The Dumb Reason Netflix Is Piling Up Debt

By Timothy Green Markets Fool.com

When streaming-giant Netflix (NASDAQ: NFLX) reported its first-quarter results on April 17, there was plenty to unpack. Subscriber growth was a bit slower than expected, with the lack of a blockbuster hit partly to blame.

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The company plans to spend $1 billion on marketing globally this year to drive growth, along with $6 billion on content. Free cash flow is expected to be negative $2 billion this year, and the company doesn't expect to be free-cash-flow positive for many years into the future. Inexplicably, Netflix users have spent more than 500 million hours watching Adam Sandler films.

What caught my eye, though, was Netflix's brief justification for its rapidly growing debt. Netflix had $3.37 billion of debt at the end of the first quarter, up from just $900 million at the end of 2014. With free cash flow set to run negative for the foreseeable future as Netflix plows cash into content, that number will keep rising going forward.

Image source: Netflix.

Investors shouldn't worry about that pesky debt, said Netflix in its first-quarter shareholder letter. Compared to other media companies, the streamer is being cautious:

Our debt to total cap ratio, at under 10%, is quite conservative compared to most of our media peers at 30%-70%, and conservative compared to efficient capital structure theory. Thus, we will continue to add long-term debt as needed to finance our expansion of original content, including in Q2'17.

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A ratio for any occasion

When I first read this section of Netflix's letter to shareholders, I assumed that by "debt to total cap ratio," the company was referring to the debt-to-capital ratio, which measures the percentage of the total capital that's comprised of debt. This is a standard ratio that describes a company's capital structure.

But Netflix's debt-to-capital ratio is nowhere near 10%. Netflix is actually talking about the debt-to-market-capitalization ratio, which is an entirely different thing. And it has nothing to do with its capital structure.

Netflix's market capitalization is about $62 billion, putting the debt-to-market-cap ratio at just 5.4%. This is indeed far lower compared to its media peers. Time Warner has a debt-to-market-cap ratio of about 31%, whileCBS Corp. has a debt-to market-cap ratio of 33%. Twenty-First Century Fox has a debt-to-market-cap ratio of 36%.

But this ratio isn't very meaningful. The denominator, the market capitalization, is a function of the optimism of investors. Netflix stock trades for seven times 2016 sales and more than 300 times 2016 earnings. Its media peers have valuations much closer to the market average. Any ratio where the denominator depends on the valuation is going to produce a lower result for Netflix, by default.

If Netflix's stock price rises by 10%, can the company pile on 10% more debt without any additional risk? If the stock price falls, will Netflix pare back its expansion plans to reflect that its balance sheet is no longer quite as "conservative?" Of course not.

Netflix's debt-to-capital ratio, which is the total debt divided by the sum of the total debt and shareholders' equity, is 53%. That's in the same ballpark as its peers. Time Warner's debt-to-capital ratio sits at 50%, CBS's at 72%, and Twenty-First Century Fox's at 58%. Using a ratio based purely on the balance sheet, Netflix's use of debt is far from conservative.

Why this matters

There's nothing wrong with taking on debt to fund expansion. Netflix would not be able to grow nearly as fast without raising additional capital. But don't let the company fool you into believing that this debt doesn't come with risk. It does.

If all this spending on content doesn't produce the return on investment that Netflix expects in the long run, this explosion of debt will be a major problem. That's the big unknown with the Netflix story. It might all work out fine, with the much larger Netflix of the future throwing off billions of dollars in cash each year, even after servicing the debt that got it there. But it also might not.

Investors should hope that Netflix isn't using the debt-to-market-cap ratio to justify decisions internally. If it is, the company might as well use the debt-to-hours-watching-Adam-Sandler-films ratio, which is also quite conservative compared to its peers.

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Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Netflix. The Motley Fool recommends Time Warner. The Motley Fool has a disclosure policy.