Image source: Netflix.
Continue Reading Below
All those movies and television shows on Netflix (NASDAQ: NFLX) don't come cheap. The streaming-video leader expects to spend $6 billion on content this year. It's hard to generate any cash with that much spending when the company has generated only $7.6 billion in total revenue over the trailing 12 months. Indeed, CFO David Wells told the audience at Goldman Sachs' Communacopia conference, "We're burning or needing, in terms of free cash flow, about $1 billion to $1.2 billion a year."
Importantly, Wells added, "I don't see that changing."
Netflix is investing heavily in its global expansion and original content -- which costs more upfront than content licensing. To fund that investment, it's been tapping the debt markets. Netflix already has $2.4 billion of long-term debt on its balance sheet, and it plans to raise more debt in late 2016 or early 2017.
How much more debt can Netflix afford?
The debt markets are still very attractive, but should investors concern themselves that Netflix is piling up a mountain of debt to fund its expansion?
Wells argues that Netflix still has some way to go before it taps out its ability to leverage the company. He says the company could raise as much as 25% of its market cap in debt. With a market cap around $40 billion, that implies Netflix could quadruple its debt load.
But if you compare Netflix with other media companies, it could be even more levered without facing much backlash, according to Wells. CBS (NYSE: CBS), for example, has $9.5 billion in long-term debt, with a market cap less than $23 billion. Viacom (NASDAQ: VIA) has $12.3 billion in long-term debt with a market cap of $15.6 billion. And Viacom is getting ready to issue another $1 billion bond offering.
Considering Netflix is a larger company than both CBS and Viacom, there's no need for it to rack up the same relative amount of debt as either of those more traditional media companies. But since it has a reliable and steady stream of revenue coming in from subscriptions every month, it can certainly afford to take on more debt than companies with more seasonality. Its $1.8 billion cash buffer helps as well.
Why it's worth it for Netflix to raise debt
Most of Netflix's debt is going to fund its growing investment in original content. Wells indicated that the company's goal is for 50% of its content to be originals eventually. Originals cost Netflix a lot up front, but they account for an outsized portion of viewing on Netflix and help reduce churn as new originals come out every month.
Licensed content from the likes of CBS or Viacom comes with a term limit. Once that term expires, Netflix either has to renew the contract with new terms or let it go. Additionally, it's much more difficult to acquire global rights for licensed content. With Netflix's global expansion earlier this year, global content rights that it can hold indefinitely are very valuable.
In the long run, original content is one of the most effective ways for it to deploy cash. Using debt effectively should enable Netflix to grow its subscriber base as quickly as possible.
At some point, Netflix will have a large enough catalog of originals that it won't have to incrementally increase its content spending every year to attract new subscribers. At that point, Netflix will theoretically become a cash-generating machine as its monthly subscription revenues start falling to the bottom line. But even Wells wasn't bold enough to venture a guess on when that might be.
A secret billion-dollar stock opportunity The world's biggest tech company forgot to show you something, but a few Wall Street analysts and the Fool didn't miss a beat: There's a small company that's powering their brand-new gadgets and the coming revolution in technology. And we think its stock price has nearly unlimited room to run for early in-the-know investors! To be one of them, just click here.
Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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.