Early investors in Netflix (NFLX 3.91%) knew they were taking a risk on a tech start-up looking to revolutionize the consumption of digital content. Fast-forward to the present day, and you'll find a slew of investors convinced Netflix is an industry staple devoid of extensive risk. Current investors or those looking to invest who subscribe to the latter mindset need to adjust their TV sets. New competition, increased content costs, and growing debt make for a risky script.
It's no secret that Netflix isn't the lone player in the streaming world anymore. Companies like Disney (DIS 0.84%), Apple (AAPL 0.86%), and Comcast (CMCSA +0.98%) have all released or are planning to release their own streaming services to compete with Netflix. While this is a win for consumers, it creates two potential issues for Netflix that we need to look at when assessing risk: the cost of content and how the company is going to pay for it.
Image Source: Getty Images.
The cost of content
The biggest winners of the streaming wars will be the content producers, actors, and production houses. The more streaming companies are competing for top resources to create original content while also entering into bidding wars for existing content, the more expensive things will get. It's the basics of supply and demand.
When asked during the most recent earnings call about the increase in the cost of producing a competitive show, Chief Content Officer of Netflix Theodore A. Sarandos said, "On a very competitive show there's probably been 30% price escalation from this time last year." In response, CEO Reed Hastings framed the rise by saying, "Content pricing is rising, but we are fortunate enough to have the largest membership, one of the biggest revenues and the biggest content budgets."
It's clear Netflix's plan to compete is to keep spending and compensate with increased memberships and revenue. But what happens when more competitors enter the market? What happens if a deep-pocketed company like Apple, Comcast, or Disney decides to up its content spending? Apple's revenue in 2018 was $260.17 billion, Comcast's was $94.5 billion, and Disney rounds it out at $59.4 billion. If these companies get a taste of favorable profits in the streaming industry, it's not far-fetched to see them increasing their already high content outlays. Apple's starting budget for streaming content is $6 billion, and Disney's is $2.5 billion. It's hard to foresee the costs of creating quality and competitive content slowing down anytime soon.
What this means for Netflix is that it will need to continue spending to stay competitive. How is the company going to pay for this? Well, Hastings touts revenue and a large membership base to foot the bill. The problem is that growth may be slowing for Netflix. As mentioned in my third-quarter earnings analysis, growth projections for Q4 of this year are identical to those of Q4 last year, which is fine unless the content bill continues to grow. It's also important to note the company did miss its projected increase in subscribers last quarter, which could signal some overzealousness in projections in the face of growing competition.
If subscriber growth and revenue don't match the growth needs of the content spending, how will Netflix pay to stay relevant? Debt. And while debt can be a good thing when used properly, it can also create risk -- and it is the main reason I find Netflix to be a risky stock.
Don't ignore the debt
Long-term debt at the end of the third quarter was $12.4 billion, a 49% increase from the same time last year. Look back three years to 2016, and debt was only $2.37 billion, considerably lower than today's figure.
While looking at the trend in total debt is important, we also want to look at this another way. A popular ratio used to determine the riskiness of a stock when compared across the industry is the debt-to-equity ratio. A higher number can signal a riskier company that's potentially carrying too much debt.
At the end of the last quarter, Netflix's debt-to-equity ratio was 1.81. The debt-to-equity ratio of the entire broadcasting media and cable TV industry in Q3 was 0.09. For the movies and entertainment industry, it was 0.05. These are not great comparisons for those thinking Netflix is a sure thing.
The bottom line: Is Netflix risky?
While Netflix is a well-known brand, the company is far from being established to a point at which it is free from significant risk. Its first-mover advantage and the days of calling Netflix a tech company are in the past. It is now in a competitive market space and vying with major players with deep pockets. If the costs of content continue to rise and Netflix can't keep up by winning new subscriptions and retaining current members, it could face significant issues with ballooning debt.
