Netflix Inc. Delivers a Fair Q1 Report, but Huge Spending Worries Investors

In this segment from the Market Foolery podcast, the teamdigs into Netflix's (NASDAQ: NFLX) latest earnings report. Analysts expected more robust subscriber growth, but operating profitability remains strong.

And while Wall Street might not have wanted to hear that investments in content would mean negative free cash flow for years to come, growth opportunities for the company are still massive.

A full transcript follows the video.

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This video was recorded on April 18, 2017.

Chris Hill: We're going to start with Netflix.First-quarter profits came inhigher than expected, but subscriber growth,a little bit lower than projected,and there's a bunch of things we can get into here. But Jim,I'll start with you,then David. What's your headline for this quarter?

Jim Mueller:Theheadline for this quarter, I think, is they'regoing to be raising more debt. Whenthey reported in theend of last year,earlier this year, theyprojected they're going to spend $2 billion in free cash flow. Negative $2 billion free cash flow. That'sbecause they're still buying a lot of content to run thatvirtuous cycle. More members, more money,more good content, more members, and so on. As long as that works, they'll be fine. They'reprofitable. Their operating profitcame in really nice at 9.7%, higher than the 7% target they have for the year. This isthe first year where management is actually targeting and actually saying, "OK, we'regoing to start becoming profitable. We've been running for so long,we're going to become profitable." But, they were saying7% target for the year,so they're going to ramp upspending a little bit in the second quarter to bring that back down, from 9.7% back to the7% target. But it's free cash flow. Companies are in business to generate cash. If you're not generating cash, you're going to have to raise cash somehow, which means they're going to be raising more debt. A line from the release letter,that's what they call it, dear shareholders, they --

Hill:That's so quaint.

Mueller:Yeah.[laughs] They think theirleverage ratio is just fine.

Hill:I'm sorry, leverage ratio?

Mueller:No,they actually call it debt to total cap. And it took me a while. I thought for a momentthey meant debt-to-capital, which is a common ratio. Debt to total capital invested in the business, that's debt andshareholder equity. No,what they're talking about is debt to market cap. That set me back. They're well under 10%compared to peers that are at 30%, 70%, in that range. And that's true.Time Warner, 31% debt to market cap. But Netflix has a debt to capital ratio of over 50%. It's about 53%.

David Kretzmann:You'retalking about the first definition you mentioned?

Mueller:Yeah, debt to invested capital. They're about53% while Time Warnersits at 48%. So they can say, "We can leverageup because Time Warner is leveraged up." But it makes me a little nervous, really.

Hill:David,what's your headline?

Kretzmann:Similar to Jim's,Netflix is reiterating that they will be in investment mode for years to come. Like Jim mentioned,in the letter, they said, "Yeah,free cash flow is negative,and it will be negative for years to come."

Hill:Many years.

Kretzmann:Yeah, many years.I don't know if that was something Wall Street wasnecessarily expecting.I think people would hope that the free cash flow wouldeventually become positive, sooner rather than later. But Netflix right now,this year, they're spending $6 billionproducing original content. And that number will continue to tick up for theforeseeable future.And the numbers that Jim mentioned,the numbers that Netflix highlightedin the letter, right now, they have about 10% of their market cap is in debt, compared toLions GateorStarz--

Mueller:Actually,it's closer to 5%.

Kretzmann:OK. So, it's under 10%. Compared toDiscovery CommunicationsorTime Warner, yeah, Netflix has a lower amount of debtcompared to those companies. Butthose other companies are also producing positive free cash flow.I feel likemanagement is stretching their definitions a little bit to say, "No,it's totally OK, don't worry, we'llcontinue to bring on billions of dollars of debt,don't worry about it." It's like, you guys aren't producing positive free cash flow. Your burn rateis actually increasing.So really, it comes down tothe original content they're producing,is it good enough, quality enoughto bring in new subscribers,continue to keep that subscriber growthgoing, andretain existing subscribers? That is what it comes down to. I thinkmost people would say, yeah, theiroriginal content tends to be pretty good, it's aneffective investment. But there are a lot of risks with the cash flow situation there.

Hill:Theywent out of their way tohighlight the fact that --they have a deal with Adam Sandler -- is it over 500 million?


Hill:"Five hundred million hours of Adam Sandler movies have been watched by our customers."

Mueller:SinceTheRidiculous 6,I think is the name of the film, which was first of their deal, andthey just extended the deal with Sandler, too.

Kretzmann:I haven't met anyone who thoughtthat was actually a good movie,but apparently a lot of people have watched it. And I did watch it.

Hill:My reaction was the same as you two in this moment, was,I just started laughing, I said, are you kidding me? Five hundred million hours' worth ofAdam Sandler movies have been watched? Butthe more I thought about it, the more I think it wassmart of them to call that out,because one of the signals that sends to Wall Street,if you think about it, is, "We knowwhat our customers are watching. We know what they're watching. We knowwhat they want to watch. Andall you people who made fun of us when we struck the deal with Adam Sandlerin the first place,500 million hours watched. How do you like me now?"

Kretzmann:In the letter, theyalso highlighted a couple of movies or shows that flopped. One of them that they mentionedwas the sequel toCrouching Tiger, Hidden Dragon, wherethey said, this is one that didn't work out so well. So they are admitting that not everything they're producing is a hit. Going forward,when they're investing this amount of money, when they'reburning this amount of cash and raising that amount of debt, it really does sting for them to have content that doesn't resonate well with audiences.I think that'll be something to watch.

Mueller:I like to hear that, too. If everything is a massive success, then they might loosen their controls on what they decide to invest in. So I like to hear that something doesn't work out as golden as most of the stuff.

Kretzmann:They're paying attention to it. They're not just throwing money blindly. So it is good to see them focusing on that.

Hill:There was a point in time with Netflix where international growth was being watched closely, and the number of countries that they were in was a point of focus. Now,it seems like since we've run out of countriesfor them to actually go into,now the opportunity and the challenge for Netflix isgetting more subscribers in those countries. Jim,can you look at this stock and say, OK,even with everything we've already said about the free cash flow,even with the fact that this is kind of still a pricey stock,is there still an enormous opportunity overseas?Because it kind of seems like there is.

Mueller:Honestly,I think there is. Full disclosure,Netflix is my single largest position in my portfolio,and I've held shares since early 2007. So I have a nice basis on these shares. That might becoloring my viewpoint a little bit,because so much of my investments aretied up in this company. But having said that, I think the addressable market,which is what your question is about, Chris, is still quite large. So they'rerecently penetrated in the U.S. about 50% or so into all of the households in the U.S. David Wells,CFO, mentioned that in the call, that some of their earlier international markets, they didn'tname them, but probably Canada orLatin America, maybe,but I was thinking probably Canada, arereaching that level as well. That does demonstrate thatit can be popular enough,and they can figure out that combination of [phone rings] -- I don't know why my phone rings,I don't know why it's audible. Apologies. They do figure out, inEurope and Australia, inLatin America, in Canada, they have figured outthe mix of content,locally grown, international,from Hollywood and the U.S. orwhatever that brings in subscribers and keeps them coming. And they're still working on that in Africa and Asia and thecountries they launched in last year. But that launch last year was in 120, 130 countries, was mostly mobile launch. There are a bunch ofmobile broadband accounts in the world, something like 3 billion of these things. Ifthey can get the penetrationin that, there's still a very big opportunityfor the company.

Kretzmann:I thinkHBOnow has 128 millionsubscribers, and management says they expect Netflix to cross 100 millionstreaming subscribers this weekend. So there's still room for them to catch HBO,potentially, in the next couple years. And, from there, as Jim mentioned, it'sjust a matter of grabbing more subscribers there. Andmanagement really is focusing on creating that local content,whether it's Mexico, Brazil, France, you name it, and trying to find the rightproportion of local content, as well as the global content that'savailable in every country.I think another deal that willcontinue to really help Netflix is their deal withDisney. This year,Rogue Onewill be streaming on Netflix, andfutureStar Warsfilms will be streaming on Netflix,a lot of the Pixar and Disney animation movies arealready on there. I think that will help to continue to attract some new subscribers.

Mueller:Certainly here in the U.S. That deal with Disney, the movie releases, is U.S. and Canada only. So they might renegotiate to get the worldwide rights to those things. But playing off your comment on productions in Mexico, theirSpanish content is not justLatin America, but the entireSpanish-speaking worldacross the planet. Their international content, theirinternationally produced content, isplaying pretty well all around the world.

Chris Hill owns shares of Walt Disney. David Kretzmann owns shares of Discovery Communications, Lions Gate Entertainment Class A, Lions Gate Entertainment Class B, Netflix, and Walt Disney. Jim Mueller, CFA owns shares of Netflix. The Motley Fool owns shares of and recommends Discovery Communications, Lions Gate Entertainment Class A, Lions Gate Entertainment Class B, Netflix, and Walt Disney. The Motley Fool recommends Time Warner. The Motley Fool has a disclosure policy.