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John Engle
John Engle
Articles (610) 

Netflix Needs a Lot More Than Breakeven Cash Flow to Justify Its Valuation

With positive free cash flow not expected until 2022, Netflix is still a long way from profitability expectations

January 21, 2021 | About:

Netflix Inc. (NASDAQ:NFLX) reported earnings for the fourth quarter of 2020 after the market close on Jan. 19. The streaming media giant handily exceeded analysts' revenue and subscriber growth expectations, but fell short on profitability.

Investors and analysts alike have proven more than willing to overlook Netflix's bottom line miss, instead choosing to focus on the company's revised guidance, which now expects positive free cash flow after 2021. This welcome news sent Netflix's stock soaring nearly 20% on Jan. 20.

For a business that has long relied on external capital to support its growth ambitions, the prospect of positive cash flow is undoubtedly a positive development. However, Netflix is still far from reaching the level of profitability that its valuation anticipates – and it is still far from certain that it ever will.

Turning the financial corner

Since its founding, Netflix has been heavily reliant on external capital injections to fund its monumental cash needs. Streaming media content, whether licensed or original, is very expensive, and Netflix has had to plow every penny of revenue and then some into building its content library. The company has borrowed billions of dollars to fuel an aggressive content strategy that has made it the biggest player in the burgeoning streaming market.

As of the fourth quarter, that has evidently changed. During the earnings conference call on Jan. 19, Netflix management painted a rosy picture of the future. The biggest headline was the new forecast of positive free cash flow from 2022 onward, but other comments also caught the attention of analysts and investors, especially those of the chief financial officer, Spencer Neumann. According to Neumann, Netflix is already debating what to do with its expected cash surplus:

"We put a premium on balance sheet flexibility, so we're going to continue to invest aggressively into the growth opportunities that we see and that's always going to come first. But beyond that, if we have excess cash, we'll return it to shareholders through a share buyback program."

While share buyback programs often make sense for mature companies, companies seeking to grow in highly competitive markets tend to find better uses for their excess cash, as Hedgeye's Andrew Freedman was quick to point out on Jan. 19:

"Sub-growth slowing, revenue growth slowing - there are no higher reinvestment opportunities out there than to buy back stock? If history is of any guide... Slowing unit growth + free cash flow + buybacks = multiple compression."

Moreover, given that Netflix does not expect to achieve full-year breakeven cash flow until 2022, one might be forgiven for questioning whether such a buyback program will be realistic any time soon. It seems, at best, to be a clear case of counting one's chickens before they hatch.

Big profits not yet guaranteed

Unrealistic buyback expectations notwithstanding, many analysts and commentators have responded to Netflix's fourth-quarter earnings with unvarnished enthusiasm. As CNBC's Alex Sherman put it on Jan. 19, "long-term Netflix investors are validated."

Not everyone is convinced by Netflix's latest story, however. Michael Pachter of Wedbush Securities, for example, remains skeptical of Netflix's eye-watering valuation. On Jan. 20, Pachter explained the key reason for his continued misgivings despite the company's apparent success:

"We have been consistently wrong about Netflix, but optimism about the company's potential to generate free cash flow growth of more than $1 billion per year seems to be misplaced."

This point seems largely to have been overlooked amid the valedictory coverage of Netflix's fourth quarter results. Yet, as industry analyst The Entertainment Strategy Guy pointed out on Jan. 19, there is a big difference between merely breaking even and actually generating vast quantities of free cash flow on a sustainable basis:

"Long term investors aren't validated yet. If you spend say $20 billion on a new business, you aren't validated when that biz achieves break even, but when that biz earns $20B in WACC adjusted terms. NFLX hasn't done that yet."

While Netflix may no longer have to go back to the capital market well to fund its insatiable appetite for new content, it is unclear how much internally generated cash will be left over at the end of each quarter. In any event, it certainly seems more than a little premature to be talking about how Netflix plans to deploy its – as yet nonexistent – excess cash.

My verdict

Many investors appear to have interpreted Netflix's latest earnings result as a key inflection point for the company, as well as a clear vindication of the bull thesis. However, while achieving breakeven operations is certainly an achievement worthy of commemoration, in my assessment, Netflix is still a long way away from significant profitability.

Years of massive, sustained free cash flow generation were baked into Netflix's share price long before the latest earnings print. With a market capitalization now in excess of $260 billion, Netflix will have to grow earnings and cash flow at a breakneck pace if it hopes to live up to the expectations that have already been priced in. Whether it can actually do so remains to be seen.

The current trend of slowing subscriber growth and accelerating competition shows no sign of reversing. Consequently, I see ample reason to doubt Netflix's ability to generate significant profits and cash flow over the long run.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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