Is Netflix on the Edge of Financial Disruption?
Monday’s news that Netflix’s long-serving CFO David Wells was stepping down from his position, has once again made the company’s financial operations the centre of attention. Wells's tenure oversaw an unprecedented level of debt issuance by the company with $8.4 billion of corporate debt currently being serviced at a weighted average coupon (interest payable to the bondholders) rate of 5.1%. In the first half of 2018, Netflix spent $182.8 million paying interest on its bonds – this is a 257.5% increase on the $80 million it spent on interest expense in the first half of 2016.
For a company which currently operates on an 8.9% profit margin and amortises content—its biggest single operational expense, a 257% increase in debt-servicing costs has a material impact on the evolving operational cost structure for the business. Currently, Netflix has $18.2 billion in streaming content payment obligations. Last month’s Q2 Netflix taper tantrum by Wall Street investors,which knocked $9.1 billon off its market cap, underlined just how fickle the financial markets are and how quickly speculators in fashionable stocks are prone to catch flight when results do not match the inflated expectations of short-termist investors.
How will Netflix manage the turn in the credit cycle?
Netflix and its fellow FAANG companies (Facebook, Amazon, Apple, and Google) have all benefited from being public at a time of historic low interest rates. This, along with an unprecedented injection of cheap money into the developed economies by central banks through quantitative easing (where central banks have created money to be utilised to buy up corporate bonds, and in Japan’s case to directly buy up equities), has led to a boom in the value of equity markets. This month it will culminate in the longest-ever US bull market run of 10 years. The FAANGs have seen this cheap money raise their market capital exponentially, dovetailing with their disruptive business practices, to create a self-perpetuating tech bull market.
However, all good things must come to an end, and the macro-credit cycle is now ending for the era of cheap money. Since 2015, the US Federal Reserve has raised interest rates seven times and has also now committed to rolling back its quantitative easing programme.
How will Netflix’s business model work in a high interest rate environment?
So far Netflix is keeping up with its debt obligations, as its topline revenue growth between H1 2016 and H1 2018 increased 187%. Its H1 operating margin increased from 1.7% in H1 2016 to 8.9% in H1 2018. However, if the current US interest rates rise from 2% to a historic norm of 4%, where it was merely 10 years ago, then the cost of borrowing doubles for Netflix as all associated interested costs rise in tandem.
If that happens, then Netflix faces additional pressures on its already delicately balanced financial foundations.