It lives in a fantasy world.
Netflix just completed a $1.6 billion junk-bond offering. The 10.5-year notes are rated B+ by Standard & Poor’s and B1 by Moody’s – four notches into junk. But no problem. Those notes sold on Monday at a yield of 4.875%, or 256 basis points over the equivalent US Treasury yield, according to LCD of S&P Global Market Intelligence.
This was just the latest – and largest – issuance in a series of ever larger bond sales.
Netflix, whose shares went from $9.94 to $192.47 in five years, is on a peculiar and accelerating treadmill: It needs to borrow ever larger amounts just to cover its ever-larger negative cash flows year after year. These negative cash flows are mostly caused by ever more spending on its proprietary streaming entertainment programming that is needed to attract ever more subscribers, who are needed to support its gigantic market capitalization of $84 billion. And that gigantic stock market capitalization is needed as a guarantee of sorts for the bondholders…. If this seems a bit circular, it’s because it is.
You’d think a company that has been publicly traded for 15 years, offers a popular service, and produces proprietary content that people want to watch would have figured out by now how to turn its business model into something that is self-sustaining. But no.
Cash flow from operations is becoming increasingly negative:
- 2015 full year: -$0.75 billion
- 2016 full year: -$1.47 billion
- 2017 Q1 – Q3: -$1.30 billion
So why can’t it find a self-sustaining business model? Because it doesn’t have to. It can always borrow the money instead of making it. That’s the logic. The bond sale on Monday came on top of a long series of bond sales.
In April, Netflix’s European entity sold €1.3 billion (currently $1.5 billion) of 10-year unsecured junk bonds in Europe at a yield of 3.625%. This is a textbook example of “Reverse Yankees” – euro-denominated bonds sold by US companies in Europe to benefit from ludicrously low costs of borrowing, including an average junk-bond yield that is below the US Treasury yield.
In October 2016, Netflix sold $1 billion of 10-year junk bonds in the US at a yield of 4.375%, at the time a spread of 263 basis points over Treasuries.
In addition, Netflix has the following bond issues outstanding:
- $500 million of 5.375% notes due 2021
- $700 million of 5.5% notes due 2022
- $400 million of 5.75% notes due 2024
- $800 million of 5.875% notes due 2025.
And that debt keeps piling up. Its “non-current content liabilities” and its long-term debt combined was $1.3 billion on December 31, 2013. Over the three years and three quarters since then, that pile has skyrocketed 530% to $8.2 billion!
In its earnings report on October 16, it announced that it would spend “$7-8 billion on content” in 2018 and that it had “$17 billion in content commitments over the next several years.”
It just doesn’t charge enough to cover the expenses. In other words, investors are subsidizing the subscribers.
It expects a negative “free cash flow” of -$2.0 billion to -$2.5 billion for the full year in 2017. And it anticipates financing its capital needs by borrowing more money.
The way the company accounts for its spending on content production and acquisition – as an asset to be amortized over many years rather than expensed all at once – allows it to show a net profit even though it’s burning through cash hand-over-fist and expects to continue to so for as far as it can see.
But the bond market doesn’t mind. The average yield of equivalently rated junk bonds, as measured by the BofAML Single-B US High-Yield index, is 5.44% — compared to the yield of Netflix’s current bond issue of 4.875%.
In other words, despite its persistent, massive, and growing negative cash flows for all times on the horizon, Netflix’s borrowing costs are lower than comparably rated companies. These are junk-rated companies with a significant risk of default. And Netflix has formidable competitors, including Amazon and everyone else out there in the entertainment business, in an industry that depends on notoriously fickle consumer preferences.
So what’s the secret? Netflix’s stock price.
Just like Tesla and some other companies that are bleeding cash in vast and never-ending amounts, their overinflated stock price acts as a guarantee – in the bondholder’s mind which has been bludgeoned by central banks – that the company can always sell more shares to raise the funds necessary to deal with its debt and cover its negative cash flow, and that therefore the risk of default is small.
And that’s true – until it isn’t. When the stock crashes, that equation goes to hell. This can happen, as unimaginable as it may seem today. Then the company has trouble issuing more shares to raise the billions needed to redeem the debts when they come due and to cover its negative cash flows. And the whole circularity falls apart.
So these bondholders are taking risks linked to the stock market, but with a return that is limited to this low yield and little else in terms of upside, under ideal circumstances if the bond makes it to maturity and gets redeemed. But if the stock crashes beforehand, bondholders get to grapple with a new reality: that the low yield didn’t compensate them for the risks.
I don’t remember ever having seen crazier times of more pandemic proportions. Read… Wall Street Piles into Cryptocurrencies, Others Speak of “Biggest Scam Ever”
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