Netflix (NASDAQ:NFLX) CFO David Wells said he would be leaving the company earlier this week. The announcement was mostly unremarkable. Wells is leaving to pursue philanthropic goals, but his departure gives the company an opportunity to fix a flawed financing strategy that began under his watch.
As investors may know, Netflix has taken a lot of heat for its expansion strategy. Earlier this year, the leading video streamer said it would spend $7.5 billion to $8 billion on content this year, and it expected free cash flow of negative $3 billion to negative $4 billion. In other words, the company plans to burn $3 billion to $4 billion in order to fund its content budget and growth ambitions.
Though Netflix's cash burn has inspired plenty of harrumphs from the chattering classes of Wall Street, I support that growth strategy, as I've explained here. Netflix is seizing the opportunity while the video streaming market is ripe, and acquiring new subscribers now is easier than getting them later, when competition from the likes of Disney or Apple, among others, intensifies.
However, Netflix's decision to fund this expansion and cash burn by selling debt instead of additional shares continues to look like a terrible choice. In less than two years, Netflix's long-term debt has ballooned from $2.5 billion to $8.34 billion. Management has defended its debt-funding strategy multiple times, saying recently:
We will continue to raise debt as needed to fund our increase in original content. Our debt levels are quite modest as a percentage of our enterprise value, and we believe the debt is lower cost of capital compared to equity.
However, there are multiple problems with this line of thinking. Let's take a look a closer look.
The debt-to-enterprise value ratio is most often used by private equity firms and other potential acquirers of publicly traded companies as it strips out factors like cash and attempts to approximate the takeover price of a company, including its debt. However, since enterprise value partially correlates to market cap, which is highly volatile and dependent on investor sentiment, it's not a good indicator of the company's ability to repay its debt. As my colleague Evan Niu has argued, debt to market value is a misguided way to look at debt. That's especially true in the case of Netflix, whose enterprise value has ranged from less than $100 billion a year to nearly $200 billion just in this year alone.
A better way to measure debt and the company's ability to repay it is with the debt/EBITDA ratio. Over the last four quarters, the company has an adjusted EBITDA of $1.3 billion, giving it a debt/EBITDA ratio of 6.4, meaning it would take the company more than six years to pay off its debt at current income levels. That ratio is significantly higher than Netflix's broadcasting-based peers like Disney, and Netflix seems bent on borrowing even more as it foresees more years of negative free cash flow, which is likely to send the ratio even higher.
The wacky WACC
As management has argued in its shareholder letters, "We believe debt is lower cost of capital compared to equity." Underscoring this belief is a principle of finance known as the Weighted Average Cost of Capital or the WACC, which is the weighted average between the cost of debt and cost of equity. Cost of debt is simply the current interest rate the company is paying on its loans. The cost of equity, on the other hand, is harder to define, but it is essentially the rate of return that shareholders require.
Since the S&P 500 has historically returned an average of 9%, investors might "require" 10% or 11% depending on the level of risk, or more for a higher-risk investment. Indeed, that's more than the 5.875% interest rate Netflix is paying on its most recent debt offering, but remember, the cost of equity and the WACC are purely theoretical. It's not an ironclad rule.
In reality, Netflix's could do a secondary stock offering with minimal dilution to current shareholders. At Netflix's current market cap of about $150 billion, the company could pay for this year's $3 billion to $4 billion cash burn with a share offering that would dilute shareholders by less than 3%. Plenty of shareholders, including myself, would rather take on a modest dilution than see the company bury itself in more debt at a time when free cash flow is negative and interest expense is already $182 million through the first six months of the year, or 20% of operating income.
Ironically, Netflix CEO Reed Hastings once complained that Netflix stock had been elevated by investor euphoria.
If I were CEO and my company's stock price was at euphoric levels (where Netflix still arguably is today at a P/E of 153), I'd take the opportunity to sell more shares. Hopefully Netflix's new CFO can show Hastings the way.