Netflix (NASDAQ:NFLX) has become one of the best-performing communication stocks of the last decade. As the pioneer of streaming media, the company has grown its subscriber base and revenue at astounding rates.
At the same time, rising costs have placed increasing pressure on the company's bottom line. Although the COVID-19 pandemic and its effect on operations may offer some reprieve, the high cost of content production could ultimately pose a threat to the Netflix growth story.
The Netflix conundrum
Netflix established itself by pioneering changes in the way the public consumes media. Its rise first destroyed the video rental industry. More recently, with a continuing cord-cutting trend, it has likely caused irreparable damage to the cable and satellite TV industries as well.
However, with these changes in the media landscape, virtually all of Netflix's peers have switched to streaming as well. Now, competitors such as Amazon, AT&T, Comcast, Disney, and many others have offered competing streaming services, often at lower subscription prices. This has increased Netflix's need for premium content while limiting its ability to raise rates. Nonetheless, Netflix stock has continued its march higher.
Netflix and net income
However, this situation has led to an unfortunate result: Netflix is only profitable from a certain point of view. Yes, in the most recent quarter, it reported earnings of $709.07 million, or $1.57 per diluted share.
However, the 2019 financial statements appear to show a discrepancy. Netflix claims that it spent about $15 billion on content in 2019. But the total cost of producing and distributing products and services at Netflix comes in at just over $12.44 billion. The company claims that content costs make up the "vast majority" of the cost of revenue.
Still, this discrepancy can only mean two things -- either Netflix did not actually spend $15 billion on content, or they did not account for their entire content cost in the cost of revenue statement.
Also, assuming the cost of revenue was exclusively content, it would leave a shortfall of approximately $2.56 billion. This is more than the net income of just under $1.87 billion that the company reported in 2019.
Hence, it is likely Netflix gets this money by compromising its balance sheet. Long-term debt rose by more than $3.81 billion in 2019. This follows a pattern of steadily rising debt, which peaked at over $14.76 billion at the end of 2019. This is a massive increase from the $2.37 billion in debt the company held in 2015. Also, with just over $7.58 billion left over after subtracting liabilities from assets at the end of 2019, it shows how much pressure the debt load places on Netflix.
Moreover, if subtracting the reported net income from the increase in long-term debt, that amounts to a net loss of more than $2.53 billion for fiscal 2019, about $5.60 per diluted share.
COVID-19 and Netflix stock
However, COVID-19 may bring a true company profit. Thanks to production shutdowns, content spending should see a dramatic decline.
These effects may have already appeared. For the first quarter of 2020, the level of long-term debt fell by $588.57 million. Such a level of debt decline is unusual for a company that has steadily increased borrowing since 2016 to fund its ballooning content budgets.
Also, free cash flow came in at a positive $161.61 million for the most recent quarter. Some believe more permanent positive cash flows are "closer than you think." However, free cash flow for 2019 came in at a negative $3.27 billion. Free cash flow could easily turn negative again once production resumes.
Netflix investors and the next earnings report
Consequently, when Netflix releases second-quarter earnings in July, investors need to look at free cash flow and two other metrics. They should also look at the cost of revenue to see if that also falls. If this declines on a sequential basis, it could signal a reprieve for the company's financials.
Also, investors need to watch long-term debt levels. Less debt would indicate that the company has moved to shore up the balance sheet.
Still, while lower content costs could temporarily bring true profits and positive cash flows, production will have to resume at some point. Unless the company can find a way to earn a profit without increasing debt, it could face a day of reckoning that will ultimately cripple Netflix stock.