When Netflix arrived in Australia last year, Tony Sanchez immediately signed up for it, expecting good content.
“When I first got it, it was disappointing,” said Sanchez, a 34-year-old American living in Australia. “I thought there would be a bigger movie selection.”
But Sanchez, a fan of comic books and anime, says Netflix is still a better option than local streaming services. The difference, he says, is the company’s original programming.
“The reason I stick with Netflix is that it has original content,” Sanchez said.
Netflix is counting on Sanchez and other viewers abroad who are drawn to its original TV shows and movies as growth in the U.S. slows down. Netflix opened up its service to 130 more countries in January, expanding its reach to a total of 190 countries. Targeting international audiences, it also debuted Netflix original British drama “The Crown” in November and its first original French series “Marseille” this summer.
But expansion abroad and increased production of original shows comes at a steep cost and a risk to investors who are betting on its growth.
“This is a tough business and Netflix is competing against some very well-capitalized people in Amazon, Hulu and HBO,” said Michael Pachter, a research analyst at Wedbush Securities. “I don’t know that it’s a foregone conclusion that they’re going to succeed.”
Big spending and big debt
Netflix plans on spending $6 billion to produce more original films and TV shows in 2017. Among television networks, this ambitious budget comes second only to ESPN, which is expected to spend a total of $7.3 billion next year on content, according to estimates by Boston Consulting Group and SNL Kagen.
Amazon, which has a market capitalization of $360 billion compared to Netflix’s $53.3 billion, is projected to spend $3.2 billion after announcing plans to double video content spending and triple it for original content in 2017.
“The thing that generally concerns us is the level of spend and the level of acceleration of content spending,” said Patrice Cucinello, an analyst at Fitch Ratings. “It is causing an accelerated free cash flow burn.”
Netflix reported a negative $1.02 billion in non-GAAP free cash flow for nine months ending Sept. 30. In 2015, it was a negative $920 million. This means that Netflix has to borrow money to meet its original content goals.
While Fitch Ratings has no official rating for Netflix, Netflix has a two-star credit rating on Morningstar and a B1 rating with Moody’s Investors Service. Ratings of Netflix are modest because of its debt. Its 2015 debt-to-earnings ratio is up to 6.5 as compared to a 1.1 ratio in 2011, as noted by Moody’s.
Netflix did not respond to requests for comment but it is clear that this borrowing will continue.
“We’ve been pretty clear along the year that we would go to market sometime this year to add a modest amount of debt to the balance sheet, and then do that on a recurring basis, as needed, to fund our content expansion,” CFO David Wells, said on the last third quarter earnings call.
At a UBS conference this week, Ted Sarandos, chief content officer at Netflix, said the company will release 20 unscripted TV shows in 2017. In the third quarter earnings report, Netflix announced plans to have 1,000 hours of original programming in 2017, a 400-hour increase from this year.
“They’re pre-funding their content investments by tapping the debt markets,” Cucinello said.
Netflix has $2.4 billion in long-term debt as of Sept. 30. This is more than double where it stood two years ago.
The company has five outstanding bonds, the largest of which — for $1 billion —matures in 2026.
Stock analysts on Wall Street are still overwhelmingly positive on the company. More than half of 44 analysts surveyed by Bloomberg recommend buying Netflix stock and nearly 30 percent recommend holding it.
But there are some, such as Wedbush’s Pachter, that advise selling it.
“They’re building up this library of content that if nobody watches it, it doesn’t have any value,” Pachter said. “If they keep losing $1 billion to do it, they’re going to go bankrupt eventually.”
Repaying its debt is reliant on the success of its shows and subsequently sustained subscriber growth. For now, things are going well for Netflix.
“From a competitive standpoint, we view Netflix as one of the strongest over-the-top content operators in the market,” said David Peterson, senior director at Fitch Ratings. “They’ve obviously begun to pivot their content strategy to focus on originally created content and that seems to be resonating with the subscriber base.”
This year Netflix won nine Emmys, out of 54 nominations, for six different shows and “Stranger Things,” a show that Netflix produced, has been well received.
“’Stranger Things’ was the talk of the summer,” said Jeff Bock, senior box office analyst at Exhibitor Relations. “We’re in the middle of Blockbuster season this summer and people are talking about something that’s on Netflix. It wasn’t in movie theaters. That’s never happened before.”
And at the moment, the company is profitable.
The company’s adjusted net income for nine months ending Sept. 30 is $163 million. Netflix net income was $123 million last year and is expected to be $299 million for 2016, as reported by analysts surveyed by Bloomberg.
“What is really driving the credit profile is their subscriber growth, which we feel is going to be increasingly driven by international expansion,” Cucinello said.
And it has indeed been a solid year for Netflix internationally. The company added 3.2 million international subscribers in its third quarter, well ahead of its forecast of 2 million. After its international subscriber growth was announced, Netflix stock jumped 19 percent on that day alone. It is currently 23 percent higher than that price at $122.83.
In contrast, the California-based company only added 400,000 domestic subscribers. But slowing growth in the U.S. came at no surprise.
About 75 percent of its legacy customers have been bumped up (by at least a dollar per month) to $9.99 a month this year. By the end of the year, all customers should be moved to this higher price bracket. That is if they don’t cancel their subscription.
Netflix plans on having 80 percent of its subscribers coming from outside the U.S. It is currently available across the world, except for a handful of countries, including China. Strict regulations have led Netflix to license content in China instead of establishing its own service there, which it still hopes to do.
“We’re closing in on 100 million members, but I remind everyone at Netflix that Facebook and YouTube have 1 billion daily actives,” said Reed Hastings, CEO of Netflix on the third quarter investor’s conference call. “We’re just so small compared to those other Internet video firms and we have a lot of catch up to do. And again, that’s investing in our content and making it globally interesting and compelling, which we’re working on.”
Expansion into other industries
Aside from its original content and international subscriber goals, Netflix quietly entered the cable TV and movie theater business.
In May, Netflix made a deal with Univision, the largest broadcast media company for Hispanics in the U.S., to air original series “Narcos” and “Club de Cuervos.” The two companies will also co-produce a new series called, “El Chapo.”
Netflix also teamed up with iPic, a luxury movie theater that serves gourmet food to viewers in reclining leather seats. iPic will showcase 10 original Netflix movies in theaters in New York and Los Angeles with the possibility of other locations.
The first two films, “The Siege of Jadotville” and “Mascots” debuted last month. This is a second attempt after Netflix original “Beasts of No Nation” was shown in theaters and online last year.
“They want to make money on any platform they can,” Bock said. “Netflix is playing with the future of film entertainment. What scares a lot of studios in town is that they’re having so much success.”
It is a bold move to invest billions into original content while expanding globally with small cash reserves and into new industries as a rookie. But it is a strategic move that makes sense to Netflix backers.
“Netflix is in an evolution of their strategy where they are doubling down on their original content spend,” Cucinello said. “We view that positively as a necessary investment because it reduces their reliance on purchasing content from third parties.”
As long as Netflix keeps hitting its quarterly international subscriber expectations and adding well-received original content, it will remain a force in the entertainment realm. And it is making small changes to its services that should help fend off competition.
Netflix now allows users to download original content to view offline, such as during a flight. It is a feature that Amazon Prime users have had since Sept. 2015.
Competition abroad became more intense last week. Amazon released Prime Video in more than 200 countries and territories, including India. The following day, Netflix announced a deal with Bollywood star Shah Rukh Khan.
“I think right now they’re at the forefront of everyone’s mind and people are waiting to see what they’ll do next,” Bock, the box office analyst, said.
Charts and photo: Kara Chin