Netflix Inc. Delivers a Fair Q1 Report, but Huge Spending Worries Investors

In this segment from the Market Foolery podcast, the team digs into Netflix's (NFLX 1.74%) latest earnings report. Analysts expected more robust subscriber growth, but operating profitability remains strong.

And while Wall Street might not have wanted to hear that investments in content would mean negative free cash flow for years to come, growth opportunities for the company are still massive.

Chris Hill: We're going to start with Netflix. First-quarter profits came in higher than expected, but subscriber growth, a little bit lower than projected, and there's a bunch of things we can get into here. But Jim, I'll start with you, then David. What's your headline for this quarter?

Jim Mueller: The headline for this quarter, I think, is they're going to be raising more debt. When they reported in the end of last year, earlier this year, they projected they're going to spend $2 billion in free cash flow. Negative $2 billion free cash flow. That's because they're still buying a lot of content to run that virtuous cycle. More members, more money, more good content, more members, and so on. As long as that works, they'll be fine. They're profitable. Their operating profit came in really nice at 9.7%, higher than the 7% target they have for the year. This is the first year where management is actually targeting and actually saying, "OK, we're going to start becoming profitable. We've been running for so long, we're going to become profitable." But, they were saying 7% target for the year, so they're going to ramp up spending a little bit in the second quarter to bring that back down, from 9.7% back to the 7% target. But it's free cash flow. Companies are in business to generate cash. If you're not generating cash, you're going to have to raise cash somehow, which means they're going to be raising more debt. A line from the release letter, that's what they call it, dear shareholders, they --

Hill: That's so quaint.

Mueller: Yeah. [laughs] They think their leverage ratio is just fine.

Hill: I'm sorry, leverage ratio?

Mueller: No, they actually call it debt to total cap. And it took me a while. I thought for a moment they meant debt-to-capital, which is a common ratio. Debt to total capital invested in the business, that's debt and shareholder equity. No, what they're talking about is debt to market cap. That set me back. They're well under 10% compared to peers that are at 30%, 70%, in that range. And that's true. Time Warner, 31% debt to market cap. But Netflix has a debt to capital ratio of over 50%. It's about 53%.

David Kretzmann: You're talking about the first definition you mentioned?

Mueller: Yeah, debt to invested capital. They're about 53% while Time Warner sits at 48%. So they can say, "We can leverage up because Time Warner is leveraged up." But it makes me a little nervous, really.

Hill: David, what's your headline?

Kretzmann: Similar to Jim's, Netflix is reiterating that they will be in investment mode for years to come. Like Jim mentioned, in the letter, they said, "Yeah, free cash flow is negative, and it will be negative for years to come."

Hill: Many years.

Kretzmann: Yeah, many years. I don't know if that was something Wall Street was necessarily expecting. I think people would hope that the free cash flow would eventually become positive, sooner rather than later. But Netflix right now, this year, they're spending $6 billion producing original content. And that number will continue to tick up for the foreseeable future. And the numbers that Jim mentioned, the numbers that Netflix highlighted in the letter, right now, they have about 10% of their market cap is in debt, compared to Lions Gate or Starz --

Mueller: Actually, it's closer to 5%.

Kretzmann: OK. So, it's under 10%. Compared to Discovery Communications or Time Warner, yeah, Netflix has a lower amount of debt compared to those companies. But those other companies are also producing positive free cash flow. I feel like management is stretching their definitions a little bit to say, "No, it's totally OK, don't worry, we'll continue to bring on billions of dollars of debt, don't worry about it." It's like, you guys aren't producing positive free cash flow. Your burn rate is actually increasing. So really, it comes down to the original content they're producing, is it good enough, quality enough to bring in new subscribers, continue to keep that subscriber growth going, and retain existing subscribers? That is what it comes down to. I think most people would say, yeah, their original content tends to be pretty good, it's an effective investment. But there are a lot of risks with the cash flow situation there.

Hill: They went out of their way to highlight the fact that -- they have a deal with Adam Sandler -- is it over 500 million?

Mueller: Right.

Hill: "Five hundred million hours of Adam Sandler movies have been watched by our customers."

Mueller: Since The Ridiculous 6, I think is the name of the film, which was first of their deal, and they just extended the deal with Sandler, too.

Kretzmann: I haven't met anyone who thought that was actually a good movie, but apparently a lot of people have watched it. And I did watch it.

Hill: My reaction was the same as you two in this moment, was, I just started laughing, I said, are you kidding me? Five hundred million hours' worth of Adam Sandler movies have been watched? But the more I thought about it, the more I think it was smart of them to call that out, because one of the signals that sends to Wall Street, if you think about it, is, "We know what our customers are watching. We know what they're watching. We know what they want to watch. And all you people who made fun of us when we struck the deal with Adam Sandler in the first place, 500 million hours watched. How do you like me now?"

Kretzmann: In the letter, they also highlighted a couple of movies or shows that flopped. One of them that they mentioned was the sequel to Crouching Tiger, Hidden Dragon, where they said, this is one that didn't work out so well. So they are admitting that not everything they're producing is a hit. Going forward, when they're investing this amount of money, when they're burning this amount of cash and raising that amount of debt, it really does sting for them to have content that doesn't resonate well with audiences. I think that'll be something to watch.

Mueller: I like to hear that, too. If everything is a massive success, then they might loosen their controls on what they decide to invest in. So I like to hear that something doesn't work out as golden as most of the stuff.

Kretzmann: They're paying attention to it. They're not just throwing money blindly. So it is good to see them focusing on that.

Hill: There was a point in time with Netflix where international growth was being watched closely, and the number of countries that they were in was a point of focus. Now, it seems like since we've run out of countries for them to actually go into, now the opportunity and the challenge for Netflix is getting more subscribers in those countries. Jim, can you look at this stock and say, OK, even with everything we've already said about the free cash flow, even with the fact that this is kind of still a pricey stock, is there still an enormous opportunity overseas? Because it kind of seems like there is.

Mueller: Honestly, I think there is. Full disclosure, Netflix is my single largest position in my portfolio, and I've held shares since early 2007. So I have a nice basis on these shares. That might be coloring my viewpoint a little bit, because so much of my investments are tied up in this company. But having said that, I think the addressable market, which is what your question is about, Chris, is still quite large. So they're recently penetrated in the U.S. about 50% or so into all of the households in the U.S. David Wells, CFO, mentioned that in the call, that some of their earlier international markets, they didn't name them, but probably Canada or Latin America, maybe, but I was thinking probably Canada, are reaching that level as well. That does demonstrate that it can be popular enough, and they can figure out that combination of [phone rings] -- I don't know why my phone rings, I don't know why it's audible. Apologies. They do figure out, in Europe and Australia, in Latin America, in Canada, they have figured out the mix of content, locally grown, international, from Hollywood and the U.S. or whatever that brings in subscribers and keeps them coming. And they're still working on that in Africa and Asia and the countries they launched in last year. But that launch last year was in 120, 130 countries, was mostly mobile launch. There are a bunch of mobile broadband accounts in the world, something like 3 billion of these things. If they can get the penetration in that, there's still a very big opportunity for the company.

Kretzmann: I think HBO now has 128 million subscribers, and management says they expect Netflix to cross 100 million streaming subscribers this weekend. So there's still room for them to catch HBO, potentially, in the next couple years. And, from there, as Jim mentioned, it's just a matter of grabbing more subscribers there. And management really is focusing on creating that local content, whether it's Mexico, Brazil, France, you name it, and trying to find the right proportion of local content, as well as the global content that's available in every country. I think another deal that will continue to really help Netflix is their deal with Disney. This year, Rogue One will be streaming on Netflix, and future Star Wars films will be streaming on Netflix, a lot of the Pixar and Disney animation movies are already on there. I think that will help to continue to attract some new subscribers.

Mueller: Certainly here in the U.S. That deal with Disney, the movie releases, is U.S. and Canada only. So they might renegotiate to get the worldwide rights to those things. But playing off your comment on productions in Mexico, their Spanish content is not just Latin America, but the entire Spanish-speaking world across the planet. Their international content, their internationally produced content, is playing pretty well all around the world.