Everybody knows that Netflix (NASDAQ:NFLX) will likely crush its subscriber addition targets in next Tuesday's first-quarter report. The COVID-19 crisis gives consumers around the world both more time and more reasons to escape reality through their Netflix accounts. But there's much less talk out there about another financial metric that is changing abruptly under the coronavirus lockdown orders -- and this is the one that actually drives the company's market value. So let's have a look at how the virus situation will alter Netflix's free cash flow in 2020.
Netflix has been consistently profitable since 2013 but the company's free cash flow has been printed in increasingly aggressive shades of red ink since 2015. That's when Netflix started to focus on original programming rather than licensing content from independent production studios. House of Cards and Orange Is the New Black got the ball rolling a couple of years earlier, but Netflix really put its back into original productions with titles like Bloodline, Daredevil, and Narcos.
The accounting treatments for licensed titles and original content are very different. Content licenses show up on the income statement as a simple cost of revenue while the licensed movie or show is available for streaming. Original content, on the other hand, is treated as a capital investment with large up-front cash costs that move onto the income statement through amortization procedures. The accelerated amortization schedule that Netflix uses for original content converts roughly 90% of the cash costs into tax-deductible costs of revenue within the first four years.
The heavy cash costs have forced Netflix to dip into the debt market several times in the last five years, building up a long-term debt balance of $14.8 billion. Netflix bears see this debt-based strategy as a deal-breaker, a financial house of cards that surely will fall down and destroy the company. We long-term bulls, on the other hand, see a smart and sustainable structure that should turn the tide and start producing more cash than it consumes within the next couple of years, generating tons of eyeball-magnet content along the way.
Unheralded COVID-19 fallout
At the end of 2019, Netflix listed $4.75 billion of assets tied into content production, 44% above the year-ago reading. Aiming further ahead, content assets in development and pre-production more than doubled to $668 million.
That's Netflix's ambitious production schedule in full flight. The company is producing billions of dollars' worth of the content that will keep consumers tuning in over the next few years, and the cash investments are only growing larger over time.
And then, the coronavirus came along.
The global health crisis helps Netflix add more subscribers and build a stronger sense of brand loyalty during this lockdown era, but the virus has also slammed the brakes on the company's content production efforts. The sound stages started shutting down in mid-March, just a couple of weeks before the end of Netflix's fiscal first quarter, and have now effectively ground to a complete standstill. Actors and stunt teams aren't working in order to slow the disease's spread and protect everyone involved. Some work can continue behind the scenes, with writers, digital special effects teams, etc. carrying on from the comfort of their own homes, but the whole production schedule is essentially paused.
This won't show up in the nitty-gritty numbers of the first-quarter results but you better believe that Netflix CEO Reed Hastings and content guru Ted Sarandos will talk about it on the earnings call. This snag undermines the positive coronavirus effects by slowing down the company's all-important content creation plans, and you should expect Netflix to save a lot of content-creation cash as long as the coronavirus shutdowns are in effect.
Tune in for cash flow details on Tuesday
Netflix will try to make up for the lost time by accelerating its cash investments as soon as possible, but there are only so many hours in the day and nobody knows when the COVID-19 containment efforts will allow the company's return to original content production. Management's official guidance currently points to negative free cash flow of approximately $2.5 billion in 2020. You should expect a significant portion of the content-producing cash costs to slide over into 2021, moving Netflix closer to break-even cash profits. Ripple effects and adjustments will follow next year, and I can't wait to see exactly how these balance shifts will affect both cash flow and subscriber additions in the long run.
Value mavens and growth investors alike often rely on cash flow as a measure of investor value, so any drastic changes to either near-or long-term cash flow trends should move Netflix's stock price at least as strongly as those much-watched subscriber addition metrics do. I, for one, will gladly pause my Tiger King binge to focus on Netflix's cash flow guidance on Tuesday.