Original content has played a big part in Netflix's (NASDAQ:NFLX) growth lately. Launched in 2012, the strategy that yielded House of Cards and Orange Is the New Black brought a few quick media-buzz wins including Emmy, Golden Globe, and Academy Award nominations.
But the original programming benefits aren't limited to Hollywood bragging rights. These shows are attracting new subscribers and keeping existing members engaged, all while logging some of the best viewing metrics in Netflix's content library. Meanwhile, the move into developing original shows has boosted the value of the brand and the service in the eyes of consumers.
So, why did the credit rating firm Moody's cite originals as a key reason to downgrade Netflix's debt rating last week thanks to a "materially" increased risk profile?
The short answer is: It's all about the money.
Follow the cash
Original series aren't funded in the same way as licensed shows, the key difference being that they require more upfront cash. Licensed programming gets expensed more-or-less evenly over the period it's available to stream. But more of the cost for original content comes out at the beginning of its run. It's an accounting difference that has major financial implications.
Because Netflix has been boosting its spending on originals relative to licensed content, the shows are becoming a bigger drag on cash flow. In fact, free cash flow just recently dipped into negative territory for the first time.
In a note explaining last week's debt downgrade, Moody's said the growing bet on originals promises to keep things that way. Moody's sees "persistent and significantly higher negative free cash flows going forward." And thanks to the debt needed to fund the shows (Netflix is directing most of its profits into its international expansion), Moody's sees debt leverage nearly tripling by 2016 -- to as high as six times adjusted earnings, from the 2.3 times the level it was at recently.
Netflix's management explained as much in their fourth-quarter shareholder letter, saying, "We will continue to grow the percentage of our content spending dedicated to originals for the next several years. This will mean more cash usage, which means more debt."
A worthwhile risk
However, CEO Reed Hastings said something else in the shareholder letter that I think should give investors more confidence that this is a risk worth taking. "Our originals cost us less money, relative to our viewing metrics, than most of our licensed content," according to Hastings.
In other words, even ignoring the touchy-feely stuff like branding, marketing, and media buzz, original shows provide a better return with respect to subscriber engagement than licensed shows do. That makes additional spending on originals a no-brainer.
Ideally, Netflix would be able to fund its exclusive programming entirely through its own profits and not take on more debt. However, the company has two huge opportunities ahead of it right now: expanding internationally and growing its original content library. In that scenario, it's understandable that management would aim to commit major resources to both of these opportunities at the same time, even if it will likely require a higher debt burden through 2016.
Demitrios Kalogeropoulos owns shares of Netflix. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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