Having burned cash for 22 years and counting.
“Don’t get me wrong: there is still lots of money out there chasing these companies,” I said in my podcast on Sunday, naming Netflix as one of the perennially cash-flow negative companies – the “cash-burn machines” – that have to borrow huge amounts of money every year to make ends meet, and that still find eager investors to lend them this money. I said this, not knowing what Monday would bring. And sure enough, Monday brought an announcement by Netflix that it would borrow another $2 billion via another bond sale – its second this year, after having already borrowed $2.2 billion in April.
These proposed senior unsecured notes, which will mature in 2030, will be sold in US dollars and euros to institutional investors, not the public. In other words, these bonds go into pension funds, insurance funds, bond funds, junk bond funds, and the like — and you may own a slice of them whether you want to or not.
Moody’s this morning rated the bonds Ba3, three notches into junk and left Netflix’s corporate credit rating at Ba3. S&P rates Netflix BB-, also three notches into junk (my cheat sheet on corporate credit ratings by Moody’s, S&P, and Fitch).
“Cash-flow breakeven” maybe, after 26 years in business.
In April 2018, Moody’s estimated that Netflix may reach “cash-flow breakeven” in 2023, and in today’s assessment it stuck to that estimate.
And here’s the thing: Netflix was founded in 1997. By 2023 the company will be 26 years old, and if all goes incredibly well, the company may finally reach cash-flow “breakeven” – not even cash-flow positive – 26 years after it was founded? I mean, give me a break.
Its balance sheet is a mess. After years of borrowing cash and then burning it, the company now has $12.1 billion in “content liabilities” and $12.4 billion in long-term debt, for a total of $25.5 billion that it owes.
That $2 billion in new debt to be issued will bring its long-term debt to $14.4 billion, and the total to $27.5 billion.
Those pesky “content liabilities.”
The “content liabilities” are incurred when Netflix enters into a contract to obtain future movie titles, and it puts the amount it owes for those titles on its balance sheet as a liability when the title becomes available to be streamed. It also records an equivalent asset on its balance sheet, which is added to “content assets” that, as of its third quarter SEC filing last week, amounted to $23 billion.
These $23 billion in content assets are future expenses that Netflix is very fast in acquiring and very slow in letting them trickle down via “amortization” to the income statement where they would hit its profit.
These “content liabilities” have to be paid in the future. Of them, the “current content liabilities,” which have to be paid over the next 12 months, amount to $4.86 billion. This explains the need to borrow $2 billion now by issuing the bonds, and to borrow another $2+ billion that way early next year.
The “content assets” are movie titles to be streamed and made money off in the future. But they’re not expensed on the income statement when they’re acquired; instead they’re parked on the balance sheet. And then, very slowly, they’re amortized over many years – meaning they’re bought in huge amounts and very quickly but expensed on the income statement in tiny drips.
So on a quarterly and annual basis, the amortization expense Netflix recognizes on its income statement, where it hits profits, is tiny compared to the amount Netflix pays over the same period for these titles.
There is some accounting justification for that method – in that these content assets will produce income in the future, hopefully. But clearly, Netflix is going way too far in pushing its interpretation of the accounting rules. And this wild interpretation of accounting rules is one of the reasons why Netflix shows a profit and a huge negative cash flow at the same time, year after year.
And this turns its income statement into garbage.
For the first nine months of 2019, the income statement showed a net income of $1.28 billion and a negative cash flow (or “free cash flow” as Netflix calls it) of -$1.6 billion, for a huge gap between net income and cash flow of $2.89 billion.
Netflix says in its filing that the huge $2.89 billion gap between net income and negative cash flow so far this year was “primarily due” to the fact that the “cash payments” it made for its “streaming content assets” exceeded the amortization expense of content assets over the same period “by $3.46 billion.”
In other words, the income statement that Netflix offers – though it likely conforms to a wild interpretation of GAAP – is garbage. In terms of Netflix, cash flow and the pileup of liabilities (content liabilities and debt) are the metrics that matter the most. But they’re too ugly to behold.
So Netflix and Wall Street analysts, whose sole purpose it is to pump up the shares, hammer home that the only metric that matters is subscriber growth because the rest is by now too ugly to behold.
Bondholders and those contemplating buying the new bonds have only one hope – and this hope is their strategy: That Netflix will continue to be able to extract money for its cash-burn machine from new investors year after year, so that it can go on burning this new cash in its operations, and thus keep its operations alive, and also pay existing investors the promised interest payments, and then the principal payments when the bonds come due – with the first set coming due in February 2021.
What happens if Netflix cannot raise new money every year from new investors to pay off existing investors and to keep its cash-flow negative operations funded? The next step would be a default.
The hope of Netflix being able to find new investors willing to play this game year-after-year is what keeps this scheme going. And for now, no problem.
In the current environment of financial repression practiced by central banks, where interest rates are below the rate of inflation and in many places below zero, these money managers are chasing any kind of yield they can find no matter what the fundamental risks, and they’re still eager to buy these bonds, hoping and praying that Netflix will be able to keep this game up long enough for these money managers to either get out from under those bonds or change jobs.
So how overvalued is Netflix? Even with its profits wildly inflated by the accounting practices described above, the shares trade at an astronomical price of 88 times these wildly inflated earnings, for a company that has been around for 22 years. I mean, yeah. Hard to believe in normal times. But these are not normal times.
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