Content Costs Could Cause a Bad Scene for Netflix Stock

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Investors remain bullish on Netflix (NASDAQ:NFLX)  stock, despite its high valuation. Visionary leadership has transformed an upstart DVD-mail business into a streaming giant. Moreover, the large amount of money NFLX spent on content has provided it with a competitive moat, even as more companies enter the streaming space.

Why Netflix (NFLX) Stock Could Be Hurt by High Content Costs

However, Netflix’s ever-increasing spending on content has left it with a heavy debt burden and large amounts of negative cash flow. Although the valuation of Netflix stock has fallen to more reasonable levels, NFLX stock could drop further if the company’s deteriorating balance sheet forces it to issue more shares.

Netflix Has Benefited From Its Strategic Vision

Since its founding more than 20 years ago, Netflix has benefited from its strategic vision. Its DVD-mail business made it a viable competitor to movie-rental stores. It subsequently destroyed movie rentals by becoming the first video-streaming company. NFLX also undermined the business model of pay-TV services.

As other streaming companies appeared, NFLX built a competitive moat by developing its own content. This, along with its move into nearly all of the world’s countries, has made Netflix a content and data powerhouse. Given all of its innovation, it is little wonder that Netflix stock commands a forward price-earnings ratio of 56. Since its earnings are expected to surge 50.7% this year, the high multiple of Netflix stock may appear to be justified.

Disney+ Will Hurt NFLX

Unfortunately for NFLX, the one rival that could challenge Netflix on the content front, Disney (NYSE:DIS), will launch its Disney+ streaming service later this year. One JPMorgan analyst expects Disney+ to attract 160 million subscribers worldwide, higher than Netflix’s current subscriber count of 139 million.

Given the low cost of streaming, most current Netflix  subscribers would likely  use both Disney and NFLX, rather than give up Netflix. For this reason, the launch of Disney+ would probably not start a Netflix-cutting trend. However, given Disney’s promise to undercut Netflix on cost, Netflix will find it more difficult to raise its fees. This loss of pricing power, in turn, will hurt Netflix stock.

Content Costs Have Undermined Netflix’s Balance Sheet

Netflix’s gargantuan  spending on content has weakened the company’s balance sheet, creating a headwind for Netflix stock. In 2018, as NFLX spent $12.04 billion on content development, Netflix’s long-term debt jumped from $6.5 billion to $10.36 billion. The company ‘s free-cash flow. meanwhile, came in at -$2.68 billion

However, one has to wonder how long the company can sustain such high spending levels. Wall Street forecasts that NFLX will spend $15 billion on content in 2019. If that prediction proves to be correct, Netflix’s free cash flow will probably come in at -$3 billion, while its debt will again rise by  about $4 billion. Moreover, its content quality will be hurt by the exodus of all Disney-owned programming from the platform.

These debt levels may seem like a pittance, since Netflix stock has a market cap of $155 billion. However, NFLX stock trades at about 30 times the company’s book value. Since NFLX has stockholders’ equity of only $5.24 billion, the balance sheet has twice as much debt as equity. At some point, the company will probably have to slow its content spending and issue more Netflix stock to repair the balance sheet. So, while a bullish case could be made for Netflix stock, the company’s debt burden could lessen or even reverse any potential gains by the shares.

The Bottom Line on Netflix Stock

Despite NFLX’s increasing profits and continued dominance in streaming, Netflix stock could be derailed by balance-sheet issues.

The costs of the content that constitutes Netflix’s moat have damaged the company’s balance sheet. These high, rising costs have led to negative cash flows and rising debts that the company cannot sustain over the long-term.

Given the elevated book value of Netflix stock, one has to assume the company will issue massive amounts of stock to repair its balance sheet. Even though NFLX’s  profit increases look impressive and its forward price-earnings ratio has begun to appear reasonable, I think the many headwinds of Netflix stock make it unattractive at these levels.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.

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