Netflix announced its intention to raise approximately $2.0 billion senior unsecured debt notes in two series, one U.S. dollar denominated and one Euro denominated. This upcoming raise will add to Netflix’s existing long-term debt of $8.3 billion as of September 30, 2018.
It is an opportunity to revisit another observation from the Devoncroft Summit | Amsterdam: Netflix’s strategic use of debt financing highlights the value of its enviable global media supply chain.
Let’s start with a brief review of the figures. I referenced the below slide (updated for Q3 results) at the Devoncroft Summit | Amsterdam. It plots the aggregate debt balance of Netflix at year-end (blue bars), the effective interest rate paid on the debt (red line), and the ratio of the debt balance to Netflix’s equity market value (shares outstanding times share price).
The aggregate debt balance is the usual talking point in media reports, but debt levels should be evaluated in the context of the overall business and the actual usage of the funds raised. I view the interest rate demanded by the market as the best arbitrator of a given Company’s financing circumstances. In the case of Netflix, the effective interest rate paid on its debt has declined with the growth of its debt balance. This is explained by a general decline in market interest rate levels and the tremendous performance of Netflix’s business over the same time frame.
For the announced $2.0 billion fundraising, the specifics of the note issuance are the subject of an upcoming negotiation with the debt purchasers. A good reference point for potential terms are the most recent USD and Euro denominated debt offerings by Netflix. An April 2018 USD $1.9 billion raise yielded a ten year maturity at a 5.875% annual interest rate. Euro interest rates are even more appealing given current market conditions. Netflix raised €1.3 billion in May 2017 at 3.625% annual interest for ten years.
The inclusion of the debt-to-equity ratio in the above chart is inspired from the following excerpt of Netflix’s Q4 2017 Letter to Shareholders,
“We anticipate continuing to raise capital in the high yield market…We are striving to make the right choices and investments to grow the value of the firm, and that is what also ultimately secures our debt. High yield has rarely seen an equity cushion so thick.”
I tend not to subscribe to this view of framing debt levels as reasonable given equity value levels. Equity value (and really valuations) are subject to constant market volatility. More compelling is management’s point on investments growing the value of the firm. Stated as a question, are the funds raised from debt offerings being reinvested in such a way to substantially grow the equity value of the firm?
To make the above more explicit, consider that Netflix’s debt offerings are needed to fund cash losses in operation. For the nine months ending September 30, 2018 this loss was $1.4 billion. Those losses are driven by a $9.2 billion cash outlay (over the same period) to add to Netflix’s content library, which exceeds the amortized level of content assets (this is what is recognized in the income statement) by $3.7 billion. So the debt funding is being used to drive investments in content.
A discussion of negative cash flows at this level is discomforting. However, given the above relationship, the debt liability is turned into a content asset. Then – and this is rhetorical – is the lifetime value of the content more valuable than the debt service? I will stop before offering an opinion on relative valuation, though the tremendous market valuation of Netflix is a vote in the affirmative.
The entire discussion above is needed to setup the value of Netflix’s digital supply chain. In many respects, the supply chain of Netflix simplifies the business to one of buying and marketing content. My above thought experiment is in fact only possible if Netflix has perfected all the steps between content and subscriber.
I attempted to sum up this observation at the Devoncroft Summit | Amsterdam with the below slide showing the mutual reinforcing properties of Netflix’s debt financing, content investments, supply chain, and equity valuation.
The European expansion of Netflix is a great example. My choice of the Netflix original Danish series The Rain is deliberate. It was released in 2018. Recall my earlier mention of Netflix’s May 2017 debt issuance of €1.3 billion Euros. You raise money is Euros to spend money in Euros (though I recognize Denmark is not using the Euro, my point remains). The Rain is filmed in Danish. According to Wikipedia, there are only 5.5 million native Danish speakers in the world – that is a limited business opportunity. The supply chain of Netflix manages the dubbing (available in English), additional of subtitles, and distribution to a both pan-European as well as a global audience.
Netflix’s has built a European supply chain allowing for distribution across 14 languages and 41 countries. The below slide illustrates this supply chain. The quote from Netflix’s then VP Digital Supply Chain, Kevin McEntee is dated December 2012. It makes the same point I am now making six years later: supply chain enables content spending. The background to the statement is the launch of Netflix in Denmark, Norway, Sweden, and Finland in October 2012 necessitating a review of how content is prepared and delivered by European studios to Netflix.
Netflix has made similar statements on the importance of supply chain to the industry community, and it has been making them for some time. Netflix’s Global Director of Post Production Partnerships and Integrations, Chris Fetner gave the keynote to the 2014 SMPTE conference. Chris advocated for the broader adoption of IMF for content distribution as a mechanism for reducing redelivery rates to Netflix. Netflix has continued its advocacy for the adoption of IMF. “If not a cure for versionitis, we’re hoping that IMF will at least provide some relief from this pernicious condition” offered a 2016 Netflix blog post.
As with other recent posts, please note I am using Netflix as a visible case study to support a much broader statement about the value of supply chain in the global media industry. The observation extends to showcase the value of technology investment in the media industry, though this is a discussion for another day. We will revisit this topic in subsequent posts, so please register to receive announcements on articles.
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