This is nuts, when does Netflix crash?

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Friday's 5 per cent jump took Netflix shares to a fresh all-time high, to value the much loved streaming company at $144bn, two-thirds more than at the start of the year.

The people proved wrong are the doubters, those who like Barrons thought its valuation was ridiculous all the way back in August, about $160 ago.

Quill Cloud

Today, the numbers represent boundless optimism: a dozen times the $12bn of revenues reported last year, 120 times the profits it is expected to generate in this one. Fast forward, and estimates from analysts prepared to put a finger in the air for 2021 average out to forecast revenues of $27bn.

Are they, and the market, wrong?

Maybe it would be easier to share that confidence if Reed Hastings submitted to the sort of quarterly conference call suffered by less exalted chief executives, where questions from the crowd are allowed. The company prefers to pre-record polite conversation with chosen analysts.

It might be easier to believe in the growth story if 48m American households weren't already signed up for the delights of Stranger Things, and marketing spend wasn't growing faster than sales. It will jump to $2bn this year, from $1.3bn in 2017, which suggests winning customers is getting harder even if, like Netflix, we believe 700m households around the world are potential customers.

Buying into the dream would be easier if the company weren't also competing with Amazon, HBO and, in the not too distant future, Disney.

Spending of $8bn on content is planned for 2018. It would be easier to believe such costs were sustainable if the group wasn't funding itself through an accumulation of debt. That borrowing may be the part the market has overlooked, or even got wrong, but it makes Netflix the epitome of the boom we now enjoy.

The company has been burning cash for years, whether we judge it on operating cash flow or free cash flow. Netflix had to find $0.5bn every quarter last year, on the latter basis.

It borrows in the bond market to fund such spending, accumulating $6.5bn in debt, and likes to talk up a ratio of debt-to-market capitalisation as if it measures financial health rather than the weight of fairy dust sprinkled on the stock.

The debt is rated junk, four notches below investment grade. Were credit markets to close, as they periodically do to weaker borrowers in moments of strife, Nextflix would be shut out.

It has $2.8bn of cash on hand, and another $0.5bn credit line, so it could wait out any reluctance by investors to lend. Maturities are evenly spread into the future.

There's a circularity to the confidence game though. On the way up free spending on TV stars, writers, and producers is treated like investment. Stock market fans buy into the story of conquest, while debt investors and rating agencies tell themselves subscriber growth will eventually take care of the lack of cash.

A broader market upset could break that spell. Forced to preserve cash, prompting a slowdown in the pace of growth, and investors might focus more on the burn rate and the company's substantial content liabilities. The group has $7.5bn of these on the balance sheet, and another $10bn of such commitments off it.

In all, contractual commitments come to $28bn, according to this table in the recent 10-K filing:

Quill Cloud

On top of that are another $3bn to $5bn of estimated commitments for unknown titles in the next three years, for instance “traditional film output deals, or certain TV series license agreements where the number of seasons to be aired is unknown”. Those costs are largely expected to fall due in 2019 and 2020.

Of course, much of these obligations will come under operating costs, and Netflix can reasonably point to large content obligations elsewhere. At the end of last year Disney listed $48bn of commitments, almost all sports related for ESPN, out of $92bn of total commitments.

Set against their respective valuations, Netflix's obligations don't look so bad. With net debt it has an enterprise value of $147bn, to Disney's $182bn.

Traditionalists, however, might prefer some harder numbers. The Mouse empire took in $55bn in sales last year, and produced $9bn of free cash flow.

Focus on the Disney valuation, however, because it gets at the question of what Netflix investors are playing for.

Imagine in a decade Netflix has grown such that it has $55bn in revenues. Also imagine it can grow subscription fees as if they were for a college education, even though it will compete against Amazon, iTunes, Spotify and whatever else comes along for entertainment spend. If the average household were to pay $15 per month, up from $9.43 today, Netflix will need 305m paying households to get there.

It could, sure. We can also argue about details of business structures, predictability of subscriptions and whether Netflix will still be growing.

Yet, if it does everything right from here, what is the upside for enthusiastic shareholders?

A decade of incredible growth would take Netflix to something like the size, heft and cultural influence of Disney today, which the market thinks is only about a quarter more valuable than the TV-streaming trailblazer.

Those feel like the wrong odds.

  1. WeWrite-down
  2. No deal Brexit is not a hedge fund conspiracy
  3. Europe’s digital infrastructure issue
  4. Let’s give a helping hand to Andrew Yang
  5. Anatomy of a malware scam
  6. ARK Invest’s Tesla model gathers dust
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  14. Bitcoin is the 10-year Treasury of our time
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  16. Amazon is furious about this negative review
  17. Missing: $500bn of American savings
  18. Blockchain for Brexit: a wonderfully terrible idea
  19. The Bank of Hodlers [sic] (sigh)
  20. Behind the curtain at China Ding Yi Feng
  21. An answer to Mark Cuban's question
  22. Crumbs! It's CRYPTO: the movie!
  23. National Beverage Corp loses its fizz, and its mind
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  31. The bitcoin price is wrong
  32. The warm fuzzy feeling of Goldman debt
  33. “Cryptoassets” are crashing again. Is it time to start calling them cryptoliabilities instead?
  34. Puff the tragic cryptowagon smokes out the Mumsnet demographic
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