Netflix (NASDAQ: NFLX) isn't shy about discussing how much cash it burns. It's been free cash flow negative for a few years now, and management wrote, "[W]e expect to be FCF negative for many years" in its second-quarter letter to shareholders. In a recent interview at the Goldman Sachs Communicopia Conference, CFO David Wells reiterated that statement. He added that the more successful Netflix is, the longer it plans to burn cash.
Netflix's ongoing cash burn means it will continue to pile up debt. And it's paying a premium on that debt, since it's already carrying a relatively high debt-to-EBITDA ratio. Considering Netflix doesn't plan to increase EBITDA anytime in the near future, it's going to continue racking up interest expenses to fund its growth.
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Original content is to blame
Wells said the company could produce positive free cash flow, or at least be close to it, if it licensed its original programming instead of financing it. Indeed, before Netflix dove headlong into original content, it occasionally produced positive free cash flow. Even its quarters of cash burn were relatively modest -- $50 million here, $20 million there. Now it's burning $2 billion to $2.5 billion per year.
But Wells says there are a couple of major advantages to producing content in-house despite the fact that it costs the company more upfront. First, it allows for better long-term economics by removing the profits of the production company. That may be why Netflix claims originals are some of its most efficient content spend. Second, Netflix obtains better control over the content and intellectual property rights, allowing it to distribute the productions globally.
So even with Netflix's high interest rates on its bond issues, it might be saving money in the long run by financing productions itself and removing the middleman.
Spending won't slow down until user growth does
Wells told the audience at Communicopia, "The faster we grow, the more we're going to reinvest in content." And that only makes sense. Netflix's originals are perhaps the biggest driving factor behind its subscriber growth. As the company expands globally, producing originals in-house is the most efficient way to secure global rights.
Right now, the incremental cost of adding another subscriber is less than the previous one, as Wells put it. Netflix is still benefiting from increased scale as subscriber growth outpaces content spend. The company had its biggest second quarter this year, adding 5.2 million global subscribers.
Eventually that won't be the case anymore. If Netflix wants to reach another subscriber it'll have to invest more than it's worth in content. But management believes it still has a long way to go before it reaches that point. It maintains the addressable market in the U.S. is 60 million to 90 million subscribers. It currently has 50 million. Globally, the opportunity is even bigger, and Netflix has yet to surpass the subscriber count of the U.S. in its international markets.
Raising debt and burning cash
Netflix says it will continue tapping the debt market to fund the capital needs of its original productions. Despite its poor ratings from credit agencies, Wells says he's fine with the company's position. Management isn't going to sacrifice the company's growth to get its bonds to investment grade, he said.
The important thing for investors to remember, though, is that Netflix is completely in control of how much it spends on content. If the growth isn't there, it's not going to spend more. Even with a bunch of new content buyers in the market, Wells says it won't impact the company's budget. Netflix will just produce fewer shows if it has to.
That said, he likened the content market to the professional athlete market. Top-notch performers are seeing bigger and bigger contracts, but replacement-level players might see their average salary go down. If anyone is capable of finding diamonds in the rough, it's Netflix and its troves of data.
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