the stock price could soar. But this plan doesn't come without risks, and it's important to consider what can go wrong before investing in the stock.

The downside of original content
One of Netflix's most important endeavors in the past few years has been creating original content. While the vast majority of Netflix's content is still licensed from third parties, and often not exclusive to Netflix, the company is spending an increasing amount of money funding the creation of original content for its subscribers. In 2015, Netflix expects to launch 320 hours of original content, three times as much as it launched in 2014.

The company has had some major successes so far. Its content has received 45 Emmy, 10 Golden Globe, and two academy award nominations in just a few short years. House of Cardsin particular has proven to be extremely popular, helping to define Netflix's brand and differentiate it from all of the other streaming options.

But this original content is expensive. Netflix spent $100 million to develop the first two seasons of House of Cards,and that only got the company exclusive streaming rights. Episodes can be purchased on Amazon Instant Video, on DVD or Blu-Ray, and even on-demand through Comcast.

Another Netflix exclusive, Marco Polo, was even more expensive, costing Netflix $90 million for just the first 10-episode season. Unlike licensing third-party content, original content requires Netflix to produce much of the required cash up front, which has caused cash flow issues for the company. Netflix's free cash flow has been negative since 2012.

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While Netflix has been successful with its original content so far, a string of expensive failures could prove disastrous for the company. According to The New York Times, a staggering 70% of network TV series were canceled within one season over the past decade, and another 11% were canceled within two seasons. Netflix's algorithms may allow it to have better luck picking winners, but the prospect of a $100 million dud, or a string of them, should be a concern for investors.

Using debt to fund expansion
Netflix doesn't earn enough profit from its U.S. operations to fully fund both its original content ambitions and its rapid international expansion. The company has turned to debt as a result, and it expects to continue to raise long-term debt as needed to fund its growth.

At the end of 2014, Netflix had $900 million in debt on its balance sheet, but in February of this year, it raised an additional $1.5 billion in long-term debt, with a weighted average interest rate of 5.7%. This will increase Netflix's annual interest payments by about $86 million, or roughly one-fifth of the company's operating profit in 2014.

As debt piles up on Netflix's balance sheet, the potential negative consequences of the company's expansion plans falling short of expectations will be magnified. If profitability in Netflix's international markets doesn't improve as quickly as the company anticipates, or if its growth in the U.S. stagnates earlier than expected, those big interest payments could become a real problem.

An explosion of competition
Netflix hasn't faced all that much direct competition over the years. Amazon has probably been the most serious competitor, and its willingness to spend heavily on content is no doubt a serious concern for Netflix. But the Internet TV revolution is still in its infancy, and competition is only going to intensify going forward.

Time Warner's HBO, which has long been tied to cable, is finally planning to offer a stand-alone streaming service, HBO Now. Set to launch this month, HBO Now will dramatically lower the cost of entry, allowing extremely popular shows like Game of Thrones to be viewed by anyone with an Internet connection and $15 a month to spare.

Sling TV, a service from Dish Network, is another recent option, allowing for the streaming of popular cable channels like ESPN. CBS is also entering the streaming business directly, offering its CBS All Access service for $5.99 per month, which includes 6,500 episodes of CBS shows on-demand, as well as next-day access to new episodes.

With streaming services less expensive than a cable package, subscribing to multiple services will likely become the norm. But with the number of options expanding quickly, Netflix will need a continuous stream of compelling, exclusive content in order to keep subscribers around. HBO has a long track record of success in that area, while Netflix has only a couple of years under its belt.

Netflix's growth so far has been nothing short of extraordinary, and its plan for worldwide domination is ambitious. But there's plenty that could go wrong, and with the amount of debt the company is taking on to fund its expansion, it's essentially betting the farm on its long-term plan. If the company succeeds, shareholders will likely be rewarded, despite the high valuation the stock currently receives. But even the slightest setback could send shares tumbling.

The article 3 Massive Risks Facing Netflix Inc. originally appeared on Fool.com.

Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.